Spain - Unemployment, Debt Management, and Interest Rate Differentials


WP/95/107-EA
Spain: Unemployment, Debt Management, and Interest Rate Differentials
by Gustavo CaƱonero


This study is about the market's assessment of the Spanish authorities'
commitment, as reflected in the interest rate premium on long-term debt
instruments, to reach the targets of the Maastricht Treaty by 1997. This
premium has been among the highest when compared with other, more developed
but highly indebted countries in Europe. The analysis extends from the last
quarter of 1989 to the crisis of September 1992, a period when there was a
strong commitment to keep the Spanish peseta under the rules of the European
Monetary System (EMS).

Although the paper considers the standard explanations for the interest
rate premium, such as the level of outstanding debt and the degree of fiscal
imbalance, it focuses on two particular aspects of the Spanish economy that
may be undermining the authorities' policy credibility. These are the high
unemployment rate and the lengthening of the maturity of the debt pursued by
the Spanish authorities in the recent past. In general, a high unemployment
rate may detract from the credibility of a stabilization program because the
probable additional destruction of jobs may worsen the initial level of
unemployment. However, a deliberate attempt to increase the maturity of
peseta-denominated debt may have undesirable signaling effects in regard to
the inflation target. Although such a policy could strengthen the
credibility of a fixed exchange rate, one could still wonder what might move
a government that purports to be committed to lowering inflation below the
prevailing rate to willingly pay the premium the market demands for longer
maturities.

An integrated model is developed that takes into account the existence
of these two constraints in building a credible policy commitment, and a
framework is provided to evaluate them empirically. Two methods are used to
estimate the resulting model. The first method uses Kalman filters to
account for the variation of credibility over time. The second method,
which uses robust errors on the model-reduced form, does not directly
estimate the variation of credibility over time. However, given the small
working sample, it provides useful contrasting evidence for the Kalman
filter estimates.

The evidence provided in this evaluation supports the view that policy
credibility in Spain is linked not only to policymakers' type, but also to
policy viability. In Spain, massive unemployment is the major threat to
credibility, thereby implying that anti-inflationary attempts could be very
costly, even if carried out by the most conservative policymaker. Clearly,
it also reinforces the need to act directly on structural variables and
casts doubts on using only monetary or exchange rate policies to help
resolve the fiscal conflict. No conclusive evidence is found in regard to
the effect that the increase in debt maturity may have had on the interest
rate premium.