Sovereign risk in the Eurozone debt crisis

Abstract

Concerns about the state of public finances in the main advanced economies have increased as a result of the global financial and economic crisis that started in late 2007 – 2008. The fiscal solvency of several euro area peripheral countries has been put under the spotlight of the market participants who started to believe that a sovereign default was likely to happen in an advanced economy member of the euro area. This thesis seeks to investigate the sovereign risk in the euro area countries during the period before, during and after the crisis by focusing on the sovereign bond and credit default swaps spreads and the factors that drive them. In Chapters 2, we investigate the determinants of the government bond yields and sovereign credit default swaps. In our analysis for the government bond yields we find that the macroeconomic fundamentals used in our analysis are highly significant for the periphery countries, while they are less or not significant at all for the core euro area countries. We also find evidence that during the crisis the fluctuations of the government bond yields are not only explained by the macroeconomic fundamentals but also explained by factors related to the uncertainty in the euro area. In Chapter 3, we employ the panel cointegration approach in order to investigate the macroeconomic and financial indicators that impacted the sovereign credit default swaps in the crisis period using data from October 2008 until December 2014. We provide fresh evidence that the financial indicators, proxied by the iTraxx index as well as liquidity indicators, proxied by the bid-ask had a dominant role in explaining the CDS in almost all countries. In Chapter 4, in regard to the study of the price discovery relationship between the government bond yields and sovereign CDS, we suggest the use of cointegration methodology and also test for a structural break using the Gregory and Hanson approach to investigate the linkages between the two instruments. The structural break test suggests that the relation changed during the crisis and that the price discovery took place in the CDS market. Finally, in Chapter 5, we investigate the main factors causing the sovereign defaults. We use a panel of 99 countries to assess the impact that various macroeconomic and political risk indicators have on sovereign defaults on foreign currency bank loans, foreign currency bonds and local currency debt, utilizing an extended database constructed by the Bank of Canada. Our results suggest that the favorable economic indicators, lower debt levels, and higher political stability all reduce the likelihood of default. We also find that the capital outflows restrictions are positively associated with higher probability of default.