Yield Spreads and Optimal Public Debt Management under the Single Currency

By Lars Tyge Nielsen

In: European Capital Markets with a Single Currency, edited by J. Dermine and P. Hillion, Oxford University Press, 1999

Abstract

This paper examines the optimal management of the public debt of member countries of the future EMU and the determinants of the yield spreads on their government bonds. The budgetary discipline imposed by the EMU will lower the default risk and default premia on government bonds. We reject the argument that default risk and default premia will necessarily become more important because individual governments or central banks no longer have the possibility of printing money or devaluing their currency in order to service the debt. Individual countries will have incentives to issue combinations of euro denominated debt and non-euro denominated debt that differ from what is socially optimal for the Union. This leads to a need for a mechanism to coordinate the public debt management of member countries.