Money Market Integration and Sovereign CDS Spreads Dynamics in the New EU States

Mardi | 2011-02-08

Petar Chobanov – Amine LAHIANI – Nikolay NENOVSKY

Summary: When the first phase of the crisis focused primarily on the interbank market volatility, thesecond phase spread on the instability of public finance. Although the overall stance of public financesof the new members is better than the old member countries, the differences within the new group aresignificant (from the performer Estonia to the laggard Hungary). Sovereign CDS spreads have becomemajor variables focused on risks and expectations about the fiscal situation of different countries. Inthe paper we investigate, first, whether there is a link in the new member states (NMS) between theexpectations about the condition of their public finances and the dynamics of money markets,including integration of national money markets with the euro area. In others word we contribute toclarify the relationship between fiscal and liquidity risks as major components of systemic risk.Second, we look on the particularities of this relationship through the different phases of the crisis andacross the different countries using different monetary regimes. This concerns mostly two oppositeextreme monetary regimes, namely, currency boards (and quasi-fixed exchange rate) – Bulgaria,Estonia, Latvia, Lithuania, or inflation targeting – Poland, Czech Republic, Hungary and Romania.The results obtained form the high frequency panel data models support the theoretical hypotheses andpolicy intuition that exists strong relationship between the liquidity risk (measured by the short termmoney markets) and fiscal risk (measured by CDS) and that this link is extremely unstable and insome sense nonlinear during the financial crisis. Our study confirm that the strong link betweenmonetary and public finance risk as apart of total systemic risk increase during the crisis especially forcurrency boards regimes, when the link becomes stronger and pronounced. For the inflation targetingcountries the link became weaker and less pronounced.