Demand for Sovereign Bonds in the Periphery: A Regime-Switching Approach

Abstract

The rise in sovereign bond holdings in stress countries could deepen a recession by allocating resources away from the private sector. Our paper investigates whether the demand function for sovereign bonds changed in the crisis period and the causes of such a change. We show that it did, and that bond holdings rose more than they would have in normal times given a set of fundamentals. However, we find this happened only for a short span of time, and similar behavior by OFIs suggests that the 0 risk weight on sovereign bond holdings was not the cause. Instead, sovereign stress is the likely driver: policies aimed at lowering the sovereign-bank nexus should target sovereign stress.

Keywords: sovereign bonds, financial crisis, banks, investment, eurozone

JEL Classification: F32, F34, F36, F41, F43, F44, F65, G15