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Contagion in the Eurozone sovereign debt crisis

Contagion in the Eurozone sovereign debt crisis

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An essay for the 2012 Undergraduate Awards (International Programme) Competition by Stefano Giulietti. Originally submitted for Senior Essay at Yale University, with lecturer Costas Arkolakis in the category of Business & Economics
An essay for the 2012 Undergraduate Awards (International Programme) Competition by Stefano Giulietti. Originally submitted for Senior Essay at Yale University, with lecturer Costas Arkolakis in the category of Business & Economics

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Published by: Undergraduate Awards on Aug 31, 2012
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11/02/2013

 
Contagion in the Eurozone Sovereign Debt Crisis
July 2, 2012
Abstract
Since the end of 2009, the Eurozone has been facing a severe sovereign debt cri-sis, which had its roots in Greece and gradually spread to other countries. Thispaper estimates an ARCH model of credit default swap spreads in order to ana-lyze whether contagion e
ff 
ects are identifiable during the crisis, that is, whetherthe financing di
culties faced by several European countries were due to investorpanic, herding or speculation, or to actual fundamental problems. The analysisshows the presence of contagion e
ff 
ects of Greece on Spain, Italy, Belgium, Franceand Portugal, both through CDS markets and credit rating downgrades. Furthercontagion is documented among Portugal, Spain, Italy and France in later stagesof the crisis.
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1. Introduction
Since the end of 2009, the Euro area has faced a severe sovereign debt crisis.The EU and IMF interventions did neither reverse the crisis nor contain itto Greece. On the contrary, the problem spread to several other countriessuch as Portugal and Ireland: even the sovereign debt markets of largeeconomies such as Spain and Italy – and to a much lesser extent, France–, came under pressure. Sovereign debt woes may have spread to othercountries when financial markets recognized an e
ff 
ective increase in creditrisk, but it may also be the case that Greece infected other debt markets bynegatively impacting the markets’ assessment of countries whose conditionswere not as critical.This paper aims at investigating whether the financing problems faced bysome Eurozone countries are disproportionate compared to their fundamen-tals, that is, whether there have been any contagion e
ff 
ects across countriesduring the debt crisis. Contagion due to market panic, investor herding,etc. is identified whenever the correlation coe
cients across two coun-tries’ credit default swap markets increase temporarily, together with theirvolatilities.An ARCH regression model is estimated in order to analyze the size andvolatility of cross-market correlations. Credit default swap spreads are usedas a bellwether of countries’ perceived default risk, as explained in Section2. The sample includes the CDS spreads of seven Eurozone countries overthe German benchmark: France, Italy, Austria, Portugal, Spain, Belgium
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and the Netherlands. The model investigates contagion caused by spilloversin CDS markets and by the e
ff 
ects of credit ratings.The analysis shows evidence that contagion stemming from Greece a
ff 
ectedPortugal, Spain, Italy, France and Belgium during the crisis. The onlytwo countries which were immune from contagion were Austria and theNetherlands. Additionally, further instances of contagion are identifiedfrom Spain to Italy, from Portugal to Spain and vice versa, and from Italyto France and vice versa.The study generally confirms the findings of Missio and Watzka (2011),who showed that the Portuguese, Spanish, Italian and Belgian bond mar-kets were a
ff 
ected by spillovers of the Greek crisis, while Austria and theNetherlands were immune to contagion
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. However, not only does this pa-per expand previous research by including France in the sample of analyzedcountries, but it also uses credit default swaps instead of bond yields as amore accurate measure of perceived credit risk.
2. Bonds vs CDS
Government bond yields and prices of CDS on government bonds are bothmeasures of a country’s credit risk as perceived by financial markets. The
1
Missio, Sebastian, and Sebastian Watzka, “Financial Contagion and theEuropean Debt Crisis.”
CESifo Working Paper No. 3554
(August 2011).
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