The international spillover of fiscal spending on financial

variables

Isabel VansteenkisteDNB/IMF workshop on Preventing and Correcting

Macroeconomic Imbalances in the Euro Area, Amsterdam

14 October 201114 October 2011

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

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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.

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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

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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

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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

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The data

• Correlation between each variable and country-specific foreign counterpart:

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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

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Estimation results

• Contemporaneous effects of country-specific foreign variables on their domestic counterparts

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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

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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)

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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

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Shock to government consumption: impact on government bond yields

• Germany

• United States

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Shock to government consumption: impact on government bond yields

• Italy

• Spain

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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

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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

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Shock to government bond yield: impact on corporate bond yield

• Germany

• United States

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Shock to government bond yield: impact on corporate bond yield

• Italy

• Spain

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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

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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

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Shock to government consumption: impact on equity prices

• Germany

• United States

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Shock to government consumption: impact on equity prices

• Italy

• Spain

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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

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