DEEP FINANCIAL LINKS ACROSS EURO ZONE COUNTRIES THREATEN
CONTAGION FROM GREECE
The more connected a country’s financial system is with that of Greece, the greater the
effect of Greece’s debt crisis on the perceived riskiness of that country’s government
debt. A 10% rise in exposure to Greek government debt increases the spread of risk to
that country by nearly 4% while a 10% increase in exposure to Greek bank debt
increases the spread of risk to that country by close to 1.5%.
These are among the findings of research by Filippo Brutti and Philip Sauré, to be
presented at the Royal Economic Society’s 2012 annual conference.
The study looks at the effect of spikes in news coverage of the Greek debt crisis on the
spreads for credit default swaps (CDS) for several European countries – a measure of
the perceived riskiness of government debt. They then look at how much greater the
effect is for countries with closer financial ties to Greece, measured by the exposure of
their banking systems to Greek default.
The research finds that the transmission of risk to the country with the largest average
exposure to Greece (1.22% of GDP) has been 46% larger than the one to the country
with the lowest average exposure to Greece (0.08% of GDP), other things being equal.
The authors conclude:
‘Our results show that financial linkages do contribute to the transmission of
sovereign default and that policy-makers are right to take seriously scenarios of
cross-country spillovers of sovereign risk through the exceptionally intense
financial linkages in Europe.’
More…
In late 2009, with the global economy inching out of the Great Recession, the sovereign
debt crisis hit Europe with a pace and vigour that led observers to question financial
stability in the entire region. Fears of sovereign insolvency initially developed in one
peripheral country, Greece, but quickly spread to other European countries.
Various competing theories of financial contagion have been put forward in the
literature, with a focus on either trade linkages, financial interdependence or investors’
reaction to changing global conditions. This study assesses the role of financial
linkages for the transmission of sovereign risk in the euro crisis.
Financial linkages may spread sovereign risk across borders through different
channels. For example, looming Greek sovereign default adversely affects banks in
France according to their exposure to Greek sovereign debt. Through implicit
guarantees, a troubled French banking system constitutes a liability of the French
sovereign, thereby increasing French sovereign credit risk.
By the same token, cross-border interbank lending can matter: as a Greek sovereign
debt crisis stresses the Greek banks, their foreign counterparties’ risk rises, affecting
the financial health of the latter’s countries.
The findings
This study estimates the contribution of financial linkages to the transmission of
sovereign risk, distinguishing in particular between transmission through exposures to
public debt and through cross-border bank linkages.
The researchers identify financial shocks that originate in Greece and analyse how
sovereign default risk of European countries, measured by sovereign credit default
swaps (CDS) spreads, responds to these shocks. They then relate the responses to the
cross-border exposure to Greek sovereign debt and debt of Greek banks.
The results show that financial linkages significantly contribute to the transmission of
sovereign default risk: a 10% increase in the exposure to Greek debt increases the rate
of cross-country transmission of sovereign risk by 3.94%. Similarly, a 10% increase of
exposure to debt of Greek banks implies that sovereign CDS react 1.47% stronger to a
Greek shock.
A back of the envelope calculation based on these estimates shows that the
transmission rate to the country with the largest average exposure to Greece (1.22% of
GDP) has been 46% larger than the one to the country with the lowest average
exposure (0.08% of GDP), everything else equal.
The method
The methodology used is a vector autoregression (VAR) model for country CDS
spreads, including global financial factors as exogenous variables. The researchers
identify a number of ‘Greek shocks’ – that is, information innovations from Greece –
and estimate the response of sovereign risk in other countries to these shocks.
To reduce a potential bias in this selection process, the identification of Greek shocks is
based on a mechanical extraction of the days containing news from Greece in three
timelines of the euro crisis, published by the Financial Times (Interactive timeline:
Greek debt crisis), the Wall Street Journal (Europe’s Debt Crisis – Timeline) and
Reuters (Europe’s Debt Crisis Timelines).
The researchers then exclude those Greek events that concur with relevant financial
news in other countries and control for global financial factors in the estimation to make
sure that the estimates reflect spillovers from Greece rather than the response to
shocks in other countries or to global market conditions.
To measure the role of financial linkages for the transmission of sovereign risk, the
researchers subsequently estimate whether the exposure to Greek debt has
contributed to the response to Greek shocks. In doing so, they adopt a difference-indifference approach and test whether within-country changes in response to Greek
shocks correlate with changes in exposure to Greek debt.
For this analysis, they use data on bilateral cross-border banks’ exposures stemming
from the Consolidated Banking Statistics of the BIS, which make it possible to
distinguish between the exposure to Greek public debt and the exposure to debt of
Greek banks. The results show that both type of financial linkages significantly
contribute to the transmission of sovereign default risk across European countries.
Conclusion
Overall, the results show that financial linkages do contribute to the transmission of
sovereign default and that policy-makers are right to take seriously scenarios of crosscountry spillovers of sovereign risk through the exceptionally intense financial linkages
in Europe.
ENDS
‘Transmission of Risk in the Euro Crisis’ by Filippo Brutti and Philip Sauré
Contact:
Filippo Brutti
University of Zurich
Department of Economics
Mühlebachstrasse 86
CH-8008 Zurich
+41 44 634 55 69
Email: filippo.brutti@econ.uzh.ch
Philip Sauré
Swiss National Bank
Börsenstrasse, 15
CH-8022 Zürich
+41 44 6313916
Email: philip.saure@snb.ch