Spain - Unemployment, Debt Management, and Interest Rate DifferentialsWP/95/107-EA Spain: Unemployment, Debt Management, and Interest Rate Differentials by Gustavo Cañonero 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. |