Determinants of sovereign bond yields: the role of fiscal and external imbalances

The rise in sovereign bond yields observed in the so-called “periphery”euro area countries from 2008 onwards can potentially be attributed to significant and rising levels of external government liabilities coupled with already high levels of public debt. The results of our estimations show that this combination of factors better explains the increase in risk premiums than fiscal variables alone. In particular, deterioration in net international investment positions to below a threshold of –50% of GDP most likely prompted an abrupt revision of market expectations. Investors appear to impose a greater penalty on countries with a “twin deficit”, that is countries with both fiscal and external deficits. One implication that can be derived from this is that periphery countries could reduce the risk premiums on their public debt by bringing their external balances back to more sustainable levels.