ECB Policy and Eurozone Fragility: Was De Grauwe Right?

Abstract

Paul De Grauwe’s Eurozone fragility hypothesis states that sovereign debt markets in a monetary union without a lender-of-last-resort are vulnerable to self-fulfilling dynamics fuelled by pessimistic investor sentiment that can trigger default. We test this contention by applying an eclectic methodology to a two-year window around Mario Draghi’s “whatever-it-takes” pledge that can be understood as the implicit announcement of the Outright Monetary Transactions (OMT) program. A principal components analysis reveals that the perceived commonality in default risk among peripheral and core Eurozone sovereigns increased after the announcement. An event study reveals significant pre-announcement news transmission from Spain to Italy, Belgium, France and Austria that clearly dissipates post-announcement. Country-specific regressions of CDS spreads on systematic risk factors reveal frequent days of large adverse shocks affecting simultaneously those same Eurozone countries during the pre-announcement period. Altogether these findings support the fragility hypothesis and endorse the OMT program.

Keywords: Sovereign debt; Eurozone fragility; Self-fulfilling dynamics; European Central Bank; Outright Monetary Transactions.

JEL Classification: E44, F36, G15, C52