Euro Area Sovereign Risk During the Crisis

IMF Working Papers, October 1, 2009

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While the use of public resources is critical to cushion the impact of the financial crisis on the euro-area economy, it is key that the entailed fiscal costs not be seen by markets as undermining fiscal sustainability.
The paper asks: to what extent do movements in euro area sovereign spreads reflect country-specific solvency concerns?
The paper suggests that euro area sovereign risk premium differentials tend to comove over time and are mainly driven by a common time-varying factor, mimicking global risk repricing.
Since October 2008, there is evidence that markets have become progressively more concerned about the potential fiscal implications of national financial sectors' frailty and future debt dynamics.
The liquidity of sovereign bond markets still seems to play a significant (albeit fairly limited) role in explaining changes in euro area spreads.

Euro area sovereign risk premium differentials tend to comove over time.
A common time-varying factor is the main driver of sovereign spread differentials, consistent with global risk repricing.
From October 2008 onward, market concerns about fiscal implications of national financial sector frailty and future debt dynamics have increased.
Sovereign bond market liquidity plays a significant but fairly limited role in explaining changes in euro area spreads.

Subjects: Financial crises, Financial sector, Return on investment, Securities markets, Sovereign bonds
Keywords: bond market, financial market, sovereign bond, WP

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