Increase in home bias in the Eurozone debt crisis: The role of domestic shocks

Abstract

Abstract:One of the most striking consequences of the recent episode of sovereign debt market stress in the Eurozone has been the increase in the share of public debt held by the domestic sector in fragile economies. However, the causes and potential consequences of this increase were only given scarce attention in the literature on the Euro area sovereign debt crisis. In order to fill this gap, we first identify the shocks that impact the variation in the share of sovereign debt held at home in an SVAR model on a sample of Eurozone countries between 2002 and 2014, distinguishing between external and domestic shocks. Thanks to several alternative tests, we show that home bias in sovereign debt responds positively to country-specific fundamentals and expectations shocks but we find no evidence that the increase in home bias is destabilizing per se in the short-run. Second, a stylized theoretical model backed by the empirical results predicts that the consequences for sovereign debt crisis depend on the relative impact of domestic initial destabilizing shocks and increased home bias. The analysis suggests that an increase in home bias in times of sovereign debt stress, despite reflecting deteriorating fiscal conditions, may make default less likely. Keywords:Eurozone, Sovereign debt crisis, Home bias, Bayesian panel SVAR JEL codes:Increase in home bias in the Eurozone debt crisis: the role of domestic shocks *Abstract: One of the most striking consequences of the recent episode of sovereign debt market stress in the Eurozone has been the increase in the share of public debt held by the domestic sector in fragile economies. However, the causes and potential consequences of this increase were only given scarce attention in the literature on the Euro area sovereign debt crisis. In order to fill this gap, we first identify the shocks that impact the variation in the share of sovereign debt held at home in an SVAR model on a sample of Eurozone countries between 2002 and 2014, distinguishing between external and domestic shocks. Thanks to several alternative tests, we show that home bias in sovereign debt responds positively to country-specific fundamentals and expectations shocks but we find no evidence that the increase in home bias is destabilizing per se in the short-run. Second, a stylized theoretical model backed by the empirical results predicts that the consequences for sovereign debt crisis depend on the relative impact of domestic initial destabilizing shocks and increased home bias. The analysis suggests that an increase in home bias in times of sovereign debt stress, despite reflecting deteriorating fiscal conditions, may make default less likely. JEL classification: E4, E5, F3, G15.Keywords: Eurozone, Sovereign debt crisis, Home bias, Bayesian panel SVAR. * We thank Stephan Sauer, Andrea Bonilla Bolaños, Aurélien Eyquem, Nicolas Houy, Bruno Ziliotto, as well as participants at the 11th Infiniti Conference, the 11th Macrofi workshop, the 2nd Finandebt Conference, the 63rd AFSE Conference and the 2nd Lyon-Tur...

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“…The results support the prediction of the theoretical model; that is, that the consequences of the sovereign debt crisis depend on initial domestic instability and the influence of increasing home bias. They also suggest that increasing home bias reflects worsening fiscal conditions under sovereign debt pressures but could also reduce the possibility of default because local companies prefer local resources [29]. Since asset markets are incomplete, the results also show a significant home bias for transnational transactions in the financial market.…”