This paper analyzes the prospects for Eurobonds by examining the determinants of interest rate differentials between Eurozone member states. It finds that default risk is the main driver of spreads, while liquidity benefits of Eurobonds would be small. Insuring weaker member states' default risk is costly for stronger states. The paper argues for conditional Eurobonds with reinforced fiscal rules and equitable risk sharing to increase integration and sustainability in the Eurozone.

1. Sovereign spreads
CARLO FAVERO AND ALESSANDRO MISALE

2. Main point
•Analyzing what the main prospects for Eurobonds are.

3. Methods
•First find the determinants of interest-rate differentials between Eurozone
Member States in order to provide the relevant stylized facts on the relative
importance of liquidity and default risk.
•Second focussing on arguments for and against Eurobonds, based on their
effects on default risk and its redistribution across participating issuers.

4. Conclusions of the paper
•Default risk is the main driver of interest-rate differentials, the efficiency gains from greater
liquidity appear to be small and appealing only to small safe issuers.
•Insuring the default risk of Member States with weaker fundamentals is not without costs for
safer Member States.
•Fiscal fundamentals seem to matter in the pricing of credit risk as they determine the sensitivity
of domestic yield spreads to other countries’ spreads.
•Sovereign yield spreads are significantly affected by market sentiment and contagion.
•The impact of this global risk variable is not constant over time, a clear sign of contagion.

5. Arguments and advice policy makers
•Reinforced surveillance and credible fiscal rules to avoid moral hazard and
increase austerity.
•Designed for equitable sharing in costs and benefits
•Strongly in favour conditional Eurobonds
•To have a sustainable Eurozone we need to have more integration between EMU
member States. I believe this paper does well in grasping the most important
points, why this should happen.

6. Unclear aspects
•When markets perceive a higher risk the yield spreads increase. The risk on both
bonds are both perceived higher. Is the spread purely a result of a longer term
inverstment?