What is the risk of European sovereign debt defaults? Fiscal space,CDS spreads and market pricing of risk |
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| Institution: | 1. Robert R. and Katheryn A. Dockson Chair in Economics and International Relations, USC, Los Angeles, CA 90089, USA;2. Department of Economics, UC Santa Cruz, Santa Cruz, CA 95064, USA;3. DeFiMS, SOAS, University of London, London WC1H0XG, UK;1. CEPN (CNRS-UMR 7234), University of Paris North, Sorbonne Paris Cité, France;2. EPEE, University of Evry Val d’Essonne, France;1. National Bank of Belgium, de Berlaimontlaan 3, 1000 Brussels, Belgium;2. Center for Economic Studies, University of Leuven, Naamsestraat 69, Leuven, Belgium;3. CESifo, Poschingerstr. 5, 81679 Munich, Germany;4. Louvain School of Management, Place de Doyens 1, bte L2.01.02 à 1348 Louvain-la-Neuve, Belgium;5. Insper Institute of Education and Research, Rua Quatá 300, São Paulo, Brazil;1. Department of Economics and Finance, Brunel University, Uxbridge, UB8 3PH, United Kingdom;2. Department of Economics and Statistics, University of Salerno, Via Ponte Don Melillo, 84084 Fisciano, SA, Italy;3. ISCTE – IUL, Business Research Unit (UNIDE-IUL), Instituto Universitario de Lisboa, Portugal;4. Department of Economics, Social Sciences Building, City University London, Whiskin Street, London EC1R 0JD, United Kingdom |
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| Abstract: | We estimate the pricing of sovereign risk for fifty countries based on fiscal space (debt/tax; deficits/tax) and other economic fundamentals over 2005–10. We focus in particular on five countries in the South-West Eurozone Periphery, Greece, Ireland, Italy, Portugal and Spain. Dynamic panel estimates show that fiscal space and other macroeconomic factors are statistically and economically important determinants of sovereign risk. However, risk-pricing of the Eurozone Periphery countries is not predicted accurately either in-sample or out-of-sample: unpredicted high spreads are evident during global crisis period, especially in 2010 when the sovereign debt crisis swept over the periphery area. We match the periphery group with five middle income countries outside Europe that were closest in terms of fiscal space during the European fiscal crisis. Eurozone Periphery default risk is priced much higher than the matched countries in 2010, even allowing for differences in fundamentals. One interpretation is that these economies switched to a “pessimistic” self-fulfilling expectational equilibrium. An alternative interpretation is that the market prices not on current but future fundamentals, expecting adjustment challenges in the Eurozone periphery to be more difficult for than the matched group of middle-income countries because of exchange rate and monetary constraints. |
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