A unified Italy? Sovereign debt and investor scepticism - Stéphanie Collet (Job Market Paper, Eu, 2012)

This paper provides an empirical study of sovereign debt integration and analyses the evolution of sovereign debt prices when several countries merge to become a “unified country”, or when the probability of such an event exists. Based on an original database of pre-Italian Bonds, this paper shows the impact of Italy’s unification on the bond prices. Italy’s unification was a long lasting process. The analysis shows that prior to the unification in 1862, the bonds issued by the future parts of the kingdom reacted in an idiosyncratic way. Around the sovereign debt integration, the paper highlights a large risk increase for low-yields bonds. Using a break point analysis and a Bayesian Dynamic Factor Model, the paper proves that until late 1860s the financial market did not believe in Italy’s Unification.

Keywords: State Succession, Unification, Financial History, Sovereign debt, Italy

Sovereign bonds have singular characteristics (Eaton and Fernandez, 1995; Shleifer, 2003). On one hand, given the official nature of the issuer, sovereign obligations are often considered as risk free assets. Indeed, the State, being entitled to raise taxes and to issue currency, cannot, in theory, go bankrupt. On the other hand, the real capacity of investors to force reimbursement is extremely limited. A sovereign State can unilaterally decide not to repay its debt, leaving the investors without any legal recourse. Understanding the implications of this paradoxical situation represents one of the main challenges of this topic (Eaton and Fernandez, 1995). Regarding the State’s capacity to repay, the literature has tried to identify the macro-economic (Manasse et al., 2003), the historical (Eichengreen et al., 2003; Reinhart et al., 2003) and the institutional and political causes of default (Kohlscheen, 2004; Van Rijckhegem and Weder, 2004). Academic literature has further investigated the motivations of the States to repay (Bulow and Rogoff, 1989; Mitchener and Weidenmier, 2004 and 2005; Tomz, 2007).

Recent papers have attempted to determine the impact of certain events on sovereign bonds’ expected rates of return. The well-known example of an event which disturbs the course of government bonds is war. Indeed, when a war breaks out, bond prices often experience sharp changes. The impact of various war-related events has been analysed for the American Civil War (Willard et al., 1996; Weidenmier, 2002; Oosterlinck and Weidenmier, 2007), for the Second World War (Frey and Kucher, 2000; Waldenström and Frey, 2004) and for the Russian revolution (Landon- Lane and Oosterlinck, 2006). For more peaceful periods, the reactions of bond prices following political changes have also been scrutinized. For instance, the effects on bond prices differ between democracies and autocracies (McGillivray and Smith, 2003; Dhillon and Sjostrom, 2009). As defaults might be linked with the political turnover (Saiegh, 2004; Bordo and Oosterlinck, 2005; Saiegh, 2005), political changes can impact sovereign bond prices. The reaction of financial markets in the case of an annexation has been investigated for the Texan (Burdekin, 2006) and Hawaiian (Burdekin and Laney, 2008) debts. The later paper finds a turning point in Hawaii’s debt related to its annexation one week after the annexation vote in the Senate.

Similar to annexation, another event can disturb sovereign bond markets: state unification. This paper focuses on the implications for state bonds of a country which faces a unification “risk”. The sovereign debts of the old entities are likely to be integrated. The study will detail the evolution of sovereign debt prices when a country unifies (or when such a probability exists) and investigates the sovereign debt integration. Puzzlingly, in spite of the importance of the amounts involved, there has been little investigation on the financial impact of a state‘s unification. Since international law requires continuity of rights and obligations, sovereign bonds would normally be carried over to the new country. However, exceptions such as war debt exist. The impact of state unification and sovereign debt integration has a contemporary echo and is regularly evoked in European debt debates.
This paper investigates Italy’s unification in the 19th century to study how the sovereign debts reacted to the progressive unification of the States (1848-1870) and sovereign debt integration (1862-1863). The choice of Italy is based on its unique unification history. Italy resulted from the unification of seven entities which took place gradually. Conte et al. (2003) also selected Italy to analyse the monetary unification (1862-1905) arising after the sovereign debt integration by focusing on prices of the integrated sovereign debt across regional stock exchanges. Italy’s unification is outstanding for academic purposes because each entity has its own bond premium and own history with events unrelated to the other entities. Up till the middle of the 19th century Italy was made up of different independent nations. Moreover, since the unification of Italy was carried out gradually, only the debts of the territory about to be attached were impacted. Italian unification integrated all those individual sovereign debts. This offers an opportunity to investigate the financial impact of sovereign debt integration.

The rest of the paper is organised as follows. Section 1 outlines a brief historical context leading to Italian unification and the associated pre-Italy sovereign debt. Section 2 focuses on the sovereign debt integration leading to the first Italian sovereign debt. Section 3 presents the data and the econometric methodology while Section 4 provides the main results and concludes. Section 5 draw parallels with the European sovereign debt issues. (...)

Stéphanie Collet: she works @ Université Libre de Bruxelles, SBS-EM, 50 av. Roosevelt, CP 114/03, 1050 Brussels, Belgium, scollet@ulb.ac.be.