The determinants of public deb and its financing

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DECLARAÇÃO

Nome: Carla Patrícia Miranda Soares

Endereço electrónico: carlapmsoarees@gmail.com

Título dissertação: The Determinants of Public Deb and its Financing Orientador: Ermelinda Amélia Veloso da Costa Lopes Fernandes da Silva Ano de conclusão: 2018

Designação do Mestrado: Metrado em Economia Monetária Bancária e Financeira

É AUTORIZADA A REPRODUÇÃO INTEGRAL DESTA TESE/TRABALHO APENAS PARA EFEITOS DE INVESTIGAÇÃO, MEDIANTE DECLARAÇÃO ESCRITA DO INTERESSADO, QUE A TAL SE COMPROMETE;

Universidade do Minho, 29/10/2018

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"Personally, I do not feel that any amount can be properly called a surplus as long as the nation is in debt. I prefer to think of such as an item as a reduction on our children's inherited mortgage."

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ACKNOWLEDGMENTS

The achievement of this master's dissertation is the result of a journey that would not have been possible without the precious collaboration of several people who accompanied me and supported me at this important stage of my life and to whom I will be eternally grateful.

Firstly, I would like to thank the professor Dr Ermelinda Lopes for her outstanding and formidable guidance, total support and availability, for the opinions and criticisms that have greatly raised my scientific knowledge, and which have stimulated the continuation and finalization of this project.

To my parents, for being such good examples of struggle and courage. My sincere appreciation for all the life teachings and sacrifices made for the sake of my dreams.

To my sister, for believing that I was capable and for always having a word of support when things did not go so well.

To my friends who were always by my side during this phase, for the companionship, friendship, strength and support in the most difficult moments.

My gratitude goes to all the people who were by my side and contributed to the realization of this dissertation.

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ABSTRACT

The need for harmonizing economic and budgetary policies in the Economic and Monetary Union, as well as the perception that a high percentage of public debt threatens future generations while increases the tax burden, led to controversial opinions, even more when considering a globalized and disturbed economic and financial context.

The recent sovereign debt crisis that affected the Euro Area, especially the Peripheral countries, highlighted the need for a more in-depth study, also emphasizing the importance of the public debt financing and its determinants. A prudent public debt management contributes to a sustainable economic growth, the main objective of the State, through an access to low financial costs and limiting its exposure to additional risks.

The aim of this study is to identify which factors influence the public debt dynamics in the Euro Area countries. For this purpose, we used a Panel data regression, with information for 18 EU Member States, from 2002 until 2016. The research findings of our key-model (14 countries) reveal the interest payments as the main explanatory variable to variations on the public debt, being this our variable to explain. Additionally, a balanced budget, the real GDP growth rate, the government bond yields and the financial sector financing are also seen to influence the public debt level. The external financing, as well as domestic financing through households, have no impact on the public debt variation. However, both proved to be statistically significant when we enlarge our data in the number of countries (18) and also including the most recent period of analysis (2013-2016).

Overall, we can conclude that the internal financing through households allows a better sustainability of the public debt when compared to external financing considering that external financing implies a debt increase through the liquidity that is lost when this type of financing is used. This conclusion has empirical evidence considering the most recent years of our analysis.

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RESUMO

A necessidade de harmonizar as políticas económicas e orçamentais na União Económica e Monetária, assim como o reconhecimento de que uma elevada percentagem de dívida pública ameaça as gerações futuras agravando a carga fiscal, tem conduzido a várias opiniões controversas, mais ainda considerando um contexto económico e financeiro globalizado e conturbado. A recente crise de dívida soberana que afetou a Zona Euro, com especial atenção para os países periféricos, realçou a necessidade de um estudo mais aprofundado despertando também para o interesse do financiamento da dívida pública e suas determinantes. Uma gestão prudente da dívida pública contribui para um crescimento económico sustentável, principal objetivo dos Estados, através do acesso a recursos financeiros a baixos custos, limitando a sua exposição a riscos acrescidos.

O objetivo deste estudo é identificar quais os fatores que influenciam a dinâmica da dívida pública nos países da Zona Euro. Para o efeito, efetuamos uma regressão com dados em painel, utilizando dados referentes a 18 Estados-Membros, desde 2002 até 2016. Os resultados da estimação do modelo-base (14 países) revelam as despesas com os juros como a principal variável explicativa para as variações da dívida pública, sendo esta a variável a explicar do modelo. Para além deste facto, o saldo orçamental equilibrado, a taxa de crescimento real do PIB, as yields dos títulos soberanos e o financiamento do setor financeiro mostram, também, ter um impacto no nível da dívida. O financiamento externo, assim como o financiamento interno pelas famílias, não provoca qualquer impacto na variação da dívida pública. Contudo, foi demonstrado que estas variáveis explicativas revelam significância estatística quando no nível de dívida é incluído um maior número de países (18), no período mais recente de análise (2013-2016). Globalmente, podemos concluir que o financiamento interno pelas famílias, permite uma melhor sustentação da dívida pública relativamente ao financiamento externo uma vez que este implica um agravamento da dívida através da saída para o exterior da liquidez relativa aos custos de financiamento. Esta conclusão tem evidência empírica considerando os anos mais recentes desta análise.

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LIST OF FIGURES

Figure 1: European Sovereign Interest Rates, 10-Year Maturity; 1992-2001 ... 10

Figure 2: Budget Balance, % GDP, Euro Area; 1999-2016 ... 11

Figure 2.1: Budget Balance, PIIGS; 2010 ... 12

Figure 3: Public Debt, % GDP, Euro Area; 1999-2016 ... 14

Figure 4: Real GDP growth rate, Euro Area; 1999-2016 ... 15

Figure 5: Government Bond Yields, 10 years maturity, Euro Area; 1999-2016 ... 16

Figure 6: U.S. Government Debt, % GDP; 1790-2000 ... 18

Figure 7: Government debt by type of financing instrument, Euro Area; 2016 ... 27

Figure 8: Debt by type of financing instrument, by Eurozone Member State; 2016 ... 28

Figure 9: Debt by maturity, by Eurozone Member State; 2016 ... 29

Figure 10: General gross debt by sector of debt holder, by Eurozone Member State; 2016 ... 30

LIST OF TABLES

Table 1: General Government Expenditure, % of GDP; 1970-1995. ... 7

Table 2: Expected Coefficients Signals ... 40

Table 3: Results of the Estimated Regression ... 62

LIST OF CHARTS

Chart 1: Variation rate of public debt. ... 43

Chart 2: Variation rate of Budget Balance. ... 45

Chart 3: Variation rate of interest payments. ... 46

Chart 4- Variation rate of government bond yields, 10 years maturity. ... 47

Chart 5: Variation rate of the real GDP growth. ... 49

Chart 6: Variation rate of non-residents financing. ... 50

Chart 7: Variation rate of financial sector financing. ... 53

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ABBREVIATIONS

ECB- European Central Bank

EMU- European and Monetary Union EU-European Union

OLG- Overlapping generations model QE – Quantitative easing

SGP- Stability and Growth Pact AT – Austria BE - Belgium CY – Cyprus DE – Germany EE – Estonia EL – Greece ES – Spain FI – Finland FR – France IE – Ireland IT- Italy LT – Lithuania LU – Luxembourg LV – Latvia MT – Malta NL – Netherlands PT – Portugal SI – Slovenia SK – Slovakia

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INTRODUCTION

A higher public debt is one of the main macroeconomic fragilities with negative implications to the international financing markets. The financial crisis has affected most of the countries in the world, namely the Euro Area, and particularly those Member States with higher public debt ratio, measured as a percentage of GDP. In fact, this situation led to a sovereign debt crisis which has spread through the peripheral countries, raising questions about the formation and structures of the Euro Area and, in an ultimate case, about its sustainability in the future.

There are several relevant studies about public debt in order to explain its evolution, emphasizing its determinants as is the case of Sinhea et al. (2011), Turner (2012), and Pirtea et al (2013), where it is found the relevance about the GDP growth rate. Additionally, the interest rate it is also another crucial determinant in explaining variations of the public debt level, as discovered by Drazen (2000), Imbeau and Pétry (2004) and Swaray (2005).

In fact, increasing national debt and budget deficits have become a critical issue in many industrialized and emerging economies, as well as its implications to the Welfare States. Considering the persistent public deficits, the governments are confronted with the choice between external and domestic financing. Its actual or even potential magnitude imposes go e e t s o o i g e ui e e t with significant effects in the economy and then in the future of enterprises and in the social welfare, not only for the present generations, but also in the near future.

Thus, the government has two choices for covering its financial needs. The first one is related with the taxation system and the second with the debt issuance. The public debt indicates how much public spending is financed by borrowing and it is the only source to the Eurozone Member States. However, debt financing puts more pressure on the future generations and in their ability to maintain economic and financial stability.

Preceding the crisis, a thinning supply of new government securities was increasingly taken up by non-resident investors, frequently undercutting bids from domestic accounts.

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Since the arrival of the crisis, the investor base of government securities has changed back towards domestic holders, where commercial banks have also started to hold more government bonds, partly to obtain collateral, regardless of a reduction in their overall balance sheet, as we conclude in this study following the arguments sustained by Andritzky (2012). Overall, we can conclude that there is, in the Eurozone, a stronger debt financing by commercial banks benefiting from lower external interest rates.

Furthermore, the role of domestic financing through households, as well as external financing, provoked a higher impact in the final period of our analysis, that is between 2013-2016.

There are different effects on the debt burden that can result considering internal or external financing. The aim of this study is therefore to identify the main determinants of Public Debt and the impact of different debt holders in its level. We propose to compile a diverse range of factors such as the budget balance, the interest payments, the long-term government bond yields, the external financing, the domestic financing through households and the financial sector financing in order to observe the size of the impact that each one of these independent variables will have in our variable to explain, the Public Debt Variation Rate.

For this purpose, we first highlight the public debt evolution in the Euro Area and its differences in others macroeconomic indicators between the Eurozone group of countries, in chapter 1. In chapter 2, we present the different public debt instruments in a short and long-run basis and it is also described the current structure and size of the public debt, by type of instrument and by debt holder within Eurozone Member State. Chapter 3 emphasizes our model, specifying the explainable and all the explanatory variables as well as the data and the period of analysis that includes 18 European countries over the period between 2002 and 2016. In the following chapters, we analyze our main results, where we can conclude the interest payments as our main explanatory variable, not all in our key-model but also in all our three estimated regressions. Finally, the synthesis of the main conclusions is presented, the limitations of the work are mentioned,and suggestions for future research are made.

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CHAPTER I

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1.1 Literature Review

The public sector plays a major role in the allocation and redistribution of resources in society, where the promotion of efficiency, equity and the stimulation of growth and stability, represent its broad guidelines for the well-being of citizens. Thus, through monetary and fiscal policies, the State influences the rhythm of economic activities.

Discussions about the importance and role of the State in the economy have been held for a long time both by the representatives of political parties and State leaders, but it also represents a vital research question in the literature of the subject [Dogan, Pelassy, 1992, p. 25].

During the eighteenth century, in the critique of mercantilism and the monopoly of commerce that Adam Smith made through his work Wealth of Nations (1776), the idea of the market invisible hand was defended, which would control the economy, balancing supply and assuming the absence of State control as in the European maritime expansion times. This would be the basis of thought for the so-called classical theory of economics (Sandmo, 2014). But what history has shown us, not only in a distant past, but also in the first years of the 21st century, was that a market without interventions could lead a society to economic chaos and crisis situations.

The efo e, the State a tio a ises he the i isi le ha d of the a ket is ot sufficiently able to regulate the economy by stabilizing it but increasing inequalities.

In fact, for the economic stability, the State has to face market failures and know how to deal with externalities and possible concentrations of economic power by some economic agents. For this reason, many reflections have focused on issues related to the structure of expenses and taxes, considered socially optimal, and in the identification of the instruments that guarantee a better allocation of the public resources, as refers González-Páramo & Zubiri (1999).

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The formation of the State, as a Nation, was directly linked to the international pacification movements of the conflicts existing in the seventeenth century. The Treaty of Westphalia, which put an end to the Thirty Years War, inaugurated the modern international system by consensually adhering to notions and principles, such as State sovereignty and Nation State sovereignty.

It also established the principles that characterize the modern State, with a special emphasis on juridical equality among States, territoriality and non-intervention. This Treaty gave, therefore, rise to the sovereign dimension of the new European States and made them self-determining in relation to the other States of the same axis of political and economic power.

Regarding the economy, the dimension of the government measured as a percentage of GDP has, in turn, always been one of the most discussed issues. The focus of the debates, which during the nineteenth century was restricted to the dimension of intervention, moved, during the twentieth century, to its nature, given the articulation of new intervention mechanisms used in different countries. From the end of the twentieth century, the concern with the institutional environment becomes a new paradigm of studies in the economic field. In this sense, discussions regarding the implementation of public and private financing models became a central theme, once it is of the public interest the economic activity efficiency as a contribution to development, as suggested by Raja and Xavier (2005) and also by Hertog (2010).

While the analysis of the classical economic theory emphasizes the important role of the market in the economy, the Keynesian approach evolves, in a post-Great Depression context, and argues that the State intervention is crucial to the economy because public spending promotes aggregate demand, stimulating the economic growth rates.

Following this perspective of thought, the Welfare State emerges, whose main function is to correct social and economic inequalities, where public institutions promote measures to improve the living conditions of all citizens and, in this way, giving them access to essential goods and services.

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As expected, the greater the State intervention is, the greater the need to raise the level of taxes in order to finance the public budget.

The role of these policies assumes, now, an additional importance once it is found that countries with better budgetary performance display relatively smaller fiscal deficits and public debt. On the opposite side, negative budgets can allow more external influence in the government policies, as argues Stein et al. (1999) and Eisl (2017), namely by external financing. To judge the size of the State in the economy, the most widely used indicator is the ratio of Government spending to Gross Domestic Product (GDP). Another indicator - the percentage of Government debt in relation to GDP _{– is also used for the same purpose.}

The following table informs about the share of public spending as a percentage of GDP in some Eurozone Member States from 1970 to 1995.

Table 1: General Government Expenditure, % of GDP; 1970-1995.

Countries 1970 1975 1980 1985 1990 1991 1992 1993 1994 1995 France 38,5 43,4 46,1 52,1 49,8 50,4 52 54,6 54 53,9 Germany 38,3 48,4 47,9 47 45,1 47,9 48,5 49,5 48,9 49,5 Italy 33 41,5 42,1 51,2 53,4 53,7 56,3 57,1 54,8 52,1 European countries 32,1 39,3 43 48,1 45,8 46,5 47,6 49,2 48 47,9 OCDE _… _… 36,5 38,9 38,4 39,3 40,5 41,1 40,3 40,3

Source: PUBLIC MANAGEMENT REFORM AND ECONOMIC AND SOCIAL DEVELOPMENT (1998). Paris: OECD;

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Through Table 1, we can observe that all countries register higher values in 1995 when comparing with the first period of analysis (1970). Italy is the Member State with the lowest observed value in 1970, registering 33% of GDP. However, in 1995, Germany registers a value of 49,5%, representing now the EU Member State with the lowest value. In this context, we can observe that there was a big increase between these two countries in these two periods, representing a growth above 16%.

Therefore, it is possible to confirm that there is an increasing in the general government expenditures, which is mainly due to the cost of the Welfare State.

The economic effects of this growth in State intervention have two distinct views within economic thinking:

i) By one hand, some authors argue that the State intervention in the economy can be detrimental, discouraging savings and investments, and inducing to higher taxes that can distort the incentives of economic agents to work, as sustained by Williamson (2006) and Bird and Wilkie (2012).

ii) On the other hand, State intervention cannot just only be associated with economic costs, because the public services may have important benefits, as referred by Fisher (1997) and create positive externalities, as Andrade et al., (2013) argues.

In fact, increasing expenditures are also linked to a negative impact in the public debt, namely with its cost (interest rates) which, in turn, lead (again) to a rise in the public debt level. A higher level of government spending means that either a worsening in tax burden will occur to cope with these new expenditures, or the government will become more and more indebted, as mentioned by Samuelson & Nordhaus (1996) and Reinhart et al. (2015).

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1.2 The sovereign debt in the Euro Area

The euro as a single currency is the latest step in a long process of politically motivated economic and monetary integration.

The European Union Treaty signed in the city of Maastricht by the Member States of the European Economic Community in 1992, defined the creation of the Euro Area. This Treaty, also known as the Maastricht Treaty had, among its main objectives, the establishment of a European Economic and Monetary Union.

The Euro Area was founded in 1999 by a group of 11 countries: Austria, Belgium, Finland, France, Germany, Holland, Ireland, Italy, Luxembourg, Portugal and Spain. In 2001, Greece became part of this group. Subsequently, a further six European Union countries joined the Euro Area: Slovenia (2007), Cyprus and Malta (2008), Slovakia (2009), Estonia (2011) and Latvia (2014) and Lithuania (2015).

The agreement required that, as a share of GDP, national budget deficits not exceed 3 percent, and government debt not exceed 60 percent. One of the justifications for choosing these values co e s to the golde ule of the pu li fi a es , hi h a gues that u e t revenue must be enough to offset current expenditure and, therefore, loans only serve to finance public investment.

Even though Member States have made significant efforts to achieve these objectives, the solutions found by some countries had short-term effects, that only delayed the costs associated with such solutions to the future and helped providing the current crises of sovereign debt in the Euro Area.

Despite some Member States already registered high public debt values, the sovereign debt crisis in the Euro Area had, at first sight, its origin in the global economic and financial crisis, initiated in 2008 in the U.S. _{These ha ges i the a ket s t e d eated severe} challenges in some others macroeconomic variables, namely in economic growth: with negative growth rates.

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The first years of the EMU revealed a certain optimism with the reduction of the interest rates and the increase of demand for investments in the founding countries of the EMU. In fact, the implicit guarantees associated with Economic and Monetary Union drove down interest rates toward German levels_{—even for countries such as Greece (Figure 1), that} arguably had poorer fiscal prospects_{— and encouraged more borrowing.}

Figure 1: European Sovereign Interest Rates, 10-Year Maturity; 1992-2001

Source: European Central Bank. Note: Greece entered the Economic and Monetary Union in 2001.

I this se se, the appa e t disappea a e of isk culminated with an excess of borrowing carried out by households, enterprises, and governments and incommensurate capital flows from Northern European countries to Southern European countries.

The weakness in the public accounts of several European countries, evidenced by their high budget deficits and rising levels of public debt, raised considerable doubts that the Maastricht Treaty and the SGP1_{were enough to guarantee the sustainability of public finances}

among such different Member States.

1_{Stability and Growth Pact}_{– The Stability and Growth Pact is an agreement among the 28 member states of the European Union, to facilitate}

and maintain the stability of the Economic and Monetary Union (EMU). The purpose of the pact was to ensure that fiscal discipline would be maintained and enforced in the EMU. All EU member states are automatically members of both the EMU and the SGP, as this is defined by paragraphs in the EU Treaty itself. The fiscal discipline is ensured by the SGP by requiring each Member State, to implement a fiscal policy aiming for the country to stay within the limits on government deficit (3% of GDP) and debt (60% of GDP); and in case of having a debt level above 60% it should each year decline with a satisfactory pace towards a level below.

0 5 10 15 20 25 30 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 G ov ern m en t Bon d y ie ld s %

France Germany Greece Ireland

Italy Netherlands Portugal Spain

Europe's Economic and Monetary Union, 1999

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According to Dureé et al. (2014), there are three lines of failure in the structure of the Euro Area that were exacerbated by the global financial crisis, which gave rise to the sovereign debt crisis. The first line of failure is the result of poor public finances, with the first decade of the monetary union not being used to reduce the public debt ratio in the countries that were subsequently most affected by the crisis. The second flaw involves persistent imbalances in current accounts, and finally, the third line of failure lies in weak productivity growth and overall GDP growth.

The figure 2 shows us the evolution of the budget balance in the Euro Area and allows us to make a comparison between the PIIGS, known as the non-compliant countries (Greece, Ireland, Italy, Portugal and Spain), the strong economies (Germany and France) and the remaining countries of the Euro Area (Austria, Belgium, Cyprus, Estonia, Finland, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Slovakia, Slovenia), evaluated as Other economies. Note that, in this section, we will analyze these countries as three different aggregated groups in order to understand their substantial differences and the reasons behind their current economic performance.

Figure 2: Budget Balance, % GDP, Euro Area; 1999-2016

Source: Eurostat. -14,0 -12,0 -10,0 -8,0 -6,0 -4,0 -2,0 0,0 2,0 1999 2001 2003 2005 2007 2009 2011 2013 2015 % GDP

PIIGS France Germany Other Economies

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The analysis of this figure makes it clear why PIIGS are known as the non-compliant countries since the budget deficit average of these group of countries had presented, since 2003, values above 3% as a share of GDP, the value set as maximum. This value has registered successive increases over the years, reaching its highest level in 2010, two years after the beginning of the financial crisis in the U.S.

The budget deficit average reached a value over 13% as a share of GDP in this year, in this group of countries. In fact, as we can see in figure 2.1, all countries in this group registered deficits in 2010, where Ireland was the most outstanding (32,1%). We can, therefore, note that this country pulled the average of the PIIGS extremely down. The year of 2010 corresponded to the year when Greece requested external aid. Later, also Portugal and Ireland suffered the TROIKA interventions (European Central Bank, International Monetary Fund and European Commission).

Figure 2.1: Budget Balance, PIIGS; 2010

Source: Eurostat. - 35,0 - 30,0 - 25,0 - 20,0 - 15,0 - 10,0 - 5,0 0,0

Greece Ireland Italy Portugal Spain

%

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Germany was, in turn, the only country, in figure 2, that registered a surplus in the pre-crisis period, but it also exceeded the threshold of 3% of GDP, such as France, over several years. This confirms the assumption that the strong economies of the Eurozone had opened precedents to other countries do not respect the established rules and not be sanctioned, as it is sustained by Bagus (2010), Avgouleas and Arner (2013) and Hall (2016).

This situation, aligned with the absence of a European market monitoring mechanism, resulted in an increase of the divergence between the Euro Area countries.

Although Germany has experienced significant improvements, France presented, on the other hand, an average weaker than the one observed by the remaining countries, defined as

Other economies _.

The year of 2010 also represented a turning point, where deficits were reduced and, therefore, improvements were recorded in the budget balance. Currently, the average of the PIIGS is within the threshold of 3% as a share of _{GDP, a d it s ette tha the o e revealed by} France.

The remaining countries, seen _{as Other economies i figu e , did not show serious} deficits in any year of the period under consideration. Only in the years of 2010, 2011 and 2012, the values presented exceeded the threshold line, with an average of 5,2%, 4,4% and 3,6% of GDP. However, these values were corrected and, from 2013 until today, remained in values within the imposed limit.

Finally, the interpretation of figure 2 allows us to conclude that some Eurozone countries, especially the ones more affected by the financial crisis, already presented persistent imbalances in their current accounts, as it was also concluded by Dureé (2014), that only after a change in the market_{s trend became more evident, revealing the weaknesses of these} peripheral countries.

As argued by Cabral et al. (2013), this crisis affected largely the national budgets of the Euro Area Member States, reducing public revenues (due to the strong slowdown in economic activity) and increasing social transfers (due to the increase of unemployment). Some specific measures to stimulate economic activity, as well as massive transfers of the State to financial

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These types of interventions accelerated the public finances dete io atio of several countries, which contributed to the Sovereign Debt Crisis, that mainly reached the so-called PIIGS since 2010 – figure 3.

Figure 3: Public Debt, % GDP, Euro Area; 1999-2016

Source: Eurostat.

The public debt started to increase exponentially in the year 2008, affecting mainly the peripheral economies of the Eurozone (PIIGS). Between 2007 and 2010, the public debt, as a share of GDP, increased from 66% to 100% in this group, which is equivalent to an increase of over EUR 150 million, in absolute terms.

In some cases, the problem, which the recession has only aggravated, was a structural deficit associated with overgenerous social spending and insufficient tax revenues. This scenario applies most profoundly to Greece and it also applies to Italy, although a slow trend in economic growth is also driving the debt dynamics there.

In fact, the sovereign debt crisis in Europe had its epicenter in Greece in 2009 when this country recognized a budget deficit, as a share of GDP, above 15% and a public debt superior to 130%. As a result, the rating agency Fitch changed the Greece's "A" level down, an unprecedented downgrade for a European country.

0,0 20,0 40,0 60,0 80,0 100,0 120,0 140,0 1999 2001 2003 2005 2007 2009 2011 2013 2015 % GDP

PIIGS France Germany Other economies

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In this sense, this t e d of de t g o th has ee follo ed a i ed d a i of the GDP s evolution, as suggested by Checherita and Rother (2013).

If the GDP grows consecutively and the percentage of debt remains stable, it could be felt that debt is under control (even when there is an increasing, in absolute terms).

In the pre-crisis period, the Eurozone countries suffered from a relatively high and stable real GDP growth, particularly in the PIIGS, as figure 4 shows. This allowed lower budget deficits and then lower public debt rates, as a share of GDP. In 2008, the financial crisis initiated in the U.S and then spread out to the old continent - in a context of globalized economies - created a recession in the Eurozone Member States. In this context, the economic activity declined and both deficit and public debt, as a percentage of GDP, suffered successive increases.

Figure 4: Real GDP growth rate, Euro Area; 1999-2016

Source: OECD.

Although in 2009, the Germany's real GDP growth rate, as well as the average of the remaining Eurozone countries, presents a lower average than the one registered by the PIIGS, these group of countries (Germany and the group of Other economies) registered a faster recovery. - 8,0 - 6,0 - 4,0 - 2,0 0,0 2,0 4,0 6,0 8,0 1999 2001 2003 2005 2007 2009 2011 2013 2015 %

PIIGS France Germany Other Economies

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In fact, by the year of 2010, all these countries already presented positive values in their economic growth. This was not the case of the PIIGS that, from 2008 until 2013, have always presented negative values, in the real GDP growth rates.

On the other hand, during the first years of the EMU it was registered a positive economic growth mainly until 2008 (essentially in the PIIGS group), that was supported by the reduction of the interest rates in the markets. However, mainly from 2009, there is a divergence between the average of the PIIGS sovereign bond yields and the Bunds (German government securities), as figure 5 shows.

With the deterioration of the public finances in this group of countries, the market confidence in the creditworthiness of the European "peripheral" economies was rapidly decreased. These countries are obliged to pay considerably higher interest rates in order to access to new financing and even a refinancing.

This increase in the interest rates is explained, not only by the worst evaluation from the rating agencies but also by the role of speculators who bet i _{so e eig de t default.}

Figure 5: Government Bond Yields, 10 years maturity, Euro Area; 1999-2016

Source: Bloomberg. 0,0 2,0 4,0 6,0 8,0 10,0 12,0 1999 2001 2003 2005 2007 2009 2011 2013 2015 %

PIIGS France Other economies Germany

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The choice to use the Bund interest rates as a reference for the remaining Euro Area countries is justified by the history of Germany anti-inflationary measures and by the fact that the German government bonds are seen, in the markets, as safe heaven, which means they have avery low associated risk, as is referred by Barrios et al., (2009) and also by Arghyrou and Kontonika (2011).

Therefore, if the spread of some given country is very high when compared to the German bonds, it is expected that the sovereign bonds of that country have a substantial associated risk.

In fact, the announcement made by the Greek government, in November 2009, of a budget deficit so much above of the projected amounts, generated a wave of mistrust in the markets that led the country to a strong recession and then requesting for a financial assistance.

According to Zandstra (2013), the Greek government signed the EUR 110 billion bailout agreement, with EUR 80 billion arranged by the ECB and the remaining EUR 30 billion by the International Monetary Fund (IMF). This situation has spread from Greece to other Eurozone countries, namely Portugal, Ireland, Italy and Spain.

The year 2011, it is the year when the major deviation between the PIIGS sovereign bonds and the German bunds was observed. The tensions were intensified, and the crisis spread to the banking sector given the high exposure of this sector to the sovereign bonds of peripheral Member States. The increased mistrust in the markets led to a drop in sovereign bond prices even for countries that were least affected, except for Germany, whose prices rose. With the fall in bond prices, banks assisted to a weakness in their balance sheets, and bank stock prices fell by around 70% during that year, as referred by Cour-Thinmann and Winkler (2013).

In addition, the Interbank Money Market became dysfunctional, and banks suffered liquidity problems due to a decreasing in deposits made by its customers.

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1.3 Some empirical studies

1.3.1 Traditional Studies

Several theoretical and empirical studies have focused on the determinants of public debt. The literature about this issue shows that the factors that can affect public debt are macroeconomic, political, institutional and structural variables, as sustained by Barro (1979), Krugman (1988), Claessens (1990) and Warner (1992).

Overall, however, the traditional studies about this issue were much more focused on the consequences of public debt, once the e pla atio s fo the de t s o igi e e, at that time, easily justified.

In fact, empirical work on debt cycles and debt sustainability has been constrained, in the past, by the lack of public debt datasets covering long time periods and a wide group of countries. Some authors also seemed to show a lack of interest in the study of public debt determinants once the causes of public debt, in that period, seemed obvious.

Figure 6: U.S. Government Debt, % GDP; 1790-2000

Source: Congressional Budget Office, The Long-Term Budget Outlook (July 2018); Historical Data on Federal

Debt Held by the Public (July, 2018).

0,0 20,0 40,0 60,0 80,0 100,0 120,0 1790 1805 1820 1835 1850 1865 1880 1895 1910 1925 1940 1955 1970 1985 2000 Revolutionary War

Civil war World War I

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As we can see from figure 6, the debt issuance programs in the U.S can be better explained by external shocks to the economy, mostly provoked by wars. The Great depression was also an important period, where a major recourse to financing was verified, mainly to implement the New Deal’s program. This explains why the early theories of government debt issuance focused on wars as the prime cause of sovereign debt accumulation.

After the Second World War, the ratio peaked in the mid-1970s, precisely when the e o o as hit the oil p i e s shocks, causing an increase in public deficits, but in very small proportions when compared to the effects of war.

Therefore, considering a context of peace, the causes of public deficits have become much less obvious, mainly in Europe (especially since the 1970s) and economists suddenly had good reasons to examine the theoretical determinants of public debt.

In the wake of the global financial crisis, where countries like Greece, Ireland and Portugal were intervened by the European Commission, the European Central Bank and the International Monetary Fund, there has been strong, renewed interest in the behavior of public debt, especially in advanced economies.

1.3.2 Recent Studies

More recently, economists as Drazen (2000), Imbeau and Pétry (2004) and Swaray (2005) confirmed that many economic factors can influence the trajectory of public debt such as interest rate, economic growth, inflation, debt stock, budget deficit and public spending.

Turner (2012) described in his work that the interest-rate-growth differential is essential to understanding long-run fiscal sustainability; higher interest rates imply higher interest payments to service government debt so adversely influencing the debt dynamics, whereas higher nominal GDP growth will tend to lower the debt-to-GDP ratio by increasing the denominator.

Using panel regression, Sinha et al. (2011) found that the GDP growth rate is negatively related to public debt and it is its most important determinant.

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Pirtea et al. (2013) also analyzed the factors that influence the debt to GDP ratio in Romania, and discovered that the primary fiscal balance, the real interest rate, the real GDP growth rate, and exchange rate are significant factors.

Furthermore, Azzimonti et al. (2016) described the importance of a balanced budget in the political economic agenda, once it is one of the main factors that help to control public debt. These results were later confirmed by Globan and Matosec (2016), when analyzing the public debt determinants in the EU new member states. The results showed that by achieving a more balanced government budget, the growth rate of public debt should decrease. Additionally, the GDP growth rate proved to be highly significant in this study, which is expected and consistent with economic theory. Higher economic growth should certainly diminish the pressure on internal and external borrowing. Finally, long-term government bond yields have been showed as significant, and with an adverse impact in the public debt. In this sense, Dimitriosi et al. (2011) concluded to the Greek economy that the levels of long-term 10-year government bond yields, traded in the secondary market, affected the levels of debt.

Consequently, we can conclude that higher interest rates lead to higher interest payments, which _{ill p o oke a i ease i the de t s le el. O the othe ha d, a ala ed} budget and sustainable GDP growth, help to explain decreases in the _{total de t s di e sio .} Therefore, the most recent approaches are more concerned with the public debt determinants, being also a motivation for our analysis in this study.

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CHAPTER 2

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2.1 General approach

The rising participation of the State in the economy is the unequivocal historical trend of the 20th century. This tendency has become accomplished with the development of the Welfare States on the post Second World War. New areas of public intervention, carried out by the State, registered increasing expenditures which ultimately lead to imbalances in public accounts.

The State, as any other economic agent, needs funding. In its particular case, the financial needs, that arise from the execution of its tasks, are covered by the contraction of debt, which is called Public Debt and it is traditionally expressed as a share of GDP. The Public Debt assume the designation of internal debt, when the State has a commitment with entities of the country, or external debt, when the amounts are owed to foreign entities.

Government debt is one of the most regularly used notions in the current economic debate: for example, countries are compared and ordered according to the sustainability of their public finances, which involves existing government debt as the starting point; public debt management agencies are vigorously trying to condense rollover risks related to government debt; investors are carefully inspecting the credit default risks on sovereign debt; and economic and fiscal policies are planned to stimulate the future course of government debt. Consequently, government debt, as the indicator of government borrowing activity, is receiving, once again, more distinction in both national and supranational fiscal agendas as also argued by Lojsch et al. (2011).

High and growing government debt may influence interest rate levels (Lopes, 2011). Moreover, increasing government debt intensifies interest expenditure and crowds out other expenditure possibly more satisfactory to economic growth such as government investment. A s o all effe t, he e advanced debt exacerbates government interest expenditure, which is financed by additional issuance of debt, creates a vicious circle that may be disadvantageous to the sustainability of the public finances and general economic conditions.

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Therefore, a common starting point for the evaluation of sustainability risks is to inspect a ou t s government debt as a share of GDP. Even though, beyond the size of government debt, its composition is also a crucial factor in determining public finance susceptibilities.

The Public Debt could be, in turn, financed by several ways depending on the particular characteristics and numerous needs felt by the State. In the following section, we will give a special emphasis to the different public debt instruments and, in the last one, we will analyze the size and structure of the public debt in the Euro Area, by Member State, including the financing instrument, and maturity, as well as by sector of debt holder.

2.2 Public Debt Instruments

The economic activity is closely linked to the role that economic agents play in the market, extending this definition to all individuals, companies and States that daily take a set of decisions with a view to maximizing their usefulness. The most recurrent choice is the decision to channel income earned for consumption/investment or for savings (bypassing present consumption for future consumption). Thus, there are, in the market, coexisting economic agents with savings, and, for that reason, with some financing capacity and others in deficit, whose investments exceed their income, in a given period and, for that reason, with a financing need.

In this sense, the financial market plays a central role, placing in direct contact, or through intermediaries such as banks, surplus and deficit economic agents, facilitating transactions between them and streamlining financing processes, as suggested by Fonseca (2010).

Usually, the classification of debt instruments is made according to its maturity, distinguishing between short-term debt instruments, as Treasury Bills, and medium/ long term debt instruments, of which the Treasury Bonds stand out. Treasury bills do not give rise to a coupon payment (interest); however, it is possible for this debt instrument to be indexed to the inflation rate, allowing to its holders retain some real remuneration.

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The Treasury Bonds, in turn, have a fixed interest rate associated and present a maturity of more than one year, representing the main financing instrument used by the State in order to meet its medium/ long-term needs. When this type of negotiable debt instrument is used, the issuer compromises to pay to its holder _{– the bondholder – a certain periodic} income _{– the i te est – a d to efu d the apital , i the stipulated te s, as sustained by} Cruz (1995).

The perpetual loans as well as the annuities also represent examples of medium/long term public debt instruments but do not require any repayment obligation by the State. In the case of perpetual loans, the state must pay indefinite periodic interests and, in the case of annuities, as long as the creditor is alive (these payments are divided in two parts: one relating to the interest and the other relating to the capital amortization)2_.

In this work, we will focus on debt securities, especially on a long-term basis, once they represent the main type of financing instrument used by the EU Member States. In fact, in 2016, debt securities represented the major instrument of financing used by most EU Member States, representing 60,5% in the PIIGS countries, 72,6% in Germany, 84,6% in France and 69,7% in the remaining countries. In the PIIGS, it should be noticed the case of Italy, which stands out with a remarkable value of 84,4%. In the Eurozone, the average fixed in 79,6% (Eurostat, 2017).

It is, now, clear that the State, in order to obtain funds, uses the market through two mechanisms: to obtain individual loans and to issue public bonds. Among the advantages of public securities issuance, it is a larger universe of potential buyers, the possibility of monetary policy execution and a lower cost of negotiation, being easier its control.

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2.3 The Size and structure of government debt in the Euro Area

The relevance of examining the size of a government debt is related to answering questions associated _{to a go e} _{e t s solvency. A government is solvent in the period t if} the discounted value of its existing and upcoming budget balance surpluses is higher than the amount of the initial stock of debt, and the discounted value of forthcoming budget deficits. In the European context, gross government debt should not exceed the Maastricht Treaty reference value of 60% of GDP, except if it is declining at a satisfactory pace. In theory, a government should always be able to finance its current and future gross debt liabilities through higher taxation, financial or non-financial asset sales by privatization, or it will fall in its liabilities.

According to Bolle et al. (2006), diverse sources of vulnerabilities may arise from the debt profile, mainly depending on the debt structure, that include the composition of debt instruments and their maturities. An inappropriate debt structure could develop channels of exposures to the real economy and to the financial system and lead to higher interest payments (Borensztein et al., 2004). Overall, lower-cost debt structures, such as the excessive use of foreign currency–denominated debt, are subject to higher risk in the occasion of an unpredicted shock, as emphasized by Köhler (2016).

In addition to this, in developed economies, the government bond yield curve serves as a benchmark for assessing private sector bonds. The maturity composition of government debt affects the yield curve and later the financing conditions of the private sector, with possible impacts on overall economic activity. As is argued by Buiter et al. (1985) and, more recently, by Shetta and Kamaly (2014), higher government borrowing - under certain circumstances - crowds out possible private sector borrowings that are crucial for long-term economic growth. On the other hand, with a high share of short-term debt, the government may be exposed to intensifications on the monetary policy rates. If a government has to take fiscal procedures to respond to the effect of higher interest expenditure on the overall budget balance, this may have a negative effect on the economic activity, as also concludes Lopes (2011). In general, debt structures that tightly depend on short-term instruments are sources of vulnerability, once short average maturities involve high refinancing risks.

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This, in turn, defines the debt portfolio management strategy based on a given cost-risk ratio. When looking at various time horizons, there is a need to measure the short-term financing risks and also to consider the debt composition in order to evaluate the scope of the necessary fiscal policy to achieve a sound medium-term budgetary position. Thus, alongside the level of the debt ratio (exhibited in Chapter 1 - figure 3, from 1999-2016), analyzes of the debt structure are also warranted.

2.3.1 Public debt financing in the Euro Area, by Member State

Figures 7 and 8 shows the composition of government debt in the Euro Area broken down by type of financing instrument. First in the Euro Area as a whole, and, second, by EU Member State, in 2016. Figure 9 shows, in turn, the composition of government debt in the Euro Area by Member State, broken down by maturity, also in 2016.

Long-term securities, i.e. securities with initial maturity of over one year, represented 71,7% of government debt in the Euro Area in 2016, while short-term securities accounted for 7,9%. Loans represented 17,3% and, finally, currency and deposits implied 3,1% of government debt.

Figure 7: Government debt by type of financing instrument, Euro Area; 2016

long-term securities 71,7% short-term securities 7,9% currency and deposits 3,1% Loans 17,3%

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Looking now more closely to the composition of government debt by Eurozone Member State, figure 8 shows that these countries have issued mainly extensive securities in 2016. In particular, long-term securities represented over 70% of total government debt in almost countries, except for Luxembourg (50,7%), Portugal (38,4%), Cyprus (31,1%), Greece (13%) and Estonia (8,6%). Special emphasis for Portugal that represented the EU Member State with the biggest percentage of government debt issued on a short-term basis as a share of total government debt, in 2016, reaching 16,7%.

The second most important instrument were loans, and this was particularly true for Estonia (almost 87% of total), Greece (about 80%), Cyprus (around 67%) and Luxembourg (around 40%) Finally, the contribution of currency and deposits to total government debt was marginal, except for Ireland and Portugal, with 10,6% and 9,3% of total, respectively. Italy is around 8%.

Figure 8: Debt by type of financing instrument, by Eurozone Member State; 2016

Regarding the government debt by maturity, this could be subdivided into several maturity brackets: less than one year, one to five years, five to seven years, seven to ten years, ten to fifteen years, fifteen to thirty, and more than thirty years.

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% AT BE CY DE EE EL ES FI FR IE IT LT LU LV MT NL PT SI SK

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In 2016, 93,7% of the government debt was issued on a long-term basis (over 1 year) in the Euro Area. For countries where the full data was available, the biggest percentage was found with an initial maturity of 10 to 15 years and over 15 to 30 years, as we can see by figure 9.

Figure 9: Debt by maturity, by Eurozone Member State; 2016

In some countries such as Estonia, Slovakia, Portugal, Ireland or even Spain this was

evident, where the debt issued with an initial maturity of 10 to 15 years represented 37,2%,

36,8%, 35%, 32,5% and 29,7% of total debt, respectively.

Even though Malta presented the biggest value with 56,8% of its total debt being issued with an initial maturity between 15-30 years, also Slovakia and Portugal represented a big percentage, with 36,6% and 26,3%, respectively.

In general, governments tend to prefer to issue long-term debt securities once the associated costs are lower and, therefore, no such strong impact on the debt level is expected.

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% AT BE CY DE EE EL ES FI FR IE IT LT LU LV MT NL* PT SI SK Euro Area short-term (<1 year) long-term (total), of which: 1-5 years (incl.)

5-7 years (incl.) 7-10 years (incl.) 10-15 years (incl.)

15-30 years (excl.) > 30 years (incl.)

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2.3.2 Public debt by sector of debt holder in the Euro Area, by Member State In general, from the point of view of the debt manager, an ideal debt structure should be a fixed-rate and long-term bond portfolio but assess the debt by debt holder is also crucial to understand the debt burden, as it is referred by Alesina et al. (1992), Adejuwon et al. (2010) and Cecchetti (2011).

Across the Eurozone countries, significant differences can be observed regarding the general government debt held by debt holders/creditors3_{, in 2016}_{– as figure 10 shows.}

Figure 10: General gross debt by sector of debt holder, by Eurozone Member State; 2016

As we can observe, debt was mainly held by non-residents in half of these countries, in the referent year. Among the Member States for which data were available, the share of public debt held by non-residents, in 2016, was highest in Cyprus (79%), followed by Latvia (72%), Austria (71%), Finland (70%) and Lithuania (69%). On the other hand, among domestic holders, financial institutions were the most important investors in government securities.

3_{Euro area government debt held by residents refers to resident holders in the country whose government has issued the debt. They are}

also efe ed as do esti edito s .

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% AT BE CY DE EE ES FI FR IE IT LT LU LV MT NL PT SI SK

Resident Financial Corporations Resident non-financial sector Non-residents (rest of the world)

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Financial institutions typically hold a significant share of public debt in most countries4_.

Debt managers must recognize that their actions can have a major impact on the balance sheets of these institutions. Furthermore, given the usually high level of financial institutions interdependence, the impacts can have systemic consequences. This effect is pertinent not only when discussing possible sovereign liability management and debt restructuring operations but also when thinking about the targeted composition of debt. Fixed rate bonds pose less risk to the government, as referred by Braga and Vincelette (2011), but may represent a higher risk to the investor. If individual investors, in search of higher profits, intensifies their exposure to the interest rate risk and there is a hike in interest rates, the market in general may suffer.

In 2016, the largest proportion of debt held by _{eside t fi a ial o po atio s se to} was recorded in Luxembourg with 63%, and also in Italy and Malta, both with 62%.

I fa t, the th eat to Eu ope s a ki g s ste e a e u h o e se ious he the crisis went beyond just Greece and Portugal and began to infect Spain and Italy once those were two much bigger countries with huge government bond markets where many European banks were heavily exposed to them. The prospect that Italy, the third largest economy of the Eurozone, could either default or leave the Euro caused, indeed, a tremendous negative impact in the markets and then eventually implied a change in its government.

Regarding the non-financial sector financing, generally, across the Eurozone, less than 10% of debt was held by this sector (which includes non-financial corporations, households and non-profit institutions serving households). However, Malta with a value of 28%, and also Ireland and Portugal, both with 11%, were the biggest exceptions.

Several arguments could be found regarding the impact of the different government debt holders. Despite of this, it seems to exist a lack of empirical studies in the literature connecting these impacts and the debt level.

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Using an OLG model, Darreau and Pigalle (2014) found that debt burdens are independent of the internal or external holding of public debt. This equivalence arises because in an open economy, holding domestic and foreign assets and bonds is equivalent, under the assumption of perfect substitutability retained in the OLG model. This meets the Ricardian equivalence, to which debt is neutral, and there is no burden, either internal or external.

Between domestic or foreign borrowing, the principal risks are those associated with interest rates, exchange rates and rollovers, as referred by Westerfield (1978), Hawkins and Turner (2000) and Amstad et al. (2018) These risks must be weighted, and governments must also consider the medium- and long-term repercussions of a possible default in the debt service, as suggested by Elmendorf and Mankiw (1998), Beaugrand (2002) and Wheeler (2004).

If it is assumed that the State will not be able to finance the repayment of debt, in the future, from its current revenues, then a taxes rise will occur, and the domestic citizens will indeed have to bear the burden of additional taxes, as it is sustained by Pereira (2001) and Hennies and Raudjärv (2013).

This will not imply serious changes in the redistribution system of the private sector if the economic agents who actually have to bear the additional tax burden are the same persons to whom the public bonds will be repaid. Although, this situation may be different if public debt is acquired by foreign buyers. Now the debt repayment and interest obligations will be to payees who are abroad. Such a trend may decrease the potential living standards of the current generation of taxpayers.

In this context, despite domestic financing is associated with higher interest rates, a worsening on the debt level is not expected, contrary to external financing, once these interests will be contained in the national economy, as argued by Asogwa and Ezema (2005) and Gill (2005). In this context, we will use these two variables in our study in order to make an empirical study that give us statistical information about the impact of external and do esti fi a i g i the pu li de t s le el.

In countries as Portugal, where fiscal adjustment measures were made after the financial crisis onset, a recent increase in the domestic financing through households could suggest that the long-term government bond yields are more attractive than the long-term interest rates of bank deposits. We can see this information through Attachment I.

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CHAPTER 3

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3.1 The Model

The present chapter intends to carry out an empirical study that allows us to evaluate the determinants of Public Debt and the impact of the different debt holders in its level. Based on the literature review examined in the previous chapter, we propose to analyze a diverse range of factors, identified by the authors referenced as being the most preeminent, creating a unique econometric model that will present the size of the impact that each independent variable will have on the dependent variable: the Public Debt Variation Rate.

Thus, it becomes imperative to define a model that allows us to include several independent variables and to isolate the effects of each of them in the dependent variable. In this context, the estimation of the public debt variation rate will be made through a multiple linear regression model that concludes the following general formulation:

y = + ∑

𝑛 𝑛

+ 𝜀

𝑘

𝑛=

In our model, y translates the dependent variable, represented by 𝑉 . 𝑃 . 𝐷 𝑖,𝑡

(variation rate of public debt in a given i country at a t moment); _{α represents the constant;}

𝑛 translates the quantification of the impact provided in the dependent variable by the 𝑛

parameter which, in turn, represents each explanatory variable included in our model; and, finally, ε represents the stochastic error.

We suggest a panel data regression with the Eurozone countries for an estimated period, between 1999 to 2017, as it covers a first phase prior to the crisis, the crisis period and the post-crisis period.

The panel data estimation is an appropriate methodology, as it tolerates the use of observations in two dimensions: time and space, allowing to obtain more information, a greater variability of data, lower collinearity, a greater number of freedom degrees and a better efficiency in the estimation, as suggested by Baltagi (2013).

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According to the author, this method also presents some limitations, particularly in the difficulty in obtaining a complete database, selectivity problems and distortions that result from measurement errors.

In this study, we opted for a balanced data panel5_{, since the use of an unbalanced}

panel can cause constraints to the econometric analysis.

3.2 Data and Variables

The data were obtained at an annual frequency, a frequency commonly used by countries for the dissemination of their economic analysis reports. The first choice of this period of time was delimited by the entry of the unique currency in circulation in 1999 and the current period (2017), and was adapted according to the data availability, which resulted in a period from 2002 until 2016, which corresponds, therefore, to the most recent data of our sample. France also had to be withdrawn from our sample due to a lack of available information. Also, Belgium, Ireland, Portugal and Netherlands only presented available information since 2013 until 2016 for the variable regarding the variation rate of households financing, which represented another limitation.

In this context, we have conducted 3 estimation models: the first one covers a period from 2002 until 2016, for the 14 countries of our sample with complete information – excluding, thus, France, Belgium, Ireland, Netherlands and Portugal; The second one will include information since 2002 until 2016 for all the 18 countries that constitute our sample, only excluding France. The third one, will be estimated for all the same 18 countries but only from 2013 until 2016.

The Eurostat database served as source for most variables, with exceptions for β 𝑉 . 𝑃𝑖,𝑡6, 𝑉 . . 𝐵𝑌𝑖,𝑡7 and 𝑉 . 𝐷𝑃 𝑖,𝑡8.

5_{Panel data can be divided into balanced or unbalanced panels: balanced is when variables are observed for each unit in each time period}

and unbalanced is when there is a lack of data in at least one time period for at least one observational unit.

6_{Data from Bloomberg, obtained in www.bloomerg.com.} 7_{Data from Bloomberg, obtained in www.bloomberg.com.}

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According to the previous chapter of the literature review, we will describe the dependent and independent variables that we will use in our model, and also the expected signals for the coefficients of each explanatory variable.

Dependent variable

• Variation rate of public debt (𝑉 . 𝑃 . 𝐷 𝑖,𝑡): calculated as a ratio between

𝑃 𝑖 𝑖,𝑡/ 𝐷𝑃𝑖,𝑡 , he e 𝑃 . 𝐷 𝑖,𝑡 represents the public debt level of a

given i country at a t moment and GDP corresponds to its Gross Domestic Product at the same time, expressed as a percentage of change in the previous period. Independent variables

• Variation rate of budget balance (𝑉 . 𝐵 𝑖,𝑡): calculated as a ratio between

𝐷 𝑖 𝑖 𝑖,𝑡/ 𝑖,𝑡/ 𝐷𝑃𝑖,𝑡 , he e 𝐵 𝑖,𝑡 represents the value of the budget

deficit/surplus of a given i country at a t moment and GDP corresponds to its Gross Domestic Product at the same time, expressed as a percentage of change in the previous period.

A positive variation of the budget balance is associated with an increase in the surplus or with a reduction in the deficit and, therefore, it is expected that presents a negative correlation with our dependent variable, as it is perceived that a balanced budget helps to explain decreases in the public debt level, as suggested by Drazen (2000), Imbeau and Pétry (2004) and Azzimonti et al. (2016).

• Variation rate of the interest payments (𝑉 . 𝑃𝑖,𝑡): calculated as a ratio

et ee 𝑃 𝑖,𝑡/ 𝐷𝑃𝑖,𝑡 , he e the 𝑃𝑖,𝑡 represents the value of

the public debt interest payments of a given i country at a t moment and GDP represents its Gross Domestic Product at the same time, expressed as a percentage of change in the previous period.

The inclusion of this variable suggests that a high level of interest payments will result in a debt increase, as concluded by Swaray (2005), Turner (2012) and Pirtea et al. (2013). Thus, a positive variation of this variable is associated with a positive change in the debt level and

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• Variation rate of the Long-term Government Bond Yields, 10 years maturity (𝑉 . . 𝐵𝑌𝑖,𝑡): Long-term interest rates are generally averages of daily rates,

measured as a percentage, where the _{. 𝐵𝑌}_𝑖,𝑡 represents the government bond yields of a given i country at a t moment, expressed as a percentage of change in the previous period.

The impact of this variable assumes a high preponderance once long-term debt securities represent the main instrument of financing used by the EU Member States, with a common reference to 10 years maturity. According to the literature review, a high level of government bond yields will result in a growth of the future debt levels, adversely affecting this variable, as discovered by Dimitriosi et al. (2011) and Globan and Matosec (2016). Following this, a positive variation of this variable is associated with a positive change in the dependent variable and so, a positive correlation it is expected.

• Variation rate of the real gross domestic product (𝑉 . 𝐷𝑃 𝑖,𝑡): Constant

price estimates of GDP are obtained by expressing values of all goods and services produced in a given year, expressed in terms of a base period, where the 𝐷𝑃 𝑖,𝑡

represents the real GDP growth rate of a given i country at a t moment. This indicator is measured in growth rates compared to previous year.

The inclusion of this variable suggests that a high level of GDP will decrease the public debt service, expressed as a function of GDP, as referred by Swaray (2005), Sinha et al. (2011), Turner (2012) and Pirtea et al. (2013). As economic theory suggests, a higher economic growth diminishes the pressure on internal and external borrowing. Thus, it is expected that a positive variation of this determinant has a positive impact on the public debt, which means it will provoke a decrease in its dimension, exhibited by its negative correlation.

• Variation rate of external financing (𝑉 . 𝑁 𝑖 .𝑖,𝑡): acquisition of debt

securities by non-residents (rest of the world), where the 𝑁 𝑖 .𝑖,𝑡 represents

the non-residents financing in a given i country at a t moment, expressed as a percentage of change in the previous period.