Sovereign Spreads: Global Risk Aversion, Contagion or Fundamentals?

Abstract

This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate. Over the past year, euro area sovereign spreads have exhibited an unprecedented degree of volatility. This paper explores how much of these large movements reflected shifts in (i) global risk aversion (ii) countryspecific risks, directly from worsening fundamentals, or indirectly from spillovers originating in other sovereigns. The analysis shows that earlier in the crisis, the surge in global risk aversion was a significant factor influencing sovereign spreads, while recently country-specific factors have started playing a more important role. The perceived source of contagion itself has changed: previously, it could be found among those sovereigns hit hard by the financial crisis, such as Austria, the Netherlands, and Ireland, whereas lately the countries putting pressure on euro area government bonds have been primarily Greece, Portugal, and Spain, as the emphasis has shifted towards short-term refinancing risk and long-term fiscal sustainability. The paper concludes that debt sustainability and appropriate management of sovereign balance sheets are necessary conditions for preventing sovereign risk from feeding back into broader financial stability concerns.

Debt Burden and Perceived Sovereign Default Risk: Evidence from Credit Default Swaps

“…With respect to the independent variables, higher credit rating score, higher GDP growth and lower deficit are predicted to reduce the observed CPD, which is consistent with economic theory. In contrast, accelerating inflation rate 8 and higher government revenue as percentage of GDP (Caceres, Guzzo and Basurto, 2010) are associated with higher default probabilities, again consistent with theory. External debt burden, however, is not statistically significant.…”

“…Their results indicated that, whereas sovereign risk is mainly determined by country-specific sovereign risk fundamentals and market liquidity, the risk premiums are primarily driven by the risk aversion of investors (Remolona et al, 2008, p. 21). Caceres, Guzzo and Basurto (2010) argued that the widening of spreads during the early period of the crisis was essentially driven by changes in the global risk aversion, but later in the crisis, country-specific factors identified by each country's stock of public debt and budget deficit as a share of GDP played the dominant role. In a similar spirit, Arghyrou and Kontonikas (2012) found evidence in favor of a regime-shift in sovereign debt pricing towards countryspecific macro-fundamentals during the crisis.…”

Asymmetric dynamics in sovereign credit default swaps pricing: evidence from emerging countries

“…They found that before the crisis, 16% of investors considered themselves “conservative,” and this number escalated to 43% after the crisis. Moreover, risk aversion has been well documented as a significant variable in sovereign CDS pricing (Basurto et al. , 2010; Heinz and Sun, 2014).…”

Analysis of Long-term Equilibrium Relationship Between KRW, RMB, JPY Exchange Rates and International Financial Market Variables: Comparative Analysis of KRW, RMB, JPY

“…The third variable is credit risk spread. In [40], the author argued that credit risk spreads represent investors' risk aversion and are explained by the spread difference between the 10-year U.S. treasury bond and credit risky bonds. In [41], the author argued that an increase in the hedge propensity of investors in the international financial market increases the credit risk spread, and that the credit risk spread is significant in explaining the EMBI index of emerging economies in 31 countries.…”