Changes in demand for Portuguese sovereign debt around the 2010-2011 crisis and the role of market power

Governments around the world maintain enormous stocks of sovereign debt. Most of this debt is issued in auctions where investors submit bids consisting of the highest price they are willing to pay to purchase a unit of debt, and how much debt they are willing to buy.

This paper documents shifts in the demand for Portuguese sovereign bonds around the debt crises of the early 2010’s. Drawing on detailed data from Portuguese debt auctions, the paper shows that during the crisis investors became much less willing to absorb new debt unless prices dropped substantially.

Importantly, this change was not only due to investors reassessing the fundamental value of the bonds. It also reflected the exercise of market power: with only a small number of primary dealers allowed to bid in the auctions, individual investors could strategically bid below value to influence prices.

The paper then asks: how much of the shift in demand is due to changes in the valuation of the assets and how much of it is due to the market power of investors and their strategic decisions? In normal times, such market power is negligible. But as the crisis unfolded, the wedge between what investors were willing to pay and what they bid widened, leaving the government unable to capture the full value of its securities. This inefficiency, though small in absolute terms, grew to about 0.6 percent of the amount raised during the peak of the crisis.

Finally, the paper suggests that during crises issuing shorter-term debt appears to reduce these inefficiency costs, though it comes with the risk of more frequent refinancing.

Click here to go to the paper by Ricardo Alves Monteiro.