Debt managers' reaction to sovereign risk in the euro area: Evidence and policy implications

When sovereign spreads increase, debt managers in the euro area face a funding dilemma. They can either issue more short-term debt, thereby increasing roll-over risk, or issue long-term debt at higher borrowing costs. The latter choice may threaten debt sustainability. Using a sample of monthly data for 10 countries in the euro area, we measure how the share of short-term debt issuance reacts to bond yields, term spreads, default spreads, and money market spreads. We find that sovereign risk is a significant variable in debt reaction functions: higher default spreads increase the reliance on short-term funding, making the euro area more prone to funding crises in individual member states. As a solution to this problem, we discuss a proposal for an interest stabilization mechanism. By providing conditional interest subsidies to distressed countries, such a mechanism can maintain market access and avoid bad bond market equilibria. It will reduce the incentive of debt managers to shorten the maturity structure of public debt and thereby make the euro area less fragile (JEL codes: E43, F45, and H63).