What is the Risk of European Sovereign Debt Defaults? Fiscal Space, CDS Spreads and Market Pricing of Risk

We estimate the pricing of sovereign risk for sixty countries based on fiscal space (debt/tax;deficits/tax) and other economic fundamentals over 2005-10. We measure how accurately themodel predicts sovereign credit default swap (CDS) spreads, focusing in particular on the fivecountries in the South-West Eurozone Periphery (Greece, Ireland, Italy, Portugal, and Spain).Dynamic panel estimates of the model suggest that fiscal space and other macroeconomic factorsare statistically significant and economically important determinants of market-based sovereignrisk. Although the explanatory power of fiscal space measures drop during the crisis, the TEDspread, trade openness, external debt and inflation play a larger role. As expectations of marketvolatility jumped during the crisis, the weakly concavity of creditors’ payoff probably accountsfor the emergence of TED spread as a key pricing factor. However, risk-pricing of the South-West Eurozone Periphery countries is not predicted accurately by the model either in-sample orout-of-sample: unpredicted high spreads are evident during global crisis period, especially in2010 when the sovereign debt crisis swept over the periphery area. We “match” the peripherygroup with five middle income countries outside Europe that were closest in terms of fiscal spaceduring the European fiscal crisis. We find that Eurozone periphery default risk is priced muchhigher than the “matched” countries in 2010, even allowing for differences in fundamentals. Oneinterpretation is that the market has mispriced risk in the Eurozone periphery. An alternativeinterpretation is that the market is pricing not on current fundamentals but future fundamentals,expecting the periphery fiscal space to deteriorate markedly and posing a high risk of debtrestructuring. Adjustment challenges of the Eurozone periphery may be perceived aseconomically and politically more difficult than the matched group of middle income countriesbecause of exchange rate and monetary constraints.