Table of Contents

Introduction Literature Review Theory Data Methodology Data Analysis Conclusion Bibliography Appendix Graphs Correlation Matrices Bonds Bond Yields

Introduction
It has been difficult to escape recent news about the Euro-crises and the turbulence on the sovereign bond markets for PIIGS. Bond yields have reached all time highs and have caused much distress for the national governments as for the whole EU. Investors are increasingly worried whether the countries can fix their finances. There is reason to believe that economic figures released about the state of the countrys economic health, has had increased importance when it comes to pricing of risk in the sovereign debt market. Macro-economic data is continuously released and is seen as an indicator of a countrys economic situation. Credit rating agencies use macro economic data when determining whether a country should keep its current rating or not. When Standard & Poors downgraded The U.S from AAA to AA+, the rating was cut partly because of the heavy debt burden and the governments budget deficit. Even though it is accepted that economic data will have an effect on bond yields, the question still remains how well the bond markets priced the risk of the PIIGS economic state and how whether it changed after the 2007 financial crises. This paper investigates the pricing of risk in the bond markets associated with the introduction of the euro. Our objective is to determine how accurately the bond markets priced the risk for the PIIGS economic health when the euro was introduced in 2002, and whether there are large prediction errors for the bond markets during this particular period. Essentially, the data should enable us to see what kind of effects EMU has had on the risk premiums that governments pay. Due to the financial crises, there is reason to divide the period of 2002 to 2011 into two periods; from the introduction of the euro to mid 2007 and mid 2007 to present date. To determine how accurately risk was priced for each country, variables such as government debt, inflation, unit labor cost and the unemployment rate were tested against the 10-year government bond spreads. This paper is divided up into seven parts. First an introductory section, followed by literature review where we examine past papers written about this topic. The third section contains a generalized theoretical discussion about bonds and bond yields. This is followed by a presentation of the data and what methodology was used. Finally, the results are presented and analyzed followed by a conclusion and appendix.

Literature Review
Various types of research have been done in the field of pricing of risk and also more generally on the effect of macroeconomic variables on bond yields. Aizenman, Hutchinson, and Jinjarak (2011) estimated the pricing of sovereign risk for PIIGS before and after the financial crises by using credit default swaps. The estimation is based on fiscal space and economic fundamentals. The authors find evidence for mispricing of PIIGS risk given the current economic fundamentals during both after and before the financial crises. Barrios, Iversen, Lewandowska, Setzer (2009) found that bond yields spreads react more strongly to domestic factors after that financial crises. Additionally, there has been extensive research on the impact of macroeconomic data on bond yields. In an essay for the Central Bank of Ireland, Liebermann (2011) found that T-bond yields reacted systematically to news of data that had short publication lags. She states that one of the most important releases was the unemployment rate. The report also found that the impact of the variables changed during the financial crises.

Bonds
A bond is a type of debt instrument that is often referred to as a fixed-income instrument because it promises either a fixed stream of income or stream of income that is determined according to formula mentioned on the next page (Bodie, 2011). The price of a bond is determined by the present value of its future cash flows. That is, the price an investor would be willing to pay to for a future stream of payments instead of having them today. This, in turn, is determined by market interest rates and several risk premiums caused by other risk factors such as liquidity risk, default risk and so on.

N Coupon Par value Bond value= + n (1+r) (1+r)n n=1

(BODIE)

Bond yields and prices are highly correlated. The price of the bond moves in the opposite direction of the yield. Since the bond price is the sum of all future cash flows, an increase in the yield would mean that the present value of future cash flows decreases. The reason for this relationship is that the price of a bond is the net present value of its future cash flows, and if the discount rate increases, the present value of the cash flows will decrease (Choudhry, 2010). The bond type discussed here are sovereign government bonds. Government bonds are issued by national governments.

Yields
The yield of a bond is the percentage return an investor can expect to receive from a bond. A bond with a higher yield implies a bond with a higher credit risk. The yield is determined by: Credit risk Credit risk can be seen as the main risk when holding a bond. Credit risk is increasing with maturity. Credit risk can be separate into three categories: 1. Default risk: the probability that the issuer will default on its own debt and wont be able to meet its obligations of repayment at the time of maturity. Bonds of governments that do no conduct sound fiscal policies usually have higher default risk and therefore investors will require a higher yield on bonds as compensation. The default risk of government bonds is rarely an outright default as much as forced restructuring and renegotiation of its debt (Di, 2005). 2. Credit spread risk; which is the probability that the bond declines more than other bonds of similar quality. 3. Downgrade risk: the risk of a downgrade from a ratings agency.

Liquidity risk A liquid market is one where there is sufficient buy and sell orders and where large-scale orders do not have a strong impact on prices (Manganelli & Wolswijk, 2009). The only market in Europe that has a liquid futures market is Germany. This increases the demand for German Bunds since you can enter and exit a trade practically immediately, and that makes it attractive for investors. Long-term investments require higher yields (Choudhry, 2010).

Risk aversion Risk aversion measures the investors willingness to take on risk. If risk increases investors seek the flight-safety or flight-to-liquidity, which in the euro zone has been Germany and its liquid markets (Barrios, Iversen, Lewandowska, & Setzer, 2009) For a market to be efficient in its pricing of sovereigns bonds it is necessary that all governments have access to capital markets on the same terms as borrowers. Another important necessity is that countries bear the risk of default and takes responsibility for the financial consequences following a default (Manganelli & Wolswijk, 2009). The Maastricht Treaty and its no-bail-out clause exists to help markets stay efficient. This clause may however be undermined, especially in large and integrated market as the Euro-area since the theory of too-big-to-fail holds (Gmez-Puig, 2002) and when a crisis like the debt crisis of the PIIGS countries occur it threatens the entire economy.

Macro variables and their influence on the Bond yields It is widely accepted that government policy has an impact on the yield curve. These include policies on public sector borrowing, debt management and open-market operations. How the market perceives the size of public sector debt will inuence bond yields; for example, an increase in the level of debt can lead to an increase in bond yields.

Lebrun and Prez (2011) state that after the EMU was created, unit labor cost growth differentials have widened in the euro area. Additionally, according to the Economist, the peripheral countries have lost a large amount of competitiveness (measured in unit labor cost) compared to Germany since 2000. Therefore we found ULC appropriate as a measure for economic health between PIIGS and Germany. We also consider the unemployment rate a useful variable because of its relationship to bond yields. Poterba and Rueben (1999) found that an increase in a states unemployment rate is associated with an increase in that states bond yields. Additionally Palumbo and Schick (2006) state that unemployment figures draw the attention of credit analysts which in turn have an effect on bond yields. According to Elmendorf and Mankiw (1998), government debt is supposed to increase the yields of the bonds since a higher debt level increases the risk of default and economic instability. A monetary union such as the EMU may increase the default risk even more at higher debt levels since the countries inside the union has given up their possibility of managing their debt thru monetary policy (Bernoth, von Hagen, & Schuknecht, 2004). Inflation rate is said to be an indicator of economic stability and as a proxy of economic management that has a positive impact on the sovereign default risk (Alexpoulou, Bunda, & Ferrando, 2009). However, higher inflation can be seen as a sign of increased government deficits which in turn signal a need for higher interest rates. Because of this, higher inflation is expected to increase the sovereign risk, which will be added to the bond price.

Data
All the collected data occurs on a monthly basis, except government debt, which has been interpolated to fit in the model. The data covers January 2002 to June 2011. The time-series have been divided into to sub-periods; the first from January 2002 till July 2007 and the other sub-period will cover the rest of the time-series, August 2007 to May 2011.This divide is made since August 2007 is seen as the starting point for the financial crisis (Elliott, 2011). The countries chosen are referred to as the PIIGS throughout the paper and include: Portugal, Ireland, Italy, Greece and Spain. These countries are often bundled together when referring to the financial crises and therefore we saw it as interesting to test all of them. Germany was included as a benchmark bond. In an essay by Barrios, Iversen, Lewandowska and Setzer (2009), the German government bond market is referred to as safest haven and having Germany as a benchmark would explain the excess premium on the bonds for PIIGS in respect to the macro variables. As an indicator of risk for the bond market, the harmonized 10-year government bond spreads were used. The bond yields were retrieved from Eurostat and are reference rates measured in percentages that have been based on government bonds that have maturity close to 10 years. To find the spread, the German yield was subtracted from each of PIIGS yields. Unit Labour Cost

Real unit labour cost (ULC) is used as a competitive indicator. It measures the average cost of labor per unit of output. It is computed as the ratio of total labor costs to real output (OECD). This index is useful as it can be compared directly between countries. The data was published by the IMF and is presented in real effective exchange rates. This means that the data was acquired by reducing every countrys trade weighted index of the bilateral nominal rate by a weighted index of unit labor costs of other countries relative to the unit labor cost in the domestic country (IMF).It is not a complete measure of competitiveness per se, yet should rather be interpreted as a reflection of cost competitiveness (OECD).

The ULC was converted into an index where January 2002=100 which was the date when the Euro was physically introduced. Unemployment Rate The Unemployment rate is seasonally adjusted data retrieved from Eurostat and is measured as a percentage of the total amount of people in the workforce. The work force includes the total of individuals who are unemployed and employed between the ages of 15 and 74 (Eurostat). Those considered as unemployed are those who do not have a job during the reference week, can start work in the next two weeks, and are actively looking for a job the past four weeks. Government debt The government debt data was retrieved from Eurostat on a quarterly basis. The Quarterly government debt is defined as the total gross debt at nominal value outstanding at the end of each quarter. The data are measured in million Euros as a percentage of GDP. (Eurostat) Since regression models require consistent time intervals, we have interpolated the data from quarterly to monthly to make it fit in the frequency. This was done in Stata where we interpolated the change in government debt in each quarter to then get the monthly change. Harmonized indices of consumer prices The harmonized indices of consumer prices (HICPs) was used as a measure for inflation and retrieved from Eurostat. This type of measurement is useful as it is designed for cross-country analysis of consumer price inflation. The HICPs are used to evaluate if the inflation criteria is fulfilled which is required by the Euro zone countries (Eurostat). The inflation rate should, according to the Maastricht treaty not be more than 1,5% above the inflation level of the three best performing EU member states(Soltes, 2011).

Methodology
Our multiple regression model consists of four macro variables that have a according to several previous studies a considerable impact on bond spreads. Not only was the German yield subtracted from each individual country to get the bond spreads, but the German data for each of the variables were also subtracted. We found this necessary because when the difference between the yields varies (the spread increases or decreases) then this must be matched on the other side of the equation with the variation between the two countries variables. For example, even though government debt might be rising in one of the PIIGS, the spread might be decreasing. This can be due to the fact that there is a variation on the German side that needs to be taken into account and therefore we subtract its government debt as well. Mathematically, both legs should be equal and therefore if the government bond yields (the left part) is considered a safe haven then the variables determining them should be considered safe as well. (den hr biten kommer utvecklas eller skrivas om)

We conducted individual regressions for each country. Each variable was tested whether they had a lagged effect or not. Government debt and unit labour cost both showed lagged effects of 1 month. Lagged variables may capture dynamic structures in the dependent variable, which in this case most likely are caused by inertia. This could be due to psychological factors where people might not fully understand the effects certain new announcement might have. It could arise because it is not yet clear whether or not the change will be permanent or only temporary (Brooks, 2002).

When running a regression model one must check to make sure that the model fulfils the ordinary least squares assumptions. The OLS describes the linear relationship between the dependent variable and the independent variables. The following are all assumptions of the OLS and if one of them is violated the model no longer contains the best linear unbiased estimators that can be obtained and improvements can be made. The first assumption is that the model is linear in its parameters.

The second assumption states that the expected error term should be zero. If not, the model has unexplained errors, which does not make it BLUE best linear unbiased estimator. The third assumption states that the model has to be homoscedastic. Homoscedasticity means that the variance should be constant and not depending on x. If this is violated then the residuals are said to be heteroscedastic. If a regression model contains heteroscedastic error terms they are no longer correct and need to be replaced with new standard errors that adjust for this. This can be done by using Newey-West standard errors. The fourth assumption is about autocorrelation. Autocorrelation occurs when two on following residuals are correlated with each other. When this occurs the residuals are said to be serially correlated. This will lead to the same problem as with heteroscedaticity and give the standard errors that are not in line with BLUE. ( )

It is possible to adjust for both autocorrelation and heteroskedasticity by creating new standard errors. This can be done by using Newey-West, which creates new standard errors that can be added to the model. The fifth assumption states that the variable x is not random and must take on at least two different values. 10

The sixth and last assumption of the regression model is that the error terms must be normally distributed about their mean if the values of y are normally distributed. A normal distribution is symmetric about its mean. To test if the sample is normally distributed the test most commonly used is the Bera-Jarque. The B-J test for normality is based on two measures, skewness and kurtosis. Skewness measures the extent to which a distribution is not symmetric around its mean and kurtosis measures how fat the tails of the distribution are. A normally distributed sample should not have any skewness and the allowed coefficient of the kurtosis is 3. The Bera-Jarque test statistic: [ ]

T is the sample size and b1 and b2 can be estimated from the residuals taken from the regression. The null hypothesis of this normality test is that the model is normally distributed (Brooks, 2002). The data was divided into to sub-periods because of the change in the economic environment and increased economic instability after July 2007. To see if there is a detectable difference between these periods we conducted a chow-test. A Chow-test tests if there is any structural change between two different periods. When conducting the test one divides the sample into different periods, in this case two, from January 2002 to July 2007 and August 2007 to May 2011. When the models have been estimated separately, including one for the whole period, and we have three different sum of squared residuals an F-test can be made (Ramanathan, 2002).

The unrestricted regression is the one where the restriction has not been included. The restriction is that the coefficients are equal across the sup-periods

11

and the restricted regression will be the single regression that covers the entire sample period.

Data analysis
All the regression models were run through the Ramsey reset test to see if all the coefficients are significant and if we have any omitted variables. The only model that did not show signs of omitted variables was Greece in both periods (see appendix). All other regression models got results telling us that the model could be improved by including more variables. When checking for multicollinearity correlation matrices and variance inflation factor tested the variables and both got results indicating that we have a problem with collinearity between are variables (see appendix). The VIF is defined as;

When variables are inter correlated it is difficult to disentangle their separate effects on the explanatory variables (Maddala, 2001). This might have an increasing effect on the R2 values without increasing the degree of explainability of the whole model. The R2 measures how much of the variation in the model that is explained by the variables. All regression models got increased R2 values in the second sub-period. In almost every case the results gave very high R2 values. This might also be because of the high correlation between the macroeconomic variables. When the correlated variables move together, it may have a positive impact on the R2 value without having any real explanation of the variation in the regression model (Nau). Therefor it is important to not look at other factors when evaluating the quality of the model such as estimates and their magnitude and directions rather than the R2 (Hill, 2011). To test for heteroscedasticity we use Breusch-Pagan. Breusch-Pagan tests if there are any variables that influence the variance. The results received from these test tells us that we have a problem with heteroscedasticity and after

12

conducting test for autocorrelation with Breusch-Godfrey the results clearly shows that the model has a problem with that as well. To account for these problems with standard errors that do not use the best linear unbiased estimators we must create new standard errors using NeweyWest. When these new standard errors are included in the model the heteroscdasticity and autocorrelation is accounted for and we can include these with the original coefficients obtained from the first regression models.

First Sub-Period The regression analysis with the corrected standard errors led to varied significance amongst the independent variables for each country in the first period.
Adjusted R F-stat 15.23 47.57 5.92 9.03 34.64

Portugal 0.017968 Ireland Italy Greece Spain

Prob. 0.0000 0.0000 0.0004 0.0000 0.0000

0.1141105 0.0283396

0.0372685 0.5519 0.5215 0.8457 0.8352 0.4098 0.3698 0.5244 0.4921 0.5917 0.5641

0.0015277 0.0579048 0.0119188 0.126773 0.0046624 0.0141835 0.0131077 0.0107276 0.0019864 0.011489 0.0154649 0.0130428

0.0087624 0.0040949 0.0230625 0.0176186

Table 1. Regression table for the first sub-period

For Portugal, the variables found significant were government debt, unemployment rate and inflation. The government debt coefficient is negative implying a reverse relationship to the bond spreads. This is obviously a contradictory result and not in line with theory yet this could indicate that bonds were mispriced. A one per cent increase in debt indicates a decrease in bond spreads by 0,04%. The effects of inflation and unemployment are both positive with and increase on bond spread for every per cent of 0,03% respectively 0,11%. This is in line with the theory that inflation and the unemployment rate has a positive relationship to bond spreads.

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The only variable found significant in the first sub-period for Ireland was government debt. An increase by one per cent would have a positive impact on bond spreads by 0,013%. Government debt and unit labor cost were the only variables that were significant for Italy. The coefficients imply that if government debt were to increase by one percent then the spreads would increase by 0.01 %. Additionally, if unit labor cost increased by one percent then spreads would increase by 0.004. Government debt was the only variable that was significant for Greece. It indicates that spreads will widen 0.013 percent if government debt were to increase by one percent. Unit labor cost, government debt and HICP were all significant for Spain. The coefficient for unit labor cost indicates that if it were to rise by one percent then the spreads would widen by 0.009 percent. In regards to government debt, the spreads would increase by 0.17 percent. A one percent increase in HICP would however have an inversely related effect on the spread where it would decrease by 0.02. The first sub period shows that the independent variable that PIIGS had in common was the government debt. The fact that the other variables had mixed results on the countries can imply that during a less volatile period these variables play a less important role for bond investors. Despite this, government debt still seemed to have some importance.

Second Sub-Period
Adjusted R F-stat 62.24 69.41

0.6448951

Prob. 0.0000 0.0000

Portugal 0.5908905 1.015671 Ireland Italy Greece Spain 1.161244 0.1022214 0.1250138 0.2399331

0.0873556 0.9320 0.9257 0.0546108 0.8948 0.8850 0.6013 0.5646

0.7882239 1.016838 0.3237773 1.016308 0.0771073

0.2051403 0.0117671 0.2918964

122.93 0.0000 153.09 0.0000 103.50 0.0000

0.0130389 0.9406 0.9351 0.7992 0.7805

0.1068272 0.0880985

Table 2. Regression table for the second sub-period

In the second period, debt has lost its significant impact on bonds in Portugal. The variables now significant are unemployment rate, unit labor cost and 14

inflation. Both unemployment rate and inflation has an increased impact on the bond spread. Inflation will now, for every percentage increase, increase bond spreads by 0,64 % and unemployment rate 1,02%. Ireland has, after testing the second sub-period changed its significant variables from only debt to unit labor cost and inflation. These to have an effect per every percentage increase of 1,16 and 1,017 percent respectively. Government debt is not significant for Italy whereas the rest are in the second sub-period. HICP indicates a negative relationship with the bond spread where a one percent increase would lead to a 0.2 decrease in spreads. Furthermore, a one percent increase in unit labor cost would increase bond yields by 0.1 percent. The coefficient also indicates that unemployment rates would have a positive effect on spreads, where a one percent increase would have the consequence of a 0.32 percent increase in spreads. Unit labor cost and unemployment rates were both significant for Greece the second period. A one percent increase in unit labor cost points to a 0.125 percent increase in bond spreads. Additionally, if unemployment rate were to increase by one percent bond spreads would increase by 1.01 percent. For Spain, HICP was the only variable that was not significant. A one percent increase in unit labor cost, government debt or unemployment rate points to an increase in bond spreads by 0.24, 0.88 and 0.77 percent respectively. In the second sub-period, unit labor cost was the common denominator for the five countries. Other than that the variables differ greatly as they did with the first period. The hypothesis that macro variables importance increases during a financial crises is supported in our model when one looks at r-squared. Since it increased between the two periods for all of the countries, it indicates that the model increased in accuracy. However, not all variables were significant during either of the two periods. This could partly imply that the bonds were mispriced during both periods.

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Further general analysis When it comes to the first sub-period, there are other factors that can be taken into account when it comes to determining the economic state and bond yield spreads of PIIGS. Firstly, although the countries are often bundled together, they differ the economic variables differ between them. Both Ireland and Spain kept within the debt requirements and ran budget surpluses. Furthermore, when credit became cheaper, entire nations could take quite different courses (Lewis, 2011). Whilst the money was borrowed by the government in Greece, it was borrowed by a few banks in Ireland. Despite this, a factor they did have in common was that the countries had been running unsustainable current account deficits (the Economist). The low interest rates stimulated domestic spending and increased inflation in wages and goods. This in turn made exports more expensive and imports relatively cheaper. Additionally, investors assumed that a Euro Zone could not default on its debt (Economist). The Euro zone could have been seen as a safety net and therefore the state of each individual country did not matter as much. In the book Boomerang, Michael Lweis states that these peripheral countries enjoyed the same credit rating as Germany did. This however changed when Germany, in the middle of the crises, implied that defaults were possible and the investors could have to bear some of the losses. The prospects of a default in the Euro Zone lead to a spiral of falling bond prices, a weakened banking system and slowing growth. New light was shining on macro variables and the states of the each countrys finances. Although the results may show signs of mispricing, there is reason be interpret them with caution. The number of observations used in the regression could have had an effect on the results because there were just too few to have an impact.

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Bibliography
Aizenman, J., Hutchinson, M. M., & Jinj, Y. (2011, September). What is the Risk of European Sovereign Debt Defaults? Fiscal Space, CDS Spreads and Market Pricing of Risk. Retrieved December 4, 2011, from The National Bureau of Economic Research: http://www.nber.org/papers/w17407 Alexpoulou, I., Bunda, I., & Ferrando, A. (2009, September 23). Determinants of Government Bond Spreads in New EU Countries. Retrieved from Social Science Research Network: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1474275&http://papers.s srn.com/sol3/papers.cfm?abstract_id=1474275 Barrios, S., Iversen, P., Lewandowska, M., & Setzer, R. (2009, November). Determinants of intra-euro area government bond spreads during the financial crisis. Retrieved December 3, 2011, from European Comission Economic and Financial Affairs: http://ec.europa.eu/economy_finance/publications/publication_summary16253 _en.htm Bernoth, K., von Hagen, J., & Schuknecht, L. (June 2004). Sovereign Risk Premia in the European Government Bond Market (working paper series). Hmtat frn European Central Bank: http://www.ecb.int/pub/pdf/scpwps/ecbwp369.pdf den 1 December 2011 Bodie, Z., Kane, A., & Marcus, A. J. (2011). Investments And Portfolio Management. New York, N.Y: Mc Graw-Hill Irwin. Brooks, C. (2002). Introductory Econometrics for Finance. Cambridge: Cambridge Univeristy press. Choudhry, M. (2010). An Introduction to Bond Markets. West Sussex, U.K: Wiley. Di, M. (2005, April 20). Retrieved December 27, 2011, from Pricing Sovereign Bonds: http://www.math.mcmaster.ca/~grasselli/sovereign_bonds.pdf Elliott, L. (2011, August 7). Global financial crisis: five key stages 2007-2011. Retrieved December 1, 2011, from The Guardian: http://www.guardian.co.uk/business/2011/aug/07/global-financial-crisis-keystages Elmendorf, D. W., & Mankiw, N. G. (1998, January). Government Debt. Retrieved December 4, 2011, from http://www.federalreserve.gov/pubs/feds/1998/199809/199809pap.pdf

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Eurostat European Comission. (den 10 March 2010). Harmonised unemployment (1 000) - monthly data. Hmtat frn http://epp.eurostat.ec.europa.eu/cache/ITY_SDDS/en/lmhu_m_esms.htm Gmez-Puig, M. (2002). Monetary Integration and the Cost of Borrowing. Barcelona: Universitat de Barcelona. Hill, C. R. (2011). Principles of Econometrics. Hoboken, N.J: Wiley. Lebrun, I., & Prez, E. (2011, May). Real Unit Labour Cost Differentiails in EMU: How Big, How Benign and How Reversible? Retrieved December 7, 2011, from IMF Working Paper: http://www.imf.org/external/pubs/ft/wp/2011/wp11109.pdf Liebermann, J. (den 18 April 2011). The Impact of Macroeconomic News on Bond Yields: (In)Stabilities over time and Relative Importance. Hmtat frn Bank for International Settlements: http://www.bis.org/cbhub/list/author/author_8219/from_01012011/index.ht m den 4 December 2011 Maddala, G. S. (2001). Introduction to Econometrics. New york, N.Y: Wiley.
Manganelli, S., & Wolswijk, G. (2009). What drives spreads in the euro. Economic Policy, 24(58), 193-236.

Nau, R. F. (n.d.). Example of regression analysis: predicting auto sales from personal income. Retrieved from Duke University: http://www.duke.edu/~rnau/regex.htm OECD. (2007). Unit Labour Costs-OECD. Retrieved 11 30, 2011, from Glossary of Statistical Terms: http://stats.oecd.org/glossary/detail.asp?ID=2809 Palumbo, G., Shick, R., & Zaporowski, M. (2006). Factors Affecting a Municipalitie's Bond Rating: An Empirical Study. Journal of Business and Economics Research , 4 (11), November. Poterba, J. M., & Rueben, K. S. (1999). Fiscal Rules and State Borrowing Costs: Evidence from California and Other States. California: Public Policy Institute of California. Ramanathan, R. (2002). Introductory Econometrics with Applications. Fort worth: Harcourt College Publishers. Ready for the ruck? Taking over the European Central Bank puts Mario Draghi in a position as perilous as Europes. (2011, October 22). The Economist . Soltes, D. V. (2011, September 14). The Euro Crisis: Euro as a Victim of the Decade Long Ignorance of the Maastricht Treaty Criteria by the EU Institutions and Euro Zone Member States. Retrieved December 05, 2011, from Social Science Research 18

Network: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1927189&http://papers.s srn.com/sol3/papers.cfm?abstract_id=1927189

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Appendix
150 0
2002m1

50

100

2004m1

2006m1 date DEBTPO DEBTIR DEBTSP

2008m1

2010m1

2012m1

DEBTIT DEBTGR DEBTGER

Graph 1. Government Debt

20 5 10 15

2002m1

2004m1

2006m1 date URPO URIT URSP

2008m1 URIR URGR URGER

2010m1

2012m1

Graph 2. Unemployment Rate

140 90
2002m1

100

110

120

130

2004m1

2006m1 date ULCPO ULCIT ULCSP

2008m1

2010m1

2012m1

ULCIR ULCGR ULCGER

Graph 3. Unit Labour Costs

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-4

-2

2002m1

2004m1

2006m1 date HICPPO HICPIT HICPSP

2008m1

2010m1

2012m1

HICPIR HICPGR HICPGER

Graph 4. Harmonized Indices for Consumer Prices

15 0 5 10

2002m1

2004m1

2006m1 date SPREADPO SPREADSP SPREADIT

2008m1

2010m1

2012m1

SPREADIR SPREADGR

Graph 5. Government Bond Yield Spreads

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Source: The Economist

Correlation Matrices Greece Period1 Spread 1.0 0.4476 0.6258 0.1659 0.2938 Unit Labor Cost 1.0 0.6818 0.1699 0.0726 Unit Labor Cost Government Debt HICP 1.0 0.1443 0.0327 Unemployment Rate

Spread Unit Labor Cost Government Debt HICP Unemployment Rate Period 2

1.0 0.5215 1.0

Spread Unit Labor Cost Government Debt HICP Unemployment Rate Ireland Period 1

Spread 1.0 0.0509 0.9041 0.5911 0.9733

Government Debt HICP

Unemployment Rate

1.0 0.2288 1.0 0.3304 0.6062 0.0423 0.9493

1.0 0.5758 1.0

Spread

Unit

Government HICP

Unemployment 22

Labor Cost Spread Unit Labor Cost Government Debt HICP Unemployment Rate 1.0 0.7974 0.7738 0.7571 0.7679 1.0 0.4980 0.7738 0.9827

Debt

Rate

1.0 0.7317 0.4276

1.0 0.7473 1.0

Period 2 Spread 1.0 0.8240 1.0 0.8664 0.9806 1.0 0.4324 0.8276 0.7686 0.8199 0.9989 0.9772 Unit Labor Cost Government Debt HICP Unemployment Rate

Spread Unit Labor Cost Government Debt HICP Unemployment Rate Italy Period 1

1.0 0.8242 1.0

Spread Unit Labor Cost Government Debt HICP Unemployment Rate Period 2

Spread 1.0 0.2456 0.1267 0.2659

Unit Labor Cost

Government Debt HICP

Unemployment Rate

1.0 0.7531 1.0 0.7080 0.5088 0.7988

1.0 0.6982 1.0

0.0999 0.9111 Unit Labor Cost 1.0 0.2964 0.3419 0.1734

Spread Spread 1.0 Unit Labor Cost 0.2624 0.5001 Government Debt 0.3756 HICP Unemployment Rate 0.8326

Government Debt HICP

Unemployment Rate

1.0 0.3027 0.6669

1.0 0.3961

1.0

23

Spain Period 1 Spread 1.0 0.9619 1.0 0.5351 0.5975 0.8424 0.9157 0.6081 0.7340 Unit Labor Cost Unit Labor Cost Government Debt HICP Unemployment Rate

Spread Unit Labor Cost Government Debt HICP Unemployment Rate Period 2

1.0 0.4814 0.3237

1.0 0.7623 1.0

Spread Unit Labor Cost Government Debt HICP Unemployment Rate Portugal Period 1

Spread 1.0 0.7039 0.5009 0.6687 0.2781

Government Debt HICP

Unemployment Rate

1.0 0.0735 1.0 0.9251 0.1800 0.8129 0.0773

1.0 0.8332 1.0

Spread Spread 1.0 Unit Labor Cost 0.5572 0.2011 Government Debt 0.3090 HICP Unemployment Rate 0.6310 Period 2 Spread Spread 1.0 Unit Labor Cost 0.8508 0.2011 Government Debt 0.8803 HICP Unemployment Rate 0.5901

Unit Labor Cost 1.0 0.0958 0.9267 0.3621 Unit Labor Cost 1.0 0.1261 0.9722 0.4804

Government Debt HICP

Unemployment Rate

1.0 0.2461 0.4672

1.0 0.1647

1.0

Government Debt HICP

Unemployment Rate

1.0 0.1684 0.2417

1.0 0.4852

1.0

24