The Determinants of Joint Sovereign Default Risk in the Euro Area

This paper examines the determinants of expected joint default probabilities of Euro Area country-pairs. Our empirical results suggest that stronger and larger economies with low Debt-to-GDP ratios seem to have lower expected joint probabilities of default. The significance of these effects decreases after the bankruptcy of Lehman Brothers in September 2008, and especially after the outbreak of the sovereign debt crisis in November 2009. In times of crisis, real economy interconnections play a more important role for joint sovereign default risk and more interconnected countries tend to have higher expected joint default risk. Between Lehman Brothers’ bankruptcy and the sovereign debt crisis, we find evidence that risk sharing within the Euro Area banking system reduced joint sovereign default risk. We cannot confirm this effect during the sovereign debt crisis. We also document the importance of regional factors on the perceptions regarding the joint probability of default. In line with our expectations, market illiquidity and uncertainty increase the joint likelihood of negative events on the Euro Area sovereign debt market.