External Public Debt, Trade Linkages and Contagion During the Eurozone Crisis

Abstract

Against the backdrop of the contagion literature, the paper analyses the impact of financial and trade linkages on sovereign bond spreads in the Eurozone crisis. Using quarterly data for a sample of EMU countries during the period 2000–13, we estimate fixed‐effect panel models with Driscoll and Kraay standard errors that are robust to general forms of spatial and temporal dependence. Our main results can be summarised as follows: first, we suggest that the ‘sudden stop’ of capital inflow towards the peripheral sovereign debt triggered a re‐segmentation of financial markets and economic systems along national borders, with negative implications for risk‐sharing and the efficient allocation of capital. The ‘home bias’ effect – that is the increase in the share of sovereign debt held by domestic banks – worsened the country‐specific risk because the twin crisis (sovereign and banking) began to be conceived as more closely intertwined within countries than before. Second, the structure of international trade helps to account for the geographic scope of contagion, even after controlling for macroeconomic and fiscal vulnerabilities. Finally, the ‘substitution effect’ of public debt securities of stand‐alone emerging countries has affected more the sovereign spreads in the core than in the periphery.