Modelling sovereign bond spreads in the euro area: a non-linear global VAR approach

Instability in the comovement among bond spreads in the euro area is an important feature for dynamic econometric modelling and forecasting. This chapter illustrates the properties of a non-linear GVAR approach to spreads in the euro area where the changing interdependence among these variables is modelled by making each country spread function of a global variable determined by fiscal fundamentals with a time-varying composition. The model naturally accommodates the possibility of multiple equilibria in the relation between default premia and local fiscal fundamentals. The estimation reveals a significant non-linear relation between spreads and fiscal fundamentals that generates time-varying impulse response of local spreads to shocks in other euro area countries spreads. The GVAR framework is then applied to the analysis of the dynamic effects of fiscal stabilization packages on the cost of government borrowing JEL Classification: C51, C58