Fiscal Discoveries and Yield Decouplings

41 Pages Posted: 1 Aug 2018

See all articles by Luis Catão

Luis Catão

International Monetary Fund (IMF)

Ana Fostel

University of Virginia

Romain Ranciere

International Monetary Fund (IMF)

Date Written: July 2017

Abstract

The recent Eurozone debt crisis has witnessed sharp decouplings in cross-country bond yields without commensurate shifts in relative fundamentals. We rationalize this phenomenon in a model wherein countries with different fundamentals are on different equilibrium paths all along, but which become discernible only during bad times. Key ingredients are cross-country differences in the volatility and persistence of fiscal revenue shocks combined with their unobservability by investors. Differences in the cyclicality of fiscal revenues affect the option value of borrowing and resulting default risk; unobservability of fiscal shocks makes bond pricing responsive to market actions. When tax revenues are hit by common positive shocks, no country increases net debt and interest spreads stay put. When a common negative revenue shock hits and is persistent, low volatility countries with higher default costs adjust spending, while others resort to borrowing. This difference signals a relative deterioration of fiscal outlooks, interest spreads jump and decoupling takes place.

Keywords: E62, F34, G15, H3

Suggested Citation

Catão, Luis and Fostel, Ana and Ranciere, Romain, Fiscal Discoveries and Yield Decouplings (July 2017). IMF Economic Review, Vol. 65, Issue 4, 2017. Available at SSRN: https://ssrn.com/abstract=3224359 or http://dx.doi.org/10.1057/s41308-016-0027-8

Luis Catão (Contact Author)

International Monetary Fund (IMF) ( email )

700 19th Street NW
Washington, DC 20431
United States

Ana Fostel

University of Virginia ( email )

1400 University Ave
Charlottesville, VA 22903
United States

Romain Ranciere

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

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