Question

Explain the “flight to quality” that happened in Germany due to the Greek Debt crisis in 2010 and explain how this impacts the price and interest rates of German and Greek bonds? Who does this help and hurt?

Answer 1

1. The direct effects news in Greece had on German

government bond yields by looking at specific events in the past, providing evidence for an effect of

flight-to-quality or flight-to-liquidity. In order to assess the amount of savings to the German budget

that may have resulted from this, we develop two different measures for counterfactual yields without

such a flight effect in Section 3. These counterfactual yields (traded on secondary markets) are then

combined with newly issued debt on primary markets in Section 4, resulting in estimates of the gains

for the German sovereign. As argued there, these estimates are most likely very conservative.

2. Bad news in Greece trigger flight into German bunds

Bad news in Greece was good news for Germany and vice versa. Faced with market uncertainty,

investors shift their portfolios towards safe assets, for example countries with high credit ratings. This

is the so-called flight-to-safety effect. Similarly, investors may also shift their portfolios towards assets

that are more actively traded (flight-to-liquidity). Both effects have been analyzed in theoretical

models (e.g. Vayanos (2004) and documented empirically for an earlier episode in the European

government bond market by Beber et al. (2009).

The Appendix reports the most important news from Greece between October 2014 and July 2015 and

its effect on German ten-year bond yields. During this time, the conservative Greek government searched

for a new president who would be appealing to the parliament. Having failed, it called elections which

were easily won by the radical left in January 2015. After winning the election, the new Syriza

government stopped many of the reforms imposed on previous governments by creditors, arguing that

austerity had only hurt the Greek population in the past. However, in the dramatic negotiations on con-

tinuing reforms and support by the Euro area (including the first default by an advanced economy on

IMF loans in the beginning of July 2015), the Greek government had to agree to even harsher austerity

measures than before. We see that every time an event made agreement on a reform package less likely (and a Grexit more likely), German government bond yields fell and each time an event increased the

likelihood of an agreement on package, German government bond yields increased . Cumulatively, bad

news for Greece resulted in a decline of German ten-year bund yields of more than 1.5%. The effect is

symmetric: Good news for Greece resulted in increases in German bund yields of about equal magnitude.

3. Counterfactual yields on German bunds without flight-to-safety

The previous section provides convincing evidence that bad (good) news in Greece lowered

(increased) German bund yields. However, in order to assess the overall effect on interest costs, one

needs to simulate German government bond yields in the absence of a crisis. Hence, we provide two

simple ways to calculate counterfactual yields for German bunds for 2010 to 2015. The first (naïve)

approach uses the average bond yield between 2000 and 2007 as a benchmark, assuming that all

deviations from such a yield can be attributed to the crisis. The second approach relaxes this

assumption and takes into account that some deviations from this normal value may be explained by

the general macroeconomic environment in Germany. Hence, we calculate the counterfactual risk-free

interest rate using a simple monetary policy rule (Taylor rule) for Germany. Both approaches yield

very similar results.

3.1. Benchmark: German bond yields

German bond yields from the introduction of the Euro until 2007 were quite stable. Reports the average yield from 2000 to 2007 and the

yields for the subsequent years until 2015. The yields between 2000 and 2007 (differing by maturity)

can be interpreted as equilibrium yields for Germany in the absence of a crisis situation. Yields for all

maturities fell to levels close to zero during the Great Financial Crisis and never recovered to their

normal level afterwards despite the fact that the German economy fully recovered in 2009 and 2010.

In this naïve approach, any difference between observed and “normal” bond yields between 2010 and

mid 2015 can therefore be attributed to the European debt crisis (which from 2010 onwards was

mostly driven by events in Greece). That is, the Greek crisis created circumstances in which Germany

was not only present as a safe haven, but actively sought as such by fleeing investors. Hence, as our first set of counterfactual interest rates, we therefore use the normal average yields observed between 2000 and 2007 on secondary markets.

4. The gains from the safe-haven effect

We use information on actual bond auctions by the German government in order to calculate the

overall gain to the budget. The variation in bond issuances of the German general government over time reflects the high

government deficit during the Great Financial Crisis, and the slow consolidation of budgets from 2011

onwards. The auctioned amounts are obtained from the reports of the Federal Financing Agency on all

auctions of newly issued bonds (including increased principal on outstanding bonds) of the central

government. However, the auctions from the Federal Financing Agency are not the only source of debt

funding of the general German government. They do not include (a) debt by states or municipalities or

(b) alternative debt financing sources like direct credit from banks. Therefore, auctions for different

maturity bands are only between 45% and 75% of total gross borrowing by the German state. Hence,

the estimates on interest saving of the German government are necessarily only a lower bound on total

gains from the Greek debt crisis.

Germany issued between 297 (2007) and 676 billion Euros (2010) each year. This is the relevant

amount for our calculations, because interest savings will only accrue on newly issued debt, not on

outstanding debt. Frequent rollovers allow Germany to “cash in” on reduced government bond yields.

With this information in hand, we can proceed to calculate the annual interest savings that accrued to

the German budget from the crisis. The difference between observed and the counterfactual interest

rates provided in the previous section gives, for every point in time and every maturity group, a yield

spread. If these yield spreads (observed minus counterfactual) are multiplied with newly issued debt,

we obtain gains from the favorable interest environment. However, these gains do not only materialize

in the year of issuance, but in all subsequent years until maturity (assuming normal coupon bonds).

Assume a bond of size one billion with a maturity of ten years that is auctioned off in 2011 for an

interest rate which is 4% below its counterfactual due to uncertainty on financial markets. Then the

German state saves 4% of one billion (40 millions) in interest payments every year until 2020. For the purposes of this analysis, we have limited ourselves to the gains that already accrued, and do not
include any future gains.
In the following, we assume that all German government bonds pay interest every year. That is, we
use the maturity of bonds in order to distribute interest gains for bonds issued between 2010 and today
over the years following the issuance until 2015. Adding gains originating and materializing between
2010 and 2015 over different maturity bands allows us to get a feeling of total savings from bond
auctions over this period. Using this conservative approach, we find savings in
the ballpark of 100 billion Euros, irrespective on how we specify the counterfactual. This should be
viewed as a lower bound of the benefits accruing to the German government from the debt crisis.
These gains are larger than the total Greek debt owed to Germany, (estimated by most accounts at 90
billion Euros, including exposure from a still to be negotiated program). That is, even in event that
Greece defaulted on all its debt, the German central government alone would have benefited from the
Greek crisis. The gains from other credit financing of the general government (another 25% to 55% of
total newly issued debt) are not even accounted for in this context.
The gains from different counterfactual scenarios are remarkably similar, ranging from 93 billion for
the normal yields scenario to 126 billion from the pre-Euro Taylor-rule scenario. The fact that very
different assumptions yield quite similar results provides a high degree of robustness.
Concerning the future, we expect Germany to continue profiting from the current situation. If the
situation calmed down suddenly, Germany would no longer be able to issue debt at depressed rates.
However, sizeable amounts of medium- and long-term bonds issued in the past years are still far away
from maturity, extending the period of German profits for some time to come.