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With European Monetary Union (EMU), there was an increase in the adjusted spreads of euro-area sovereign securities over Germany (corrected from the foreign exchange risk), causing a lower than expected fall in borrowing costs. The objective of this paper is to study the reasons for this increase, and in particular, whether the change in the price assigned by markets was due to domestic factors (credit risk and/or market liquidity) or to international risk factors. The empirical evidence suggests that it may have been a change in the market assessment of domestic (both liquidity and default risk) rather than international factors that caused the observed increase in adjusted spreads with Monetary Integration, even though, since market size scale economies have increased since EMU, their effect differs according to the size of the market.

European Monetary Union (EMU) caused large-scale changes in euro-area sovereign securities markets (see Danthine et al., 2001 and BIS Study group on fixed income markets, 2001). Before the introduction of the euro, yield differentials between European sovereign borrowers were mostly determined by four factors: expectations of exchange rate fluctuations, differences in domestic tax-regimes, differences in credit risk, and differences in market liquidity. The removal of foreign exchange risk in January 1999 and the elimination (or reduction to insignificant levels) of differences in tax treatment during the 1990s eliminated two of these factors, and paved the way for a much more integrated and competitive public debt market. As a result, euro-area government bond markets began to be considered as a single market, comparable in terms of size to the US or Japanese markets. Nevertheless, segmentation did not disappear completely. In 2006, public debt management is still decentralised under the responsibility of 12 sovereign issuers with differences in rating and a variety of issuing techniques (see Favero et al., 1999). These are features that distinguish the euro-area debt market from its US and Japanese counterparts. One example of this segmentation is the persistence of yield differentials. This paper sets out to examine this persistence and to explore what happened to euro-area countries' yield spreads on government bonds after the introduction of the euro. The pre-EMU literature speculated that with the elimination of currency risk, yield spreads would narrow and would primarily reflect default risk. Conversely, market participants and member state debt managers appeared to believe that EMU yield differentials would be due mostly to liquidity factors. Therefore, in order to reduce borrowing costs, debt managers introduced substantial innovations that were expected to enhance the liquidity of their bonds. Actually, the main effects of the introduction of the euro in government bond markets were on the one hand, an increase in the degree of substitutability among securities issued by different treasuries and higher levels of competition between issuers to attract investors, which led to a certain reorganisation of the market structure, and on the other, a gain in the importance of credit risk and market liquidity in yield differentials. Before Monetary Union differences in these factors were perhaps not completely priced due to market segmentation.1 Therefore, a first point that will be assessed in this paper is whether EMU has increased credit risk by denying governments the emergency exit of money creation and by forbidding both the ECB and the EU to bail-out troubled governments; or whether, conversely, the maximum threshold that countries have for both their budget deficit and their level of public indebtedness (resulting in broad improvements in budgetary balances) and the possibility that markets do not regard the “no-bail-out” clause as credible, especially in the case of large markets (i.e. that the theory “too big to fail” holds), have actually resulted in a decrease in perceived credit risk. Secondly, the introduction of the euro reduced segmentation among euro-area government bond markets. The removal of the exchange rate risk brought down an important barrier that had fostered captive domestic markets and had gone some way to explaining the home bias that existed in cross-border investments in the European Union. Adjaouté et al. (2000) traced the extent of the home bias, in both the bond and equities markets, for the major European countries – the UK, France, Germany, Spain, the Netherlands, and Italy – during the period 1980–1999.2 The increased substitutability of sovereign securities after EMU intensified the rivalry between sovereign issuers to attract investors, since they were competing directly for the same pool of funding. In this new scenario, market liquidity differences may have become a more significant component of yield spreads. This is the second point that will be assessed in this study. Nevertheless, as the literature on this topic is limited, the analysis will also build on findings in the empirical literature regarding sovereign bond yield spreads on emerging markets, which have suggested that spreads are also sensitive to international risk factors, mainly US risk factors and interest rates (see Codogno et al., 2003).3 The analysis in this paper will then be threefold: first, we break down the European yield spreads into their two main domestic components (market liquidity and credit risk differences) which remained after the removal of currency risk. Second, we examine whether there was a change in the price assigned to them by markets after the introduction of the euro which might explain the yield spread behaviour observed. Third, we will examine the effects of international risk factors on yield differentials. The main goal of the analysis will be to identify the possible factors behind the observed average increase of 11.98 basis points in yield spreads during the first three years of Monetary Union, once they are corrected from the exchange rate factor (following Favero et al., 1997 we will correct pre-EMU spreads by estimating the foreign exchange factor as the differential between the 10-year swap rate in the currency of denomination of the bond and the 10-year swap rate in Deutsche marks). The sample is composed of daily data from January 1996 to December 2001 (therefore, the same time interval – three years – will be considered for both pre-EMU and EMU periods) and includes all EMU countries except Luxembourg (whose public debt market is negligible), and Greece (which did not join Monetary Union until January 2001). We will present the results of four different specifications: (I) a static panel regression, (II) a dynamic panel regression, (III) a static regression for each individual country, and (IV) a dynamic regression for every individual country, with the same explanatory variables in all four.4 The relative debt-to-GDP ratio will be used to identify differences in default risk, while two different variables will be used to capture market liquidity: the bid/ask spread (a proxy of market tightness) and on-the-run/off-the-run differentials (a complementary measure of market liquidity). Finally, the spread between 10-year fixed interest rates on US swaps and the yield on 10-year Moody's Seasoned AAA US corporate bonds is introduced in the model as a proxy of international risk factors. To the best of our knowledge, no empirical analysis to date has used a daily dataset for two of the most important measures of liquidity, the bid/ask spreads and on-the run/off-the run yield differentials, corresponding to the trading activity in the whole of the euro-securities market. The results of all the specifications are highly consistent, providing evidence that market size scale economies increased with Currency Union and that the rise was higher in smaller debt markets. A change in the market assessment of domestic (both liquidity and default risk) rather than international factors (which would play a smaller role) might be behind the observed increase in adjusted spreads with Monetary Integration, even though their effect varies according to market size. Hence, the empirical evidence suggests that the removal of the exchange rate barrier has penalised small markets, not only because they are potentially more illiquid, but also because after EMU the “too big to fail” theory seems to hold: that is, the smaller the market, the higher the credibility of the “no-bail-out” rule. So, in the current context of increased competition between euro-area government securities markets, their relative success might be dependent on their size. The rest of the paper is organised as follows: Section 2 explains the foreign exchange correction applied in the pre-EMU period. Section 3 outlines evidence concerning Monetary Integration in Europe and the evolution of the relative cost of borrowing. Section 4 focuses on the various domestic and international factors to which adjusted spreads might be sensitive, and describes the data. Section 5 explains the models and estimation methodology. Section 6 reports the results. Lastly, Section 7 draws conclusions.

Euro-area countries’ adjusted spreads over 10-year German securities experienced an average rise of 11.98 basis points in the first three years of Monetary Union. This resulted in a lower than expected decrease in the costs of borrowing (which actually increased in the case of Austria, Belgium, France and the Netherlands). Therefore, changes either in domestic risk factors (market liquidity and/or credit risk), in international risk factors or in their market pricing may have occurred with EMU. The results of all specifications are highly consistent; they provide evidence that market size scale economies seem to have increased with Currency Union and that the smaller the debt market, the higher the rise. Specifically, a change in the market assessment of domestic(both liquidity and default risk) rather than international factors (which would only play a smaller role) might be behind the increase observed in adjusted spreads with Monetary Inte- gration, even though the effect differs according to the size of the market. 21 Therefore, the removal of the exchange rate barrier seems to have punished smaller countries twice (they are forced to compete in terms of liquidity with larger countries for the same pool of funding, only being able to offer smaller bond issues), by making them pay both higher liquidity and a higher default risk premium than larger ones. This empirical evidence is also in concordance with the fact that the three countries that account for around 59% of the euro-area government securities markets (Italy, France and Spain) are precisely the ones with lowest adjusted spread rise since Monetary Integration (see Tables 1a and 1b ). As mentioned, international risk factors appear less significant than local ones in explaining adjusted spread changes. In addition, default risk only seems to be relevant when it is accom- panied by a small market size. These results then show that the theory ‘‘too big to fail’’ holds: it is expected that large countries will receive financial support in case of fiscal distress (bail-out). This explains why the default risk premium has decreased for some big countries since EMU. In small countries, on the other hand, markets expect that the ‘‘no-bail-out’’ clause will hold, and membership of the monetary union has increased the default risk since these countries have lost monetary authority. In Italy, for instance, in spite of its very high debt-to-GDP ratio, the associated default risk might be compensated by both the increased liquidity characteristic of a big market and the lack of credibility of the no-bail-out clause. Finally, these results reinforce the self-fulfilling nature of market liquidity. Both in the case of the smallest or the largest debt markets, illiquidity or liquidity presents a non-linear behav- iour that supports the idea that traders’ transactions flee from illiquid to liquid debt markets. So, the more liquid (illiquid) a market is, the more traders want (do not want) to participate in it, resulting in an increase (decrease) in the liquidity of the market. In particular, as the German sovereign debt market is the second-biggest in the euro-area (only surpassed by the Italian), both a concentration of trading activity and a drop in the credibility of the ‘‘no-bail-out’’ rule might have occurred in the German market. Consequently, wider liquidity and perceived default risk differences vis-a ` -vis German bonds might have been transformed into higher adjusted spreads. To conclude, with the introduction of a common currency and in the current context of higher competition between euro-area government securities markets, the success of euro- area sovereign securities debt markets may be highly dependent on their market size.