The international spillover of fiscal spending on financial variables

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

2. Outline • Introduction and review of the literature • The model • The data • The estimation results • 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 • 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