By Junaid Arefeen
The recent onset of the sovereign debt crisis in the Eurozone has brought the viabil-ity of the Eurozone as a currency area into question. The unsustainable debt and deﬁcit balances accumulated by several Eurozone nations since the adoption of the common currency in 1999, and the consequent incidence of high levels of sovereign default risk in the euro-area, indicate that the ﬁscal convergence criteria employed by the European Central Bank to monitor the ﬁscal discipline and sustainability of its members have been largely ine↵ectual. This paper draws upon the theory of optimum currency areas, and proposes a set of business cycle convergence criteria that can be employed as an alternate means to minimize the risk of ﬁscal imbalances and sovereign default. Economic theory suggests that a currency union with convergent business cycles will be insulated from asymmetric shocks, removing the need for countries to rely wholly on their ﬁscal policies when dealing with negative shocks (as would be the case in a currency union with non-synchronous countries su↵ering from negative asymmetric shocks). Therefore, as the risk of ﬁscal imbalances is minimized, a currency union with synchronous business cycles is expected to have low incidences of sovereign default risk. This paper tests this economic intuition empirically, and employs a multivariable panel regression model to determine the relationship between business cycle convergence and sovereign default risk (proxied using sovereign yield spreads). The regressions reveal that the degree of business cycle convergence is one of the main determinants of yield di↵erentials, and the relationship between the two is negative (as expected). The consistency of the results to numerous robustness checks provide a strong case for substituting the current ﬁscal convergence criteria with measures that assess the degree of business cycle convergence.
Advisor: Andrea Lanteri, Cosmin Ilut | JEL Codes: E32, E43, F34, F44, F45 | Tagged: Cycle Convergence, Optimum Currency Area, Sovereign Default Risk