1. The international spillover of fiscal spending on financial variables Isabel Vansteenkiste DNB/IMF workshop on Preventing and Correcting Macroeconomic Imbalances in the Euro Area, Amsterdam 14 October 2011

2. Outline 1.Introduction and review of the literature 2.The model 3.The data 4.The estimation results a)The impact of a shock to government consumption on government bond yields b)The impact of a shock to government bond yields on corporate bond yields c)The impact of a shocks to government consumption on equity prices 4.Conclusion 2

3. Introduction and review of the literature Potential spillovers from fiscal expansion and exit strategies are high on the agenda of international policy discussions Theoretical literature: domestic fiscal policy can have international implications, however final effect unclear  2 country Mundell-Fleming framework: debt financed spending bids interest rate up  Frenkel and Razin (1992): introduction of intertemp. budget constraint and gov. spending entering the utility function separably, interest rate movement depends on marginal savings propensity of domestic and foreign agents. Empirical literature: few studies  Main focus on the real side international implications of fiscal spending shocks.  Analysis focussed on the earlier years of the monetary union. 3

4. Introduction and review of the literature Our approach: empirical GVAR model Expand the time variables of interest, country scope and time span  Six variables: fiscal spending, real GDP, inflation, equity prices, government bond yields and corporate bond yields  Country selection: G7 (excl. Canada), Spain and Sweden.  Quarterly data: 1980Q1-2008Q4 4

5. The model GVAR akin to Dees, di Mauro, Pesaran and Smith (2007) and Pesaran, Schuermann and Weiner (2004) Individual country-specific VECMs are estimated in which country- specific variables are related to corresponding country-specific weighted average of other countries’ variables + deterministic variables 5

6. The data Fiscal spending, real GDP, inflation, equity prices, government bond yields and corporate bond yields – 1980Q1 to 2008Q4.  Real GDP/Inflation: national sources  Fiscal spending: national accounts real government spending (national sources)  Equity prices: MSCI share price index with net dividend, in local currency (Haver Analytics)  Government bond yield: 10-year benchmark yield (national central banks)  Corporate bond yield: Long term corporate bond yield of investment grade corporates (AAA to BBB) (global financial database) Foreign variables weighted using trade weights (export plus import) for period 2000-2008 from IMF DOTS 6

7. The data Correlation between each variable and country-specific foreign counterpart: 7

8. Model testing Integration properties of the series: series I(1) with few exceptions Rank of cointegration space (trace test statistics):  Japan, Sweden, UK: 2 cointegrating relationships  Italy and Spain: 3 cointegrating relationships  France, Germany and United States: 4 cointegrating relationships Testing weak exogeneity of country specific foreign variables 8

9. Estimation results Contemporaneous effects of country-specific foreign variables on their domestic counterparts 9

10. Estimation results Generalised impulse response functions (Pesaran and Shin, 1998)  The impact of a shock to government consumption on government bond yields  The impact of a shock to government bond yields on corporate bond yields  The impact of a shocks to government consumption on equity prices 10

11. Shock to government consumption: impact on government bond yields Domestic bond yield response  Positive and statistically significant  Response grows and peaks after around 3-5 quarters (except IT)  Largest response: ES (20 bp), weakest response: IT (8 bp) 11

12. Shock to government consumption: impact on government bond yields Spillovers – 2 distinct groups  US/DE/UK: countries with a large, liquid financial sector and fiscal policy perceived to be sustainable (over sample period) → risk free government bond market  Impact positive and statistically significant  Fiscal spending shocks lead to an increase in global interest rates  Size: 4 bp at peak  ES/IT: Peripheral countries  Impact of a shock on DE/US/UK government bond yields negative and statistically significant (at peak 2-5 bps)  Impact on other peripheral countries government bond yields positive and statistically significant (at peak) 6-10 bps 12

13. Shock to government consumption: impact on government bond yields Germany United States 13

14. Shock to government consumption: impact on government bond yields Italy Spain 14

15. Shock to government bond yield: impact on corporate bond yield Domestic corporate bond yield response  Positive and statistically significant  US/ES: responses peaks instantaneously while in DE/IT it peaks after 2-8 quarters  Response ranges at peak between 13 and 49 bps 15

16. Shock to government bond yield: impact on corporate bond yield Spillovers – 2 distinct groups  US/DE/UK: countries with a large, liquid financial sector and fiscal policy perceived to be sustainable (over sample period) → risk free government bond market  Impact positive and statistically significant  Instantaneous spillover of 10 bps  ES/IT: Peripheral countries  Insignificant results for other countries 16

17. Shock to government bond yield: impact on corporate bond yield Germany United States 17

18. Shock to government bond yield: impact on corporate bond yield Italy Spain 18

19. Shock to government consumption: impact on equity prices Theory/other empirical studies: impact unclear  Keynesian effects could boost consumption/growth and created better earnings expectations  Government budget deficits may exert upward pressure on nominal interest rates and hence lower equity prices  Permanent substantial increases in government debt may signal unsound fiscal behaviour and lower equity prices 19

20. Shock to government consumption: impact on equity prices 2 distinct groups  US/DE/UK: countries with a large, liquid financial sector and fiscal policy perceived to be sustainable (over sample period) → risk free government bond market  Domestic impact positive and statistically significant (at peak US:+2.5%; DE: +4%)  Spillovers positive but not statistically significant  ES/IT: Peripheral countries  Domestic impact negative and statistically significant (at peak IT: -1%, ES:-5%)  Spillovers small and insignificant 20

21. Shock to government consumption: impact on equity prices Germany United States 21

22. Shock to government consumption: impact on equity prices Italy Spain 22

23. Conclusions Empirical (non structural) approach to analyse the international spillover effects of fiscal shocks  Focus: impact of fiscal spending shocks on financial variables  Methodology: GVAR, 6 variables, 8 countries, 1980Q1-2008Q4 Main findings  Fiscal policy of large countries with perceived risk free government bonds matter not only domestically but also internationally  Safe haven countries benefit from lax fiscal policies in other countries since their government and corporate bond yields go down while equity prices go up  Importance of responsible policy conduct of safe haven (anchor) countries  Peripheral countries are punished for lax fiscal policy, moreover they punish other peripheral countries 23