16.1 Introduction

The recent economic crisis, triggered by problems in the subprime mortgage market in the USA, has hit economies around the world. Systemic banking fragility associated with the deterioration of the economic outlook and fiscal stimulus packages left behind quite fragile fiscal positions. The banking crisis has turned into a sovereign debt crisis. The details regarding the origins of the euro zone crisis are discussed in Chapter 3 by Durré and Smets. Here, we explore the fact that increases in countries' fiscal deficit and debt levels can bring an increased perception of sovereign risk. In the sovereign bond markets, this movement can cause higher yields on bonds of these countries to finance their debt.

Following Ang and Piazzesi (2003), we use an arbitrage-free affine term structure model to assess how European sovereign yield spreads (measured as the difference between the relevant countries' bond yield and Germany's bond yield) are affected by fiscal variables. The countries we study are Italy, Greece and Spain. We use monthly data from January 1999 to March 2010 for Italy and Spain, and from January 2001 to March 2010 for Greece. We also check how some of the results change when the sample is extended further, with the deepening of the debt crisis.

In the literature on the European sovereign bond market, the papers tackling the role of fiscal variables on bond yield spreads are not conclusive.