Sovereign CDS Spreads in Europe: The Role of Global Risk Aversion, Economic Fundamentals, Liquidity, and Spillovers

78 Pages Posted: 27 Feb 2014

See all articles by Frigyes Heinz

Frigyes Heinz

International Monetary Fund (IMF)

Yan Sun

International Monetary Fund (IMF)

Date Written: January 2014

Abstract

By analysing data from January 2007 to December 2012 in a panel GLS error correction framework we find that European countries’ sovereign CDS spreads are largely driven by global investor sentiment, macroeconomic fundamentals and liquidity conditions in the CDS market. But the relative importance of these factors changes over time. While during the 2008/09 crisis weak economic fundamentals (such as high current account decifit, worsening underlying fiscal balances, credit boom), a drop in liquidity and a spike in risk aversion contributed to high spreads in Central and Eastern and South-Eastern European (CESEE) countries, a marked improvement in fundamentals (e.g. reduction in fiscal deficit, narrowing of current balances, gradual economic recovery) explains the region’s resilience to financial market spillovers during the euro area crisis. Our generalised variance decomposition analyisis does not suggest strong direct spillovers from the euro area periphery. The significant drop in the CDS spreads between July 2012 and December 2012 was mainly driven by a decline in risk aversion as suggested by the model’s out of sample forecasts.

Keywords: Sovereign debt, Europe, Euro Area, Spillovers, Capital markets, Liquidity, Economic models, CESEE countries, financial spillovers, CDS spreads, debt threshold, current account, public debt, current account balance, debt crisis, global liquidity, debt sustainability, sovereign bonds, financial markets, debt restructuring, external financing, public finances, sovereign debt crisis, stock market volatility, international financial markets, external shock, financial sector, debt defaults, current account deficit, current account balances, sovereign default, budget balances, corporate bond

JEL Classification: E44, G12, G15

Suggested Citation

Heinz, Frigyes and Sun, Yan, Sovereign CDS Spreads in Europe: The Role of Global Risk Aversion, Economic Fundamentals, Liquidity, and Spillovers (January 2014). IMF Working Paper No. 14/17, Available at SSRN: https://ssrn.com/abstract=2398818

Frigyes Heinz (Contact Author)

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

Yan Sun

International Monetary Fund (IMF) ( email )

700 19th Street NW
Washington, DC 20431
United States

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