Monday, June 18, 2012

ECB Study: Lack of Crisis Response Causing Contagion in Europe

Empirical Study on European Sovereign Spillover Risk

An empirical ECB study published in February 2012 analyzing the effects of the sovereign debt crisis found that spillover from the economic situation in Greece is affecting risk premiums across the PIIGS countries, as well as in the Eurozone at large, to a smaller degree. In other words, the European Union’s inaction with respect the European sovereign debt crisis is making the situation worse. This is happening due to investor fears of contagion. The fear is that the longer European leaders remain inactive in attempts to contain the situation in Greece, the more afraid investors become.

This was determined empirically by testing European bond yield spreads for sensitivity to general market conditions, publication of the budget-balance-to-GDP ratio, sovereign credit ratings changes, and Greek, Irish, and Portuguese sovereign credit ratings changes.The ECB study points out that a lot of the movement in the market happens automatically, as large institutional investors fulfill their fiduciary obligations to dump their riskier investments as they rebalance the risk profile of their portfolios.

The study concludes that because of economic losses caused by the simple contagion fears, the Eurozone’s highest priority should be to reduce contagion risk in Europe. It’s just a shame that Angela Merkel doesn’t see things that way.

Since the intensification of the crisis in September 2008, all euro area long term government bond yields relative to the German Bund have been characterized by highly persistent processes with upward trends for countries with weaker fiscal fundamentals. Looking at the daily period 1 September 2008 – 4 August 2011, we found that three factors can explain the recorded developments in sovereign spreads: (i) an aggregate regional risk factor, (ii) the country-specific credit risk and (iii) the spillover effect from Greece. Specifically, higher risk-aversion has increased the demand for the Bund and this is behind the pricing of all euro area spreads, including those for Austria, Finland and the Netherlands. Country-specific credit ratings have played a key role in the developments of the spreads for Greece, Ireland, Portugal and Spain. Finally, the rating downgrade in Greece has contributed to developments in spreads of countries with weaker fiscal fundamentals: Ireland, Portugal, Italy, Spain, Belgium and France.

The European Central Bank (ECB) is the institution of the European Union (EU) that administers the monetary policy of the 17 EU Eurozone member states. It was established by the treaty of Amsterdam in 1998 as the Eurozone's central bank. 

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