Bounding the productivity default shock : Evidence from the The European Sovereign Debt Crisis

Interest rate spreads on sovereign debt were negatively correlated with the evolution of stock prices during The European Sovereign Debt Crisis. In particular, for a sample of 9 european countries there was a year (between 2009 and 2012) in which the correlation between stock prices and spreads was almost -1. We use this fact to estimate the upper bound of productivity default shocks using a continuous time structural model of default. At every instant the government maximizes expected tax revenues, where the only source of uncertainty is TFP, which follows a regime switching brownian motion. By estimating TFP regimes, to match interest rate spreads on sovereign debt and stock prices, we compute the ratio of the productivity if there was a default relative to the no default benchmark. This is a measure on how much productivity could countries loose at default. We found a robust negative relation between the costs of default and the probability of default. That is, financial markets incorporate into prices the risk of default immediately.