DP9635 Currency Risk in Currency Unions
Sovereign yield spreads within currency unions may reflect the risk of outright default. Yet, if exit from the currency union is possible, spreads may also reflect currency risk. In this paper, we develop a New Keynesian model of a small member country of a currency union, allowing both for default within and exit from the union. Initially, the government runs excessive deficits as a result of which it lacks the resources to service the outstanding debt at given prices. We establish two results. First, the initial policy regime is feasible only if market participants expect a regime change to take place at some point, giving rise to default and currency risk. Second, the macroeconomic implications of both sources of risk differ fundamentally. We also analyze the 2009--2012 Greek crisis, using the model to identify the beliefs of market participants regarding regime change. We find that currency risk accounts for about a quarter of Greek yield spreads.