Working Paper: CEPR ID: DP9249
Authors: John Beirne; Marcel Fratzscher
Abstract: The paper analyses the drivers of sovereign risk for 31 advanced and emerging economies during the European sovereign debt crisis. It shows that a deterioration in countries? fundamentals and fundamentals contagion ? a sharp rise in the sensitivity of financial markets to fundamentals ? are the main explanations for the rise in sovereign yield spreads and CDS spreads during the crisis, not only for euro area countries but globally. By contrast, regional spillovers and contagion have been less important, including for euro area countries. The paper also finds evidence for herding contagion ? sharp, simultaneous increases in sovereign yields across countries ? but this contagion has been concentrated in time and among a few markets. Finally, empirical models with economic fundamentals generally do a poor job in explaining sovereign risk in the pre-crisis period for European economies, suggesting that the market pricing of sovereign risk may not have been fully reflecting fundamentals prior to the crisis.
Keywords: bond spreads; cds spreads; contagion; ratings; sovereign debt crisis; sovereign risk
JEL Codes: C23; E44; F30; G15; H63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| deteriorating fundamentals (E32) | increase in sovereign yield spreads (H63) |
| heightened sensitivity to fundamentals (G41) | increase in sovereign yield spreads (H63) |
| deteriorating fundamentals (E32) | increase in CDS spreads (F65) |
| heightened sensitivity to fundamentals (G41) | increase in CDS spreads (F65) |
| pre-crisis period (H12) | less reflective pricing of sovereign risk (G19) |
| crisis period (H12) | more reflective pricing of sovereign risk (F34) |
| mispricing of sovereign risk (F34) | changes in fundamentals (F31) |
| regional contagion (R11) | rise in sovereign risk (F34) |
| herding behavior (C92) | dynamics of sovereign risk (F34) |