William R. Emmons

English

Research Papers in Economics

Convergence in 
the Euro-zone?
During the three months leading up to the Jan. 1, 1999,
debut of the euro, market yield spreads between partici-
pating countries’government bonds and the German
benchmark government bond narrowed to 0.25 percent-
age points or less.  The top chart shows vanishing yield
spreads for the bonds of Italy, the Netherlands and France
relative to Germany, a phenomenon that was widely antic-
ipated.  By meeting the Maastricht criteria for economic
and fiscal convergence, the 11 participating countries had
provided a basis for financial-market convergence, as
well.  If investors continued to believe that the pre-exist-
ing currencies would remain locked together forever in
the form of the euro, then all exchange-rate risk premiums
should vanish from bond yields.  In recent months, how-
ever, yield spreads have increased.  Why?
Positive yield spreads between a euro-zone member
country’s sovereign debt and German bonds could be due
to any of several factors, including:  (1) differences in
market liquidity, (2) the risk of loss due to government
default on bond payments, or (3) the risk that a country
might leave the euro and devalue its new currency against
the currency of Germany.  Bond-market turbulence in the
fall of 1998 and ensuing flight to highly liquid securities,
such as German government bonds, clearly showed that
differences in market liquidity contribute to yield spreads.
The relative stability in the ranking of euro-zone mem-
bers’yield spreads over time suggests that country-specif-
ic default risk is probably another component of the
spread.  Finally, devaluation risk is a plausible contributor
to euro-zone yield spreads.  For example, market specula-
tion about Italy’s long-run suitability for monetary union
has caused periodic spikes in the Italian yield spread that
have no counterpart in, say, French yield spreads.
How important is membership in European monetary
union for maintaining low bond yields?  The bottom chart
shows that during 1999, the bond yield spreads (relative
to German government bonds) of two European Union
countries that are not currently participating in the mone-
tary union—the United Kingdom and Sweden—have
increased relative to the yield spread of Finland, a mone-
tary-union participant.  This suggests that countries firmly
entrenched in the monetary union benefit from the mar-
ket's view of the euro as a hard currency.
Persistent positive yield spreads against the German
bond across the euro-zone indicate, however, that, despite
initial “europhoria” at the outset of European monetary
union, true bond-market convergence has failed to occur.
Indeed, after six months, yield spreads on non-German
euro-zone benchmark bonds were slightly higher than
they were six months before monetary union took place.
—William R. Emmons
October 1999
MonetaryTrends
Views expressed do not necessarily reflect official positions of the Federal Reserve System.

Convergence in the Euro-zone?

http://research.stlouisfed.org/publications/mt/19991001/cover.pdf

Convergence in the Euro-zone?

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics