Revisiting the link between government debt and sovereign interest rates in the euro area

This section explores the determinants of sovereign interest rate spreads of euro-area countries (in relation to Germany). It focuses on the role of fiscal, macroeconomic and institutional fundamentals, considering also some contextual factors such as global risk aversion and controlling for the influence of central banks’ asset purchases. Through extensive testing of various (fiscal) variables, interactions and non-linearities, the analysis confirms that sovereign spreads respond to fundamental variables, especially government debt, in non-linear fashion. The results also show that structural factors can largely mitigate the government debt impact on spreads, as the marginal effect of government debt on spreads would be close to zero in countries with the highest potential growth and strongest institutions. From a policy angle, the results remind us that, even in an environment of persistently low rates, governments with less solid fundamentals pay more than others to borrow and are exposed to higher risks. They highlight that policies reinforcing potential growth and government effectiveness can be expected to improve investors’ perception of sovereign risk and their forbearance of higher debt.