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 the model predicts sovereign credit default swap (CDS) spreads, focusing in particular on the five countries 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 factors are statistically significant and economically important determinants of market-based sovereign risk. Although the explanatory power of fiscal space measures drop during the crisis, the TED spread, trade openness, external debt and inflation play a larger role. As expectations of market volatility jumped during the crisis, the weakly concavity of creditors' payoff probably accounts for 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 or out-of-sample: unpredicted high spreads are evident during global crisis period, especially in 2010 when the sovereign debt crisis swept over the periphery area. We "match" the periphery group with five middle income countries outside Europe that were closest in terms of fiscal space during the European fiscal crisis. We find that Eurozone periphery default risk is priced much higher than the "matched" countries in 2010, even allowing for differences in fundamentals. One interpretation is that the market has mispriced risk in the Eurozone periphery. An alternative interpretation 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 debt restructuring. Adjustment challenges of the Eurozone periphery may be perceived as economically and politically more difficult than the matched group of middle income countries because of exchange rate and monetary constraints.
|Date of creation:||Sep 2011|
|Date of revision:|
|Publication status:||published as Aizenman, Joshua & Hutchison, Michael & Jinjarak, Yothin, 2013. "What is the risk of European sovereign debt defaults? Fiscal space, CDS spreads and market pricing of risk," Journal of International Money and Finance, Elsevier, vol. 34(C), pages 37-59.|
|Contact details of provider:|| Postal: |
Web page: http://www.nber.org
More information through EDIRC
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Diamond, Douglas W & Dybvig, Philip H, 1983.
"Bank Runs, Deposit Insurance, and Liquidity,"
Journal of Political Economy,
University of Chicago Press, vol. 91(3), pages 401-19, June.
- Francis A. Longstaff & Jun Pan & Lasse H. Pedersen & Kenneth J. Singleton, 2011.
"How Sovereign Is Sovereign Credit Risk?,"
American Economic Journal: Macroeconomics,
American Economic Association, vol. 3(2), pages 75-103, April.
- Jeffery D Amato, 2005. "Risk aversion and risk premia in the CDS market," BIS Quarterly Review, Bank for International Settlements, December.
- Dooley, Michael & Hutchison, Michael, 2009.
"Transmission of the U.S. subprime crisis to emerging markets: Evidence on the decoupling-recoupling hypothesis,"
Journal of International Money and Finance,
Elsevier, vol. 28(8), pages 1331-1349, December.
- Michael P. Dooley & Michael M. Hutchison, 2009. "Transmission of the U.S. Subprime Crisis to Emerging Markets: Evidence on the Decoupling-Recoupling Hypothesis," NBER Working Papers 15120, National Bureau of Economic Research, Inc.
- Joshua Aizenman & Nancy Marion, 1999.
"Reserve Uncertainty and the Supply of International Credit,"
NBER Working Papers
7202, National Bureau of Economic Research, Inc.
- Aizenman, Joshua & Marion, Nancy, 2002. "Reserve Uncertainty and the Supply of International Credit," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 34(3), pages 631-49, August.
- Marian Micu & Eli M Remolona & Philip D. Wooldridge, 2006. "The price impact of rating announcements: which announcements matter?," BIS Working Papers 207, Bank for International Settlements.
- Sergio Mayordomo & Juan Ignacio Peña Sánchez de Rivera & Eduardo S. Schwartz, 2010.
"Are all Credit Default Swap databases equal?,"
Business Economics Working Papers
wb104621, Universidad Carlos III, Departamento de Economía de la Empresa.
- Calvo, Guillermo A, 1988. "Servicing the Public Debt: The Role of Expectations," American Economic Review, American Economic Association, vol. 78(4), pages 647-61, September.
- Stephen Cecchetti & Madhusudan Mohanty & Fabrizio Zampolli, 2010. "The future of public debt: prospects and implications," BIS Working Papers 300, Bank for International Settlements.
- Joshua Aizenman & Yothin Jinjarak, 2011.
"The Fiscal Stimulus of 2009-2010: Trade Openness, Fiscal Space, and Exchange Rate Adjustment,"
in: NBER International Seminar on Macroeconomics 2011, pages 301-342
National Bureau of Economic Research, Inc.
- Joshua Aizenman & Yothin Jinjarak, 2012. "The Fiscal Stimulus of 2009–2010: Trade Openness, Fiscal Space, and Exchange Rate Adjustment," NBER International Seminar on Macroeconomics, University of Chicago Press, vol. 8(1), pages 301 - 342.
- Antje Berndt & Iulian Obreja, 2010. "Decomposing European CDS Returns," Review of Finance, European Finance Association, vol. 14(2), pages 189-233.
- John Kiff & Jennifer A. Elliott & Elias G. Kazarian & Jodi G. Scarlata & Carolyne Spackman, 2009. "Credit Derivatives: Systemic Risks and Policy Options?," IMF Working Papers 09/254, International Monetary Fund.
- Fontana, Alessandro & Scheicher, Martin, 2010. "An analysis of euro area sovereign CDS and their relation with government bonds," Working Paper Series 1271, European Central Bank.
- Obstfeld, Maurice, 1996.
"Models of currency crises with self-fulfilling features,"
European Economic Review,
Elsevier, vol. 40(3-5), pages 1037-1047, April.
- Obstfeld, Maurice, 1996. "Models of Currency Crises with Self-fulfilling Features," CEPR Discussion Papers 1315, C.E.P.R. Discussion Papers.
- Maurice Obstfeld, 1995. "Models of Currency Crises with Self-Fulfilling Features," NBER Working Papers 5285, National Bureau of Economic Research, Inc.
- John Ammer & Fang Cai, 2007. "Sovereign CDS and bond pricing dynamics in emerging markets: does the cheapest-to-deliver option matter?," International Finance Discussion Papers 912, Board of Governors of the Federal Reserve System (U.S.).
- Alessandro Beber & Michael W. Brandt & Kenneth A. Kavajecz, 2006.
"Flight-to-Quality or Flight-to-Liquidity? Evidence From the Euro-Area Bond Market,"
NBER Working Papers
12376, National Bureau of Economic Research, Inc.
- Alessandro Beber & Michael W. Brandt & Kenneth A. Kavajecz, 2009. "Flight-to-Quality or Flight-to-Liquidity? Evidence from the Euro-Area Bond Market," Review of Financial Studies, Society for Financial Studies, vol. 22(3), pages 925-957, March.
- Frank Packer & Chamaree Suthiphongchai, 2003. "Sovereign credit default swaps," BIS Quarterly Review, Bank for International Settlements, December.
When requesting a correction, please mention this item's handle: RePEc:nbr:nberwo:17407. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: ()
If references are entirely missing, you can add them using this form.