Was the European sovereign crisis self-fulfilling? Empirical evidence about the drivers of market sentiments (original) (raw)
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SSRN Electronic Journal, 2000
We assess the nature of the European sovereign crisis in the light of a model borrowed from the second generation of currency crises. We bring the theory to the data to empirically test the presence of selffulfilling dynamics and to identify what may have driven the market sentiment during this crisis. To do so we estimate the probability of default of five European "peripheral" countries during January 2006 to September 2011 with a panel smooth threshold regression. Our estimation results suggest that 1/ both the fundamentals and "animal spirit" ignited the European sovereign crisis; 2/ the sovereign Credit Default Swap market (CDS), the rating agencies and the CDS of the banking sector have played dominant roles in driving market sentiments.
Animal Spirits in the Euro Area Sovereign CDS Market
2012
We study the determinants for the sovereign credit default swap (CDS) spreads of five Euro-area countries (Greece, Ireland, Italy, Portugal, Spain) in the post-Lehman-Brothers period. We find that there are regime switches in the process of sovereign CDS spread changes. We consider three alternative empirical hypotheses associated with regime switches. Under the first hypothesis, there are rational sunspot equilibria. Under the second hypothesis, there is a unique fundamental equilibrium and the regime switching is caused by changes in policy makers' preferences. The third hypothesis relaxes the rational expectations assumption. Under this hypothesis, indicators of the market fundamentals are not always precise. They are better indicators if cognitive biases are small and the rational expectations economy is a good approximation for reality. However, if market uncertainties enlarge the cognitive biases, the market-based indicators of fundamentals are no longer precise. In this ...
2011
In this paper we take an innovative econometric look at the Euro Zone Sovereign Debt Crisis. We are particularly interested in understanding which determinants have led investors to ask for higher yields on sovereign debt from the Euro shatter belt. We dismiss the definition of speculation previously used in the literature, on the basis of the irrelevance of Granger Causality as an operational tool for this purpose. Instead, we suggest that speculative behavior would only exist if market assessment would be unrelated to economic fundamentals of such countries. Using a cross section of countries, we improve on the scarce literature on the Econometrics of Credit Default Swap Markets on sovereign debt. Firstly, we use an ordered probit model to determine whether economic fundamentals are driving the implied rating assessments. Secondly, we provide a pioneering application of quantile regression to this domain, to determine which variables matter at different conditional quantiles of th...
Journal of International Money and Finance, 2017
During the euro-area financial crisis, interactions among sovereign spreads, sovereign credit ratings, and bank credit ratings appeared to have been characterized by self-generating feedback loops. To investigate the existence of feedback loops, we consider a panel of five euro-area stressed countries within a three-equation simultaneous system in which sovereign spreads, sovereign ratings and bank ratings are endogenous. We estimate the system using two approaches. First we apply GMM estimation, which allows us to calculate persistence and multiplier effects. Second, we apply a new, system time-varying-parameter technique that provides bias-free estimates. Our results show that sovereign ratings, sovereign spreads, and bank ratings strongly interacted with each other during the euro crisis, confirming strong doom-loop effects.
2020
Recent studies suggested that financial markets correlations and volatilities change during crisis periods. This paper presents a practical framework to test the volatility of sovereign credit default market and sovereign bond market indexes during the sovereign crisis period. Furthermore, our research tests the dynamic relationship between the sovereign CDS market evolution and the sovereign bond market, based on a sample of 10 developed Eurozone countries. Then, we integrate the bond debt's sensitivity presented by its maturity, which is a line of research supported by previous studies. Our results show that both markets are sensitive to internal shocks. Moreover, the dynamic relationship between the two markets is more sensitive to negative information than positive information. Finally, maturity significantly affects the sensitivity of sovereign bonds to CDS market evolution. This study contributes to the empirical literature by presenting, to the best of our knowledge, an unprecedented empirical investigation of the sovereign bond maturity effect's sensitivity to the sovereign CDS market evolution.
Business and Economic Research
We explore whether governments may have faced scenarios of self-fulfilling prophecy and multiple equilibria during Europe’s sovereign debt crisis. To this end, we estimate the effect of interest rates and other macroeconomic variables on sovereign debt ratings, and of ratings on interest rates. We detect a nonlinear effect of ratings on interest rates which is strong enough to permit multiple equilibria. The good equilibrium is stable, ratings are excellent and interest rates are low. A second unstable equilibrium marks a threshold beyond which the country slides towards an insolvency trap. Coefficient estimates suggest that countries should stay well within the A segment of the rating scale in order to remain safe from being driven towards default.
The impact of distressed economies on the EU sovereign market
Journal of Banking & Finance, 2013
Financially distressed economies inside the European Union (EU) are being blamed for producing a general increase in borrowing costs. This article analyzes the channels of default risk transmission within the EU countries using the information content in the sovereign Credit Default Swap (CDS) market. We proceed in two directions. First, we test the existence of cross-border volatility effects between the central and the peripheral EU countries. Second, we explore the effect of distressed economies on the default and risk premium constituents of sovereign default swaps. We show a significant volatility spillover from distressed to central European Economic and Monetary Union (EMU) economies. This causality pattern leads to a significant impact on the default swap risk premia. On average, the risk premium accounts for approximately 42% of central EMU spreads and 56% of the spreads for those countries outside of the EMU. The peripheral risk also affects the default component of central economies, although its impact is lower.
Applied Economics Letters, 2012
This paper evaluates the dynamic relationship between sovereign credit default swap (CDS) and bond markets for the 2001-2007 period. We compare monthly five year CDS premiums with Emerging Market Bond Index Global (EMBIG) stripped spreads for thirty sovereign bonds, providing a thorough analysis of sovereign credit markets with an extensive and high quality data set. Our first finding is that the relationship between sovereign CDS and bond markets has strengthened over time. Second, we show bond markets' leading role in the price discovery mechanism. This result is in sharp contrast with studies on corporate credit markets and it reveals the inefficiencies surrounding sovereign credit markets. Third, we provide an econometric methodology which is more meaningful in the sovereign context. Consequently, we propose a new measure to check for the appropriate error correction mechanism in the Vector Error Correction Model (VECM) framework. The results of our study possess valuable information for issuers, regulators, investors, and traders of sovereign securities.
Theory and evidence on self-fulfilling sovereign debt crises
2016
This work analyzes theoretically and empirically the potential self-fulfilling features of sovereign debt crisis. The theoretical model modifies Cole and Kehoe (1996, 2000) by considering that the default is partial. In the model, there are debt limits within which self-fulfilling crises may occur. The numerical results show that, within the crisis zone, up to an intermediate debt level, the optimal government policy is to run down the debt until it reaches the safe limit to avoid higher borrowing costs. Above a certain amount, however, the government chooses to run up the debt, to avoid sharp reduction in government spending. The empirical investigation assesses the determinants of the probability of default in Portugal. The model builds on Jeanne and Masson (2000) and is brought to Portuguese data using a Markov-switching regime framework. The results show that between 2000-14 two regimes subsisted: a tranquil and a crisis regime. The switch between regimes seems to be unrelated with macroeconomic fundamentals, which is interpreted as self-fulfilling jumps in the beliefs of credit markets.
Differences of opinion in sovereign credit signals during the European crisis
The European Journal of Finance, 2016
Motivated by the European debt crisis and the new EU regulatory regime for the credit rating industry, we analyse differences of opinion in sovereign credit signals and their influence on European stock markets. Rating disagreements have a significant connection with subsequent negative credit actions by each agency. However, links among Moody's/Fitch actions and their rating disagreements with other agencies have weakened in the post-regulation period. We also find that only S&P's negative credit signals affect the own-country stock market and spill over to other European markets, but this is concentrated in the pre-regulation period. Stronger stock market reactions occur when S&P has already assigned a lower rating than Moody's/Fitch prior to taking a further negative action.