University of Groningen Financial markets: market Information, investment strategies and spillovers Dreher, Ferdinand Torin

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Financial markets: market Information, investment strategies and spillovers

Dreher, Ferdinand Torin

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Investment Strategies and Spillovers

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2019 Ferdinand Torin Dreher

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Investment Strategies and Spillovers

PhD Thesis

to obtain the degree of PhD at the University of Groningen

on the authority of the Rector Magniﬁcus, Prof. E. Sterken

and in accordance with

the decision by the College of Deans.

This thesis will be defended in public on Thursday 11 July 2019 at 16:15 hrs.

by

Ferdinand Torin Dreher

born on 5 September 1989 in Bad Soden, Germany

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Co-supervisor: Dr. J.P.A.M. Jacobs Assessment committee: Prof. A. Belke Prof. J.M. Berk Prof. P.C. Schotman

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Processed on: 4-6-2019 PDF page: 5PDF page: 5PDF page: 5PDF page: 5 Economics is a ﬁeld I kind of stumbled into. Learning about Ricardo and

Smith at school was the appetiser that got me curious, but at no point did I think I would continue with economics for this long. Eventually I almost stumbled into the PhD as well, albeit, at that point, with an ambition of ending up in a central bank. Now that I have reached this point I realise that a PhD has its ups and downs, but with the beneﬁt of hindsight I can also safely say that the experience, and university in general, has given me so much. It has been rewarding and about much more than economics. It has taught me to think critically and venture out looking for the explanation to the many things I don’t understand. Arriving at the end of this journey has required the support of many people and very few things seems more important than to reﬂect and acknowledge some of them.

First and foremost I would like to thank my supervisors, Jakob and Jan. Thank you for the trust you placed in me from the start. I always felt like you wanted me to be able to follow my own ambitions in achieving what I wanted from the PhD and I appreciate you allowing me to study a diverse range of academic questions. Jakob, I still remember the ﬁrst time we spoke, and that immediate feeling that coming to Groningen was a great idea. Your ability to often point me in the right direction when I hit a stumbling block has taught me to take a step back more often and re-evaluate. Jan, your attention to detail has been the perfect complement. I am immensely grateful for all the time you were happy to spend on drafts, econometrics or any other (last-minute) question. At the beginning you both told me that your supervisory styles complement each other, and I couldn’t agree with you more. My thanks also go to Professor Belke, Professor Berk and Professor Schotman for agreeing to read my thesis and providing me with valuable

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Processed on: 4-6-2019 PDF page: 6PDF page: 6PDF page: 6PDF page: 6 to think broadly. I have also beneﬁtted from helpful comments and guidance

from colleagues in GEM and EEF on several occasions. The Gemmies and SOM, in particular Arthur and Ellen, were also always there to help.

Esther, Tommy and Johannes, working with you on two of the chapters was rewarding, fun, supportive and motivating.

My time in Groningen would not have been the same without the PhD group in GEM. Maite and Stefan, I credit you both with helping me arrive in Groningen. You were the driving force behind a supportive and fun atmosphere in GEM that I loved every minute of. Aobo, Fred and Kailan, the general craziness in your oﬃce so often made the day. Nikos, your hospitality and kindness is something that also really stuck out. I would like to acknowledge many more of you, Timon, Daan, Johannes, Joeri and others more. I really appreciate the friendships, the community and our fun weekend trips. Kailan and Abdul, thank you for the very enjoyable times sharing an oﬃce. Sheridan, thank you for making life in the American South a fun experience.

Outside of university, I owe gratitude to friends with whom I have been blessed for multiple years now. Felix, our (and especially your) ability to uphold a strong friendship from afar has reassured me that pursuing my goals in a foreign country would never endanger my connection to home. In the same way, Sebastian, I am grateful to be leaving university with such a long-standing and immensely fun friendship reaching back to the beginning of primary school. Robin, thank you for our friendship, I will never forget it. Marcel, I feel like the years we studied together were probably the most insightful ones for me as a person - all the reﬂecting with you inspired me. Romina, thank you for understanding me, energising me, making me laugh and creating great memories with me. All of you are awesome.

Finally, I would like to thank my family. Mum and Dad, you supported me throughout, read many drafts, moved me and my belongings around Europe several times, and encouraged me to follow my aspirations, whatever they were. Alison, you have always been the ﬁrst person I’ve wanted to talk to. Thanks for cheering me up whenever needed and sharing your perspective with me - it is always the one that matters most.

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1 Introduction and overview 1

2 Constraining political budget cycles 15

2.1 Introduction . . . 15

2.2 Political budget cycles and their institutional constraints in the enlarged EU . . . 17

2.2.1 Political budget cycles . . . 17

2.2.2 Constraining political budget cycles: Media strength and ﬁscal institutions in the enlarged EU . . . 19

2.3 Data and methods . . . 22

2.4 Empirical results . . . 25

2.4.1 Fiscal institutions as constraints to political budget cycles 26 2.4.2 Press freedom . . . 29

2.4.3 Controls . . . 33

2.4.4 Robustness . . . 34

2.5 Conclusion . . . 35

Appendix . . . 37

3 From carry trades to curvy trades 47 3.1 Introduction . . . 47

3.2 Nelson-Siegel factors and exchange rate movements . . . 51

3.3 Carry trade construction . . . 55

3.4 Characteristics and predictability of carry and curvy trades . 56 3.4.1 Curvy trades yield higher Sharpe ratios . . . 56

3.4.2 Lower negative return skewness . . . 59

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Processed on: 4-6-2019 PDF page: 8PDF page: 8PDF page: 8PDF page: 8 3.4.4 Time consistency and out-performance of short positions 60

3.4.5 Standard predictors of carry trade returns . . . 64

3.5 Cross-sectional asset pricing . . . 66

3.5.1 Set-up of cross-sectional asset pricing tests . . . 66

3.5.2 Asset Pricing Tests . . . 70

3.6 Conclusion . . . 79

4 Spillovers at the Lower Bound 81 4.1 Introduction . . . 81

4.2 Literature . . . 84

4.2.1 Unconventional policies in the G4 economies . . . 84

4.2.2 Transmission . . . 87

4.2.3 Identiﬁcation . . . 90

4.2.4 Contribution to literature . . . 91

4.3 Methodology . . . 96

4.3.1 Vector Autoregressive model . . . 98

4.3.2 Restrictions . . . 102

4.4 Data and model . . . 104

4.4.1 Model variations . . . 106 4.4.2 Model suitability . . . 109 4.5 Results . . . 114 4.5.1 Three-country model . . . 116 4.6 Sensitivity of results . . . 135 4.7 Conclusion . . . 138 Appendix . . . 141 Bibliography 147 Summary 163 Samenvatting 167

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Processed on: 4-6-2019 PDF page: 9PDF page: 9PDF page: 9PDF page: 9 2.1 The interplay of institutional constraints and their predicted

impact on the occurrence of PBCs . . . 23

2.2 Results for the full sample . . . 26

2.3 Results for press freedom sample splits . . . 30

2.4 Descriptive statistics . . . 38

2.5 Robustness: Government size, ideology and exchange rate regime 40 2.6 Robustness: Output gap, old age dependency and inﬂation -full sample . . . 41

2.7 Robustness: Output gap, old age dependency and inﬂation -press freedom sample splits . . . 42

2.8 Robustness: Crisis indicator - full sample . . . 43

2.9 Robustness: Crisis indicator - press freedom sample splits . . 44

2.10 Robustness: Young versus established democracies - subsamples 45 2.11 Robustness: Press freedom adjusted for internet usage . . . . 46

3.1 In-sample predictions of FX returns—including standard predictors . . . 54

3.2 Excess returns Rxt+1 . . . 56

3.3 Return distributions of carry trade strategies . . . 57

3.4 Frequency of currencies used as funding currencies by carry trade strategies . . . 62

3.5 Frequency of currencies used as investment currencies by carry trade strategies . . . 62

3.6 In-sample predictions of carry trade excess returns . . . 65

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Processed on: 4-6-2019 PDF page: 10PDF page: 10PDF page: 10PDF page: 10 3.8 Cross-sectional asset pricing— dollar (DOL) and volatility

(VOL) factors . . . 73

3.9 Cross-sectional asset pricing—dollar (DOL) and high-minus-low (HML) factors . . . 74

3.10 Cross-sectional asset pricing: Factor-mimicking portfolios . . 77

3.11 Beta sorted portfolios: Descriptive Statistics . . . 79

4.1 Macro controls . . . 107

4.2 Correlations 1995-2008 . . . 115

4.3 Correlations 2009-2016 . . . 115

4.4 US, EA, UK direct eﬀects (structural form) . . . 124

4.5 US, EA, UK overall eﬀects (reduced form) . . . 129

4.6 Variance decomposition 1995–2008 . . . 133

4.7 Variance decomposition 2009–2016 . . . 134

4.8 Robustness 2009–2018: structural form . . . 136

4.9 Robustness 2009–2018: reduced form . . . 141

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1.1 General government gross debt in the EU . . . 3

1.2 Fiscal balances around elections, low income countries (1990– 2010) . . . 4

1.3 Euro area yield curves over time . . . 8

1.4 Annual real GDP growth in the Euro area, US, Japan and UK 11 2.1 Eﬀect of ﬁscal institutions on PBCs in full sample . . . 28

2.2 Fiscal institutions and PBCs in strong media environments . 31 2.3 Fiscal institutions and PBCs in weak media environments . . 32

2.4 Press strength thresholds and PBCs . . . 33

2.5 Strength of ﬁscal rules and press in the enlarged EU . . . 39

3.1 Mean returns over time . . . 58

3.2 Mean returns and skewness of portfolios . . . 61

3.3 Sharpe ratios over time . . . 63

3.4 Decomposition of portfolio returns . . . 68

4.1 Methodological approach . . . 98

4.2 Structural-form restrictions . . . 105

4.3 Reduced-form restrictions . . . 105

4.4 Three-month money market rates . . . 112

4.5 Ten-year government bond yields . . . 112

4.6 Stock indices . . . 113

4.7 Shadow short rates . . . 113

4.8 Regimes 1995-2008 . . . 118

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Processed on: 4-6-2019 PDF page: 12PDF page: 12PDF page: 12PDF page: 12 4.10 Relative variance of assets across regimes (1995-2008) . . . . 120

4.11 Relative variance of assets across regimes (2009-2016) . . . . 121 4.12 Alternative shadow rates . . . 139

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Introduction and overview

Background and motivation

Financial markets in many ways represent the pulse of an economy. They experience highs and lows, albeit in a more fast-paced manner than the real economy. The ability to therefore deduce market participants’ current sentiment and expectations about the future from financial market variables is key to the fields of international macroeconomics and finance. In addition, since economic policymaking, in particular of central banks, works through financial markets, using asset prices allows policymakers to answer questions about the current state of the macroeconomy.

This thesis incorporates three empirical projects, each with a separate methodology, research question and unique link to ﬁnancial markets.

One of the most prominent traded assets are government bonds. In my first project, Chapter 2, I explore the interplay between two institutional constraints to fiscal policy manipulation before elections that could play a role in bond valuations. Incorporating a link to the field of political science, the project aims to understand the influence of institutions in securing soundness of fiscal policy during election campaigns. The likelihood of debt repayment is a key factor driving the valuation of government bonds. This applies with regard to the interest rates on long-term sovereign bonds as well as on spreads between different euro area economies in the case of the European Union, even more so during the sovereign debt crisis in Europe. Haugh et al. (2009), for example, show that movements in sovereign spreads in the euro area were

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Processed on: 4-6-2019 PDF page: 14PDF page: 14PDF page: 14PDF page: 14 aﬀected not only by general risk aversion during the crisis, but also that risk

aversion magnified the relevance of fiscal performance, for example, in the form of debt service-to-tax receipts ratios and expected budget deficits. Beirne and Fratzscher (2013) come to the same conclusion with regard to credit default swap spreads as an indicator of sovereign risk – that both deteriorating fundamentals and heightened sensitivity to these fundamentals matter, while von Hagen et al. (2011) also support the notion of markets penalising the same fundamentals more strongly, suggesting a need for continued efforts in complying with the Stability and Growth Pact’s deficit and debt limits and and building up fiscal buffers in good times. Therefore, understanding how elections and institutions affect fiscal budgets is of interest to policymakers as well as lawmakers, all the more in times of potentially heightened market attention to fundamental fiscal variables.

In Chapter 3, I look at another key asset, currencies, to analyse how information contained in the distribution of interest rates across maturities can be used to come up with predictions for exchange rate returns. As a result, we can not only determine investment strategies, but also study whether information already contained in the market is incorporated into prices. We focus on a popular trading strategy for exchange rates, the carry trade, which relies on investing in high interest rate currencies for their interest and exchange rate returns, and build an alternative strategy that uses information included in interest rates across a range of maturities. We argue that the signal used to predict the exchange rate, the curvature of the yield curve, can be associated with the monetary policy stance of the central bank.

Chapter 4 examines financial markets’ response to unconventional monetary policy. Specifically, the project aims at uncovering not only how the multitude of signals from unconventional monetary policy are incorporated in asset prices, but also how these effects spill over into other countries due to the integration of financial markets.

These projects are clearly very different from one another in the specific research question and methodology, but nonetheless share the common theme of how financial markets incorporate information into asset prices. In addition, the projects not only answer current policy questions as well as providing

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Processed on: 4-6-2019 PDF page: 15PDF page: 15PDF page: 15PDF page: 15 fundamental monetary policy and ﬁnancial market insights, but also link to

related ﬁelds of political economy and ﬁnance.

Political Budget Cycles

The valuation of a government’s bond depends critically on the sustainability of its debt, in other words, the ability of a government to repay its debt when it matures. Crucially, the sustainability of government debt depends on the stock of debt as well as potential future deﬁcits, with high deﬁcits casting doubt on a government’s commitment towards repayment. As Figure 1.1 shows, debt levels in the European Union, have risen substantially in a few years time.

Figure 1.1: General government gross debt in the EU

BE DE ES FR IT NL UK 0 20 40 60 80 100 120 140 0 2 4 6 8 10 12 14 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 % of GDP ( E U 28 av er ag e) in tr ill ion €

Note: Figure 1.1 shows the general government gross debt of EU member states on the

primary vertical axis (in trillions of euros) and of the EU in total on the secondary vertical axis (as a percentage of GDP). Source: Eurostat

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Processed on: 4-6-2019 PDF page: 16PDF page: 16PDF page: 16PDF page: 16 Figure 1.2: Fiscal balances around elections, low income countries (1990–2010)

-1.5 -1 -0.5 0 0.5 1

Public consumption Public investment Total taxes Overall fiscal balance

% of

GD

P

Election year One year after Two years after

Note: Figure 1.2 shows regression estimates from Ebeke and ¨Olcer (2013) with ﬁscal values

represented as % of GDP. Only statistically signiﬁcant regression estimates are shown. Source: Ebeke and ¨Olcer (2013)

Around the time of elections, the appropriateness of budget deficits is often challenged. This can arise both before and after elections. An example of potential manipulation before an election was brought forward by the Polish political opposition in relation to the parliamentary election of 2015. Specifically, the accusation was that the incumbent government was influencing fiscal policy strategically, with re-election being the motivation for such behaviour. The manipulation of fiscal policy by the incumbent to enhance chances to get re-elected is generally known as a political budget cycle (Nordhaus, 1975). By manipulating fiscal policy, the incumbent government attempts to signal competence in policymaking through greater provision of public goods (or a stronger economy), at greater cost to the taxpayer. In recent years, the field of political economy has studied political budget cycles (PBCs) from multiple contextual perspectives and with a host of different samples,

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Processed on: 4-6-2019 PDF page: 17PDF page: 17PDF page: 17PDF page: 17 budget variables, levels of temporal or regional aggregation to often conﬁrm

the existence of such political budget cycles. However, as a meta-analysis by Philips (2016) shows, these contextual conditions and the setup of the study and its sample can matter substantially for the findings, although there is overall evidence for such cycles. Contrasting this is the meta-analysis by Mandon, Pierre and Cazals, Antoine (2019) which concludes that there is little to no evidence of cycles, while publication selection bias, an issue also found to matter in Philips (2016), is found far more strongly in the data, as well as the strong conditionality on institutions. Given the ongoing debate, any results thus need to be treated with caution and assessed with regard to several other conditioning factors to ensure robustness of the result. An example of a study with significant estimates is by Ebeke and Ölcer (2013) who study low-income countries between 1990 and 2010 (Figure 1.2). Typically, public consumption rises in election years; in the following years, tax revenues rise and public investment falls. While the debate initially centered around this being a new democracy phenomenon, PBCs have since also been shown in both new and established democracies. The focus has thus shifted to the institutional environment in which these cycles occur (de Haan and Klomp, 2013). A prominently examined sample is that of the European Union, for which some member states display evidence of PBCs (Mink and de Haan, 2006; Shi and Svensson, 2006; de Haan and Klomp, 2013).

We add to the literature in this field by zooming in on two factors argued to matter for the prevention of PBCs, namely press freedom and national fiscal rules, and the contingency that exists between them. Within the European Union there is substantial heterogeneity in both factors, while the strengthening of fiscal rules has received particular attention within the EU in recent years. Using a range of panel data methods with data for 25 member states, we assess fiscal balances between 1996 and 2012 for the EU and ask how institutions have hindered electoral cycles in fiscal policy in both established and new EU members. We employ three different econometric approaches to our panel, fixed effects, two stage least squares, and the generalised method of moments, to robustly quantify our hypothesized contingency on institutional factors, and split our sample to provide insights for different samples of countries and institutional strength. We find that governments throughout

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Processed on: 4-6-2019 PDF page: 18PDF page: 18PDF page: 18PDF page: 18 the enlarged EU ﬁscally stimulate the economy prior to elections. Based on

these results, we echo the findings of Shi and Svensson (2006) and Vergne (2009) that a larger share of informed voters reduces PBCs. We find that this is also the case in EU countries with a high level of freedom of the press. By employing a more detailed indicator of press freedom, however, we also find that there is a certain threshold of press strength that – once passed – eradicates PBCs. We additionally hypothesize and find evidence for a peculiar interaction effect of different institutional constraints: fiscal institutions limit the extent of opportunistic fiscal behaviour in EU Member States that lack a strong press to control unsustainable government spending, while they are seemingly irrelevant in countries with a strong press. We suggest that this may be due to higher degrees of political pressure to break rules in environments with strong media and the possibility for governments to engage in ‘creative accounting’ in countries with weaker media environments.

Our findings highlight the strong nature of conditionality of PBC evidence discussed extensively also in the survey by Dubois (2016). Therein lies the relevance for lawmakers and researchers alike. For lawmakers, aiming towards stronger institutions is key to eradicating PBCs. In the European Union in particular, where fiscal institutions and the strength of the press have each individually received much attention in recent years, our results provide more guidance on how to improve fiscal discipline and where existing institutions may still need further support. Some empirical support for our creative accounting hypothesis comes from Alt et al. (2014), who show how the electoral cycle and limited budget transparency at the national level lead to the undermining of the EU’s Stability and Growth Pact through creative accounting and fiscal ’gimmicks’. One of the many avenues for future research mentioned in Dubois (2016) would be of great interest in this context as well, namely how PBCs develop (with regard to these institutional factors) over the electoral cycle, i.e. immediately after elections, and with regard to more detailed components of the government budget. The main limitation of our study relates to the collinearity of the interaction effect of fiscal institutions with press freedom, resulting in us using sample splits for press freedom. While a regression that jointly models these two institutional factors and their

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Processed on: 4-6-2019 PDF page: 19PDF page: 19PDF page: 19PDF page: 19 contingency would be desirable, this correlation of explanatory variables is a

general diﬃculty within the literature (de Haan and Klomp, 2013).

Carry trades

As a consequence of the financial crisis that began a decade ago, central banks around the world reacted by providing major stimulus to their economies through monetary easing. This included interest rates effectively reaching a lower bound. Among the many implications for the macroeconomy and monetary policy, one heavily discussed effect of low interest rates is capital flows out of low-interest rate economies. This issue was, and still is, debated also in central banks (Cœuré, 2018).

Given low interest rates, financial market participants will, all else being equal, seek investment opportunities in economies with higher interest rates. This has implications for a prominent trading strategy, the carry trade. Following this strategy, an investor borrows in a low-interest rate economy and invests in a high-interest rate economy. The uncovered interest rate parity (UIP) theory points to an exchange rate depreciation of the investment currency equivalent to the interest rate differential over the investment horizon. The empirical failure of UIP, however, with appreciation of high-interest rate currencies first shown by Bilson (1981) and Fama (1984), motivates the carry trade as a trading strategy that generates excess returns but is also susceptible to crashes.

Traditional carry trade strategies are based on differences in short-term interest rates. This strategy generates high returns, on average, which have been explained in the literature with the help of risk factors such as crash risk, in other words the risk of a rare but sharp jump in the price of a currency impacting the strategy’s returns. This trade, however, neglects any other information embedded in yield curves. As shown in Figure 1.3, the economic and monetary policy conditions in the euro area have changed completely in the last years. This reflects the major policy measuresof the ECB and is seen at the short end, long end and in the overall shape of the curve. The short end of the yield curve is generally seen as reflecting current monetary policy conditions, while the long end of the curve incorporates market participants’

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Processed on: 4-6-2019 PDF page: 20PDF page: 20PDF page: 20PDF page: 20 Figure 1.3: Euro area yield curves over time

-2 -1 0 1 2 3 4 5 0 5 10 15 20 25 30 Yi el d i n %

Residual maturity in years

Dec-2004 Dec-2007 Dec-2010 Dec-2013 Dec-2016

Note: Figure 1.3 shows yield curves for AAA rated central government bonds in the euro

area. The curves are based on data for the ﬁrst day of the respective month. Source: ECB

inflation expectations. The shape of the curve can reflect differences between short-term conditions and anticipated long-term monetary policy conditions, and is sometimes used as a recession indicator (when the curve inverts). While the carry trade by construction only draws on the short end of the yield curve and makes investments on the foreseen interest rate return component of the trade, there is a growing literature pointing to the signalling ability of the yield curve for the macro-economy, future interest rates and the exchange rate. We therefore study whether the shape of the yield curve has more to say about potential exchange rate investments and why this may be the case.

Chapter 3 therefore derives return distributions of carry trade portfolios among G10 currencies, where the signals to buy and sell currencies are based on summary measures of the yield curve, the so-called Nelson-Siegel factors. We extract these Nelson-Siegel factors, approximating the shape of the yield

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Processed on: 4-6-2019 PDF page: 21PDF page: 21PDF page: 21PDF page: 21 curve using zero-coupon bond yields. Our analysis shows that the diﬀerential

of curvature factors has predictive power for exchange rate returns in a panel of major currencies. We therefore develop a strategy that invests in currencies likely to appreciate, rather than currencies that yield a high interest rate. We ﬁnd that a strategy based on the relative curvature factor, a trade we label the ‘curvy trade’, yields higher Sharpe ratios and a smaller return skewness than traditional carry trade strategies when forming portfolios of currencies according to the signal. Curvy trades build less upon the typical carry currencies, like the Japanese yen and the Swiss franc, and are hence less susceptible to crash risk. In line with that, standard pricing factors of traditional carry trade returns, such as exchange rate volatility, fail to explain curvy trade returns in a standard linear asset pricing framework using both Fama-MacBeth regressions and GMM estimations for the Stochastic Discount Factor representation. The ﬁndings are in line with recent interpretations of the curvature factor (Moench, 2012; Dewachter and Lyrio, 2006). A relatively high curvature signals a relatively higher path of future short-term rates over the medium term, in other words a more hawkish monetary policy stance, placing appreciation pressure on the currency.

The implications for policymakers and market participants stem primarily from this link. Our ﬁndings improve the understanding of currency-bond linkages, which are particularly relevant for investors, not just due to the strong performance of the strategy, but also because yield curves in many countries are likely to change shape as monetary policy normalises. An aspect limiting our analysis is the historical availability of bond yields at a high frequency and the resulting small number of currencies. A larger number of currencies would allow for a more robust assessment of performance in portfolios sorted according to the relative curvature factor. This is relevant in particular for the asset pricing exercise. Future research needs to be conducted to conﬁrm our conclusion that the returns are not explained by compensation for risk. In addition, empirical evidence of our explanation for the link between curvature and trading strategies, that draws on the literature, could strengthen this hypothesis.

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Monetary policy spillovers

A further consequence of the low interest rate environment from late 2008 onwards was the implementation of unconventional monetary policy (UMP) measures. While low interest rates can matter for foreign exchange rates, as highlighted in Chapter 3, they have additional implications for domestic and foreign asset markets (see Blinder et al., 2017). Spillovers in financial markets, in particular when originating from monetary policy, are of interest in conventional policy times too. However, reaching the effective lower bound of interest rates introduced a completely new variety of monetary policy measures, including most notably forward guidance and asset purchases. These measures can work through different channels than conventional policy, and in many cases were targeted at restoring monetary policy transmission in specific markets. Therefore, the direction, magnitude and significance of spillovers between markets may have changed. Given the need for an exit from these unconventional policies and the differing paces with which this is taking place amongst major central banks, this is a relevant policy issue today (Cœuré, 2018), especially with regard to potential benefits from coordination

among diﬀerent policymakers.

This research is particularly interesting given the highly integrated nature of financial markets and economies. This can be seen also in the GDP growth data for the four economies used in Chapter 4 (Figure 1.4). The effects of the financial crisis and following economic crisis were remarkably global, with all four economic areas strongly hit at the same time. Research into spillovers becomes even more interesting after the crisis, given that since then the paths of these economies, in particular those of the euro area and the US, diverge. Understanding spillovers hence becomes even more relevant when central banks are conducting policy at very different stages of the business cycle.

The implementation of unconventional monetary policy measures by all G4 central banks (the Federal Reserve, the European Central Bank, the Bank of England, and the Bank of Japan) has triggered a large literature examining the announcement effects on financial markets. Within this literature, authors have focused primarily on the effects of UMP on domestic government bond yields, stock prices, and exchange rates. In addition to findings of lowered longer-term yields, depreciated currencies, and strengthened equity markets,

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Processed on: 4-6-2019 PDF page: 23PDF page: 23PDF page: 23PDF page: 23 Figure 1.4: Annual real GDP growth in the Euro area, US, Japan and UK

-6 -4 -2 0 2 4 6 1990 1995 2000 2005 2010 2015

Euro area United States Japan United Kingdom

Note: Figure 1.4 shows the annual real GDP growth rate at market prices based on constant

local currency. Source: World Bank

the spill-over eﬀects into other currency areas have gained attention, motivated in part by eﬀects felt in emerging markets.

Our contribution is to combine the analysis of domestic and international announcement effects in a joint framework, building on the methodology by Ehrmann et al. (2011) that uses heteroskedasticity for identification, in a structured approach to finding an appropriate model. To my knowledge, this is the first study of unconventional monetary policies in a joint empirical setting. Using a Vector Autoregressive (VAR) model with daily data and extending the model setup to more than two economies, the primary question we ask is whether spillover effects in times of conventional policies are comparable to those in times of unconventional policies. We re-evaluate the results of previous studies using heteroskedasticity in a data driven approach for the identification of shocks, a method requiring weaker assumptions than those

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Processed on: 4-6-2019 PDF page: 24PDF page: 24PDF page: 24PDF page: 24 used in most other contributions to the literature. Our ﬁndings broadly

confirm global spillovers, both in times of conventional and unconventional policies. In particular, US monetary policy had significant effects on global markets throughout times of conventional and unconventional policies. In addition, we show that unconventional policy spillovers within short-term interest rates and longer-term government bond yields rise in magnitude vis-`

a-vis conventional policy spillovers. Overall, the share of variance in markets explained by foreign markets changes, at times substantially, when performing a variance decomposition for the model.

Whilst being able to make statements on spillovers and changes observed between samples, the limited sample size prevents me from assessing the potential effects of tapering and how the rise of interest rates moving away from the zero lower bound, as well as the reduction in asset purchasing programmes, affects global linkages. In this regard, it shall be interesting to see whether a discrete change in spillover patterns can be found when monetary policy normalises in multiple countries, in other words whether changes “remain” in a potentially new monetary policy environment. This is an interesting avenue for future research and from a policy perspective a very relevant topic. Such work would focus on the impact of returning to conventional policymaking, both in its transitional period and when the range of unconventional measures are either ended or part of the regular toolkit. Further research could also use the methodological framework in smaller geographic regions with multiple economies of a broadly similar size. As suggested by Ehrmann et al. (2011), the use of high frequency data could also provide an additional and clearer insight into the transmission channels. Furthermore, adding effective exchange rates and other assets such as corporate bonds could shed light on further links between markets.

While limitations to my work and numerous avenues for future research exist, the ﬁndings are highly relevant, in particular for policymakers. An understanding of linkages across markets and countries aids the design of policies that safeguard against a spillover of a (foreign) shock to domestic markets, especially given debates about a new normal in policymaking closer to the lower bound than in previous decades. One way of achieving stability in markets and economies may be through greater international cooperation. The

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markets and internationally. Shedding light on how the increased complexity in monetary policy can aﬀect the transmission across markets and borders, allows both policymakers and investors to react to the changing environment arising from major central banks that are at diﬀerent stages of a transitional process.

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Constraining political budget

cycles: Media strength and

ﬁscal institutions in the

enlarged EU

2.1 Introduction

In the summer of 2014, the Polish administration was accused of engaging in a “political business cycle”, a concept that goes back to Nordhaus (1975), by attempting to manipulate the economy prior to elections (Chapman, 2014). The incident matched a common assumption in the literature on political business cycles, namely that these cycles are merely characteristic of younger democracies (Brender and Drazen, 2005). However, the recent literature on fiscal manipulations prior to elections, so-called political budget cycles (PBCs), also finds substantial evidence of PBCs in established democracies, among them many EU Member States (Mink and de Haan, 2006; Shi and Svensson, 2006; de Haan and Klomp, 2013). The discussion has hence shifted increasingly towards analysing specific conditions under which PBCs prevail in heterogeneous country samples (de Haan and Klomp, 2013). The relevance of contextual conditions for finding evidence of political budget cycles is

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Processed on: 4-6-2019 PDF page: 28PDF page: 28PDF page: 28PDF page: 28 emphasized in meta-analyses by Philips (2016) and Mandon, Pierre and

Cazals, Antoine (2019) and a recent literature review by Dubois (2016). Two context conditions have featured prominently in this debate and are likely to matter for the occurrence of PBCs in the enlarged EU: press freedom and the strength of national ﬁscal rules. The absence of a free press and the consequent presence of uninformed voters have been considered key in accounting for PBCs in many developing countries and young democracies (Shi and Svensson, 2006; Vergne, 2009). But also the EU shows substantial diﬀerences in the freedom of its media outlets: the younger central and eastern European democracies only established a free press as a form of checks and balances on governmental behaviour in the 1990s, and recent developments in Hungary, but also in old EU Member States such as Italy, call media freedom in the EU into question. Yet, we do not know whether PBCs are contingent on the freedom of media outlets in the EU.

Likewise, fiscal rules have been found to incentivize greater budget discipline, both in election and non-election times (Debrun et al., 2008; Stanova, 2012). They have been substantially upgraded in the enlarged EU in the past decade, above all in the course of the financial and economic crisis that led to a revision of the Stability and Growth Pact and fostered the establishment of stronger fiscal rules in many EU Member States.

However, ﬁscal rules are considered to require a certain amount of transparency and public scrutiny in order to function without incentivizing ‘creative accounting’ practices (Milesi-Ferretti, 2004; de Haan and Klomp, 2013). While media outlets are key for creating this transparency, to the best of our knowledge the study of whether the impact of ﬁscal rules and institutions on PBCs is contingent on the media environment in which they operate has so far been neglected. This chapter addresses this gap in the literature by providing an empirical investigation of how these institutional constraints jointly impact on PBCs in the enlarged EU.

Using budget surplus data from 1996 to 2012 for estimations based on two stage least squares (2SLS), bias corrected and difference generalized method of moments (DGMM) regressions of different samples, we find that governments throughout the enlarged EU fiscally stimulate the economy prior to elections. Based on our results, we echo the findings of Shi and

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reduces PBCs. We find that this is also the case in EU countries with a high level of freedom of the press. By employing a more detailed indicator of press freedom, however, we also suggest that there is a certain threshold of press strength that – once passed – eradicates PBCs. We additionally hypothesize and find evidence for a peculiar interaction effect of different institutional constraints: fiscal institutions are apt to formally limit the extent of opportunistic fiscal behaviour in EU Member States that lack a strong press to control unsustainable government spending, while they are seemingly irrelevant in countries with a strong press. We suggest that this may be due to higher degrees of political pressure to break rules in environments with strong media and the possibility for governments to engage in ‘creative accounting’ in countries with weaker media environments.

Our findings line up well with subsequently published work by Veiga et al. (2017) which compares the relative importance of different factors affecting the

incentives for opportunistic policies and the resulting occurance of political budget cycles occuring. They conclude that media freedom matters more than other contextual conditions.

The chapter is structured as follows. Section 2.2 introduces the general concept of political budget cycles and embeds the approach of the chapter in the wider debate on institutional constraints to PBCs. Section 2.3 presents the methodological approach and the data used. Section 2.4 presents the empirical ﬁndings. We conclude with a discussion of their implications.

2.2 Political budget cycles and their institutional

constraints in the enlarged EU

2.2.1 Political budget cycles

Political budget cycles were initially considered to be a relatively wide and homogenously spread phenomenon in democracies. Traditional political business cycle theory argues that as the primary objective of any elected government is re-election, governments have an incentive to stimulate demand before elections in order to improve a country’s macroeconomic performance and, hence, an incumbent’s chances of re-election (Nordhaus, 1975). This

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adaptive expectations and assumes that opportunistic cycles occur in the run-up to elections independent of the political ideology of the government. Critics of this approach have developed opportunistic models in which voting behaviour is based on rational expectations, assuming that voters and politicians have asymmetric information about the politicians’ competence (see e.g. Rogoff and Sibert, 1988; Rogoff, 1990). As Mink and de Haan (2006) criticize, these models initially included the almost untestable assumption that only competent politicians engage in PBCs, relying on their competence to help them bring the economy back on track after election. Instead, they argue in favour of a moral hazard model in which an incumbent’s competence is only revealed to voters and themselves after election. Hence, voters make their decision conditional on the information on economic outcomes available to them before the election that they then attribute to the incumbent’s competence. This incentivizes the creation of PBCs and leads to the general expectation of higher deficits before elections.1

The empirical evidence for PBCs in different country settings, however, has not been coherent, providing little support to the assumption that PBCs are indeed a homogenously spread phenomenon (de Haan and Klomp, 2013). In addition, as shown by Eslava (2011) in a survey of recent literature, there is also little evidence corroborating the assumption that voters generally reward high-deficit governments because they derive direct utility out of increased pre-electoral spending or because they mistake the subsequent macroeconomic performance for a signal of incumbency competence. Her review rather suggests that voters are fiscal conservatives, who either reward or at least do not punish governments for fiscal restraint, in line with the views of Peltzman (1992). Yet voters’ ability to punish high-deficit governments crucially depends on whether they can accurately monitor government behaviour (Eslava, 2011).

Consequently, recent research has focused on explaining the heterogeneity between countries by investigating the conditions that stimulate or prevent the occurrence of PBCs. The capacity of voters to monitor and of governments to conceal spending is usually attributed to diﬀerences in the political and

1_{These incentives are nicely formalized by the time inconsistency model originally}

proposed by Kydland and Prescott (1977), where the optimal policy diﬀers before and after elections.

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Processed on: 4-6-2019 PDF page: 31PDF page: 31PDF page: 31PDF page: 31 institutional environment of countries; manifested, for example, in their

experience with democracy, the presence of institutional checks and balances or differences in fiscal transparency (see de Haan and Klomp, 2013, for a comprehensive overview). Brender and Drazen (2005), for example, argue that evidence of PBCs in larger samples of developed and developing countries is mainly driven by new democracies and transition economies that lack institutions and actors to accurately inform and enable voters to monitor public spending decisions and punish incumbents in the case of abuses. Contradictory evidence of PBCs in the democratically experienced and developed western European member states (Buti and Noord, 2004; von Hagen, 2003; Efthyvoulou, 2012), however, suggests that these differences rather impact the strength of PBCs, but not their general occurrence (de Haan and Klomp, 2013). Others have argued that specific institutional features such as access to a free press and rent-seeking opportunities (Shi and Svensson, 2006; Vergne, 2009), or fiscal institutions and transparency (Alt and Lassen, 2006; Stanova, 2012) account for differences in voter information, and hence for PBCs in different country settings.

2.2.2 Constraining political budget cycles: Media strength

and ﬁscal institutions in the enlarged EU

Two prominent conditioning factors in this respect – media strength and fiscal institutions – are likely to be highly relevant for explaining the occurrence of PBCs in the enlarged EU. To begin with, press freedom has been considered to limit PBCs, as better informed voters are likely to punish politicians for engaging in strategic economic manipulations prior to elections, rendering PBCs a highly risky exercise that may eventually even backfire on candidates (Peltzman, 1992; Alt and Lassen, 2006, for a similar argument related to fiscal transparency).2_{In this vein, Shi and Svensson (2006) emphasize and document} the importance of voters’ access to media, as well as the overall freedom of the press to provide adequate information to citizens (see also Akhmedov and Zhuravskaya, 2004; Vergne, 2009). While all EU Member States host

2_{As Drazen and Eslava (2010) suggest, governments may still engage in PBCs under}

these conditions, but are more likely to manipulate the composition of government spending, instead of increasing the overall budget.

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Processed on: 4-6-2019 PDF page: 32PDF page: 32PDF page: 32PDF page: 32 a generally free press, data by Freedom House on laws and regulations, as

well as on political and economic freedoms of print and broadcast media, suggest that there is indeed substantial variation in media strength within EU Member States, both old and new (Figure 2.5, Appendix). This variation is likely to matter. As research on media’s eﬀect on political outcomes in non-election times has shown, it is not only the freedom of the press, but also its de facto strength in terms of media pluralism and the independence of ownership, that matters to hold governments accountable (Besley and Prat, 2006). In other words: whether incumbents will be detected and punished by the electorate when attempting to engage in PBCs does not only require a media that is free to report on government abuses without fearing legal or political punishment. It also requires strong media outlets that have the human resources and economic capacity to conduct journalistic investigations and inform voters accordingly. We thus hypothesize that a strong media environment is likely to be an eﬀective constraint to PBCs in the enlarged EU, as it increases the risk for incumbents to be detected and punished by the electorate when attempting to engage in PBCs.

However, the effect of media strength on constraining PBCs is unlikely to be linear. Rather, we assume that there is a certain ceiling-effect or threshold that – once passed – makes the media an effective watchdog for government behaviour. Once this strength has been reached, the costs for governments to engage in PBCs are considered prohibitively high and PBCs are hence effectively deterred. A similar assumption also underlies Shi and Svensson’s (2006) distinction between free and unfree media environments. We adjust it to account for variation in press strength in developed countries to test whether it is indeed ‘the case that even the evidence for Europe fits the hypothesis that electoral changes in fiscal aggregates concentrate in countries with less well informed voters’ (Eslava, 2011, p. 650).

Unlike press freedom, which figures as an informal constraint to PBCs, fiscal rules such as the Stability and Growth Pact in the EU or national numerical fiscal rules set formal budget targets and thereby arguably limit the extent to which incumbents can engage in (pre-electoral) spending. A sizeable strand of the literature is devoted to the effect of fiscal institutions on budgets in non-election times. The general conclusion within this work is that fiscal

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This is shown in particular by empirical studies in the European context, where the effect is generally robust, significant (Debrun et al., 2008) and particularly relevant in times of revenue shortfalls (Wierts, 2008a,b). While the independent effect of fiscal institutions on pre-election spending has also been well documented in the literature on PBCs (de Haan and Klomp, 2013; Stanova, 2012), it has rarely been considered as being contingent on press freedom.

The literature on fiscal institutions in non-election times, however, argues that the functioning of fiscal rules crucially depends on the transparency of a budget in order not to incentivize creative accounting practices. As argued by Milesi-Ferretti (2004), creative accounting is less attractive for incumbents if budget transparency, and thus the costs of detection, are higher. Strong media outlets are key in creating this transparency by critically reporting on spending and accounting decisions and thus allowing the larger public to monitor how fiscal rules are being implemented. Alt et al. (2014) provide some empirical support for this in the context of the Stability and Growth Pact, finding that governments have at times resorted to ”gimmickry” which improves public finance statistics in the absence of an actual policy in order to comply with rules.

In environments that host a weak press, we thus first hypothesize that strong fiscal rules are more likely to limit the degree to which PBCs occur in the reported budget. We assume incumbent governments to seek adherence to formal fiscal rules in order to signal competence to voters. At the same time, as argued above, incumbents who do not have to fear rigorous media coverage have a greater incentive to engage in opportunistic spending in order to increase their chances of re-election. In the presence of strong fiscal rules and a weak media, they can thus do so to an extent that either remains within the limits of the fiscal rule or can be concealed by creative accounting. Numerous studies document that the latter approach is a widespread reaction to deal with tight fiscal rules in the EU: governments frequently circumvent formal fiscal constraints, among other methods by using stock-flow adjustments that affect debt but leave deficits unchanged or by shifting debt or deficits to non-constrained areas (Beetsma et al., 2009; Benito et al., 2013; von Hagen

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Processed on: 4-6-2019 PDF page: 34PDF page: 34PDF page: 34PDF page: 34 and Wolﬀ, 2006). In a detailed case study on infrastructure ﬁnancing in Spain,

for example, Benito et al. (2008) document how the Spanish government incorrectly accounts for publicly ﬁnanced infrastructure to comply with the EU’s SGP. We thus expect to see that strong ﬁscal institutions limit pre-electoral spending under these conditions, either because they constrain the magnitude of spending or because they incentivize creative ways of concealing PBCs in the budget.

We also hypothesize that in contexts where pressure from a strong and free press is high, fiscal rules may be largely irrelevant, but also unnecessary for constraining PBCs. First, there is little prospect of success for incumbents engaging in creative accounting practices. Governments that are confronted with a strong and free press face greater risks of being detected if they try to cover excessive pre-election spending by falsely pretending to adhere to strong fiscal rules. Second, whether or not to adhere to fiscal rules is likely to be more disputed in strong media environments – also in non-electoral times. Schick (2003, p. 27) argues that ‘budget rules are political rules’ and that whether they are respected ultimately depends on the will of politicians, who are – as a side effect of increased public scrutiny to the budget process – increasingly exposed to political pressures from outside. In this regard, a strong and independent press may also increase pressure on politicians not to adhere to rules. More importantly, however, as argued above, a strong media environment is likely to increase the risk of being detected, and hence turns PBCs into highly risky endeavours for incumbents. It is thus likely to function as a sufficient deterrent for incumbents not to engage in fiscal manipulations prior to elections. Table 2.1 gives an overview of all hypotheses.

2.3 Data and methods

Our sample covers all current EU countries except for Malta, Cyprus and Croatia. Its time frame ranges from 1996 – the year in which all CEECs (central and eastern European countries) formally applied for EU membership (Cameron, 2009) – to 2012. Table 2.4 in the Appendix gives an overview of variables, descriptive statistics and data sources.

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Processed on: 4-6-2019 PDF page: 35PDF page: 35PDF page: 35PDF page: 35 Table 2.1: The interplay of institutional constraints and their predicted impact

on the occurrence of PBCs Media Strong Weak Fiscal Insti-tutions

Strong no incentive for incumbents

to engage in PBCs

incentive for incumbents to engage in limited PBCs - formal and informal constraints

high: creative accounting penalized - political pressure is high:

ﬁscal rules less relevant

- formal constraints high: creative accounting is incentivized - political pressure low:

ﬁscal rules limit extent of PBCs

Weak no incentive for incumbents

to engage in PBCs

incentive for incumbents to engage in full PBCs - informal constraints high,

no formal constraints

- no formal or informal constraints - no limits to PBCs

In order to investigate to what extent we observe PBCs in the enlarged EU, and whether and how they are constrained by institutional features, our baseline equation takes the form of

surplusi,t = α0+ α1electioni,t+ α2ﬁscalinsti,t + α3electioni,t× ﬁscalinsti,t+ α4pressi,t

+ α5surplus_i,t−1+ α6growthi,t+ α7debti,t−1+ αi+ ui,t (2.1)

where surplusi,t is the dependent variable defined as the budget surplus as a percentage of GDP of government i in year t, following Hallerberg et al.’s (2002) assessment of fiscal cycles. Following Franzese (2000), we code the electioni,t variable in such a way that the 12 months preceding an election are coded as the share of the 12 months falling into the relevant calendar year. The variable thus displays values between 0 and 1. As controlling for the endogeneity of elections would result in a substantial loss of observations in our already limited sample, we rely on Brender and Drazen (2005), who argue that there is neither a clear theoretical argument nor empirical evidence for endogenous election dates to substantially alter the results. The fiscal institutions variable fiscalinsti,t is based on data provided by the European Commission’s (2014) Fiscal Rule Index. The index captures the characteristics of fiscal rules based on the legal base of the rule, the room for revising objectives, the nature of the body that monitors and enforces the rule, the

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Due to high degrees of multicollinearity with electioni,t, the inclusion of an additional interaction term of press freedom (pressi,t) with electioni,t strongly blurs the results.4 _{We thus decided to include press}

i,t as a control variable and work with sample splits later on to investigate whether different degrees of press freedom trigger differences in PBCs and constraints by fiscal institutions. This is common practice in the literature on political budget cycles (see e.g. de Haan and Klomp, 2013; Brender and Drazen, 2005). We measure media strength with the help of Freedom House’s Press Freedom indicator (Freedom House, 2014) that captures the freedom of print and broadcast media. The index’s categorical assessment of free, partly free and unfree media, jointly with the amount of radios per capita, has been used in studies on PBCs previously (Shi and Svensson, 2006). However, since its 1994 edition, the index has also awarded countries more detailed scores to assess their media environment in terms of laws and regulations, political pressure, economic influences and repressive actions against media representatives and outlets (Freedom House, 2014).

We also control for factors that impact on the budget surplus irrespective of elections. In line with Hallerberg et al. (2002), we include the one-year lag of the budget surplus (surplus_i,t−1) to measure path dependence. We assume that voters in high-debt countries may eye excessive spending more critically (see Redˇzepagi´c and Llorca, 2007; Staehr, 2008, for related arguments and empirical evidence) and control for general government consolidated gross debt (debt_i,t−1). We include the GDP growth rate (growth_i,t) to control for business cycle dynamics in the respective economy that are not related to PBCs.

3_{The fact that the European Commission includes ﬁscal rule visibility in the media as}

one component in its index does not pose a problem for the inclusion of press freedom as a further explanatory variable. The Commissions questionnaire asks speciﬁcally about the degree of media coverage and the likelihood of public debate regarding non-compliance with the ﬁscal rule. It does not make any statement about the quality and independence of this coverage, as measured by Freedom Houses press freedom indicator.

4_{The correlation between these two variables is 0.87. Correlation of the host of}

explanatory variables mentioned in the literature is a challenge in general, as shown by de Haan and Klomp (2013), and prevents the inclusion of large numbers of explanatory variables in any study of political business cycles.

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Processed on: 4-6-2019 PDF page: 37PDF page: 37PDF page: 37PDF page: 37 Following previous studies on PBCs (see e.g. Efthyvoulou, 2012),

we conduct fixed effects regressions to control for further country-level heterogeneity. As we assume that the budget surplus may affect the growth rate of a given year, we deal with this potential endogeneity of growth by running 2SLS regressions in which we use two lags of growth as instruments in the first stage regression. In order to cope with the inconsistency of LSDV (least-squares dummy variable) estimators arising in autoregressive panel data models (Nickell, 1981) and better deal with our unbalanced panels, especially for the resulting rather small sample sizes (where both the cross-sectional and time dimensions i and t are small), we also estimate our results based on bias corrected LSDV (LSDVC) regressions5 (Bruno, 2005; Bun and Kiviet, 2003). In addition, we report the results of a DGMM (difference generalized method of moments) estimation (Arellano and Bond, 1991) to show the validity of our 2SLS and bias correction results when we account for both the dynamic panel bias and the endogeneity of growth. The Difference GMM estimation uses up to 4 lags. In the choice of instruments, presst, debt_t−1, and electiont are treated as exogenous, while f iscalinstt and electiont× fiscalinstt are treated as predetermined, but potentially endogenous. growthtis treated as an endogenous variable. The Arellano-Bond tests for second order autocorrelation in differences. When p < 0.1, we would assume autocorrelation, i.e. endogeneity, and would be required to switch to a higher lag order of instruments. The Sargan and Hansen test are tests for over-identifying restrictions. When p < 0.1, the set of instruments would not be exogenous and should be reduced.6

2.4 Empirical results

The empirical results are shown in Table 2.2 and Table 2.3, starting with the full sample in Table 2.2, for which we apply 2SLS ﬁxed eﬀects, bias corrected

5_{The bias correction is initialized by the Arellano–Bond estimator. This method requires}

the assumption of strict exogeneity to hold for all variables besides the dynamic variable (surplus). Simple pooled OLS and fixed effects regressions yield very similar results (although magnitudes differ somewhat) but are not reported due to the econometric issues of these methods discussed above.

6_{The Hansen test (unlike the Sargan test) is robust to heteroskedasticity and}

autocorrelation, but is weakened by instrument proliferation, hence perfect scores of 1 should be treated with caution (Bruno, 2005).