Liquidity, Government Bonds and Sovereign Debt Crises

This paper analyses the European financial crisis through the lens of the sovereign bond liquidity. Using novel data we show that government securities are the prime collateral in the European repo market, which is becoming a primary source of funding for the banking system in the Euro area. We document that the repo haircuts on peripheral government bonds sharply increased during the crisis, reducing their liquidity and amplifying the movements in the yields of these securities. We study the impact of a rise in haircut to public bonds on the business cycle and on asset prices through a dynamic stochastic general equilibrium model with liquidity frictions. The model predicts a flight to liquidity and a fall in investments which reduces the economic activity. We show that the government may alleviate the negative impact of the liquidity shock by issuing more short-term bonds which provide an alternative liquid instrument to investors. The negative impact of a rise in haircuts on the value of bonds is confirmed by a Bayesian structural vector autoregressive model for the Irish economy. JEL classification: E44, E58, G12