Sovereign CDS Spreads in Europe: The Role of Global Risk Aversion, Economic Fundamentals, Liquidity, and Spillovers
IMF Working Papers, January 28, 2014
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Bibliographic details
- Authors: Frigyes F Heinz, Yan M Sun
- Published: January 28, 2014
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781484393017.001
Methodology
- Data analyzed: January 2007 to December 2012.
- Empirical approach: panel GLS error correction framework.
- Additional analysis: generalised variance decomposition analysis; out-of-sample forecasts used to assess drivers of recent movements.
Main findings
- Primary drivers: global investor sentiment (risk aversion), macroeconomic fundamentals, and CDS market liquidity conditions largely determine European sovereign CDS spreads.
- Time variation: the relative importance of these drivers changes over time.
- 2008/09 crisis period: high spreads in Central and Eastern and South-Eastern European (CESEE) countries were driven by:
- weak economic fundamentals (examples cited: high current account decifit, worsening underlying fiscal balances, credit boom),
- a drop in liquidity,
- a spike in risk aversion.
- Euro area crisis period resilience: marked improvement in fundamentals (examples cited: reduction in fiscal deficit, narrowing of current balances, gradual economic recovery) explains CESEE resilience to financial market spillovers.
- Spillovers: the generalised variance decomposition analysis does not suggest strong direct spillovers from the euro area periphery.
- July 2012–December 2012 episode: the significant drop in CDS spreads between July 2012 and December 2012 was mainly driven by a decline in risk aversion, as indicated by the model’s out-of-sample forecasts.
Policy-relevant implications
- Monitoring global risk aversion is critical for understanding sovereign CDS dynamics across European countries.
- Strengthening macroeconomic fundamentals (fiscal balances, current account positions, containing credit booms) can reduce vulnerability to large CDS spread increases during periods of global stress.
- Maintaining or restoring CDS market liquidity can mitigate spread spikes during crises.
- Direct contagion from euro area periphery may be limited; country-specific fundamentals and global sentiment can be more important than direct spillovers from periphery countries.
Source: IMF Working Paper — “Sovereign CDS Spreads in Europe: The Role of Global Risk Aversion, Economic Fundamentals, Liquidity, and Spillovers”