Deciphering financial contagion in the euro area during the crisis

Abstract

Financial market interdependence has been at the epicenter of the crisis in the euro area. This paper tests for the existence of financial contagion during this crisis, defined as the international transmission of country-specific shocks beyond the normal channels of financial interdependence. Since contagion relates purely to countryspecific shocks, we combine the standard contagion test of Favero and Giavazzi (2002) with an innovative narrative approach to separate out global and euro area shocks from country-specific shocks. Financial contagion has been widespread during the crisis in the euro area. About 80 percent of country-specific shocks are contagious. We also find significant evidence of flight-to-safety effects between the core and the periphery of the euro area. Global and euro area shocks have been important drivers of sovereign bond yields in the euro area.JEL Classification: E44; F34; F36; G01; G12.

Heterogeneous Market Beliefs, Fundamentals and the Sovereign Debt Crisis in the Eurozone

“…; Favero and Missale ). There is evidence of ‘contagion’, that is, the transmission of high spreads across countries via non‐fundamental channels (Caceres et al . ; De Grauwe and Ji ; Tola and Wäldi ). There is evidence of SF processes via the positive feedback mechanism among market beliefs of default, higher spread, higher fiscal effort, reinforcement of market beliefs (De Grauwe and Ji ).…”

European government bond dynamics and stability policies: taming contagion risks

“…As the American "subprime" crisis burst a credit bubble in the European banking system, privately held debt was transferred to public balance sheets to prevent a chain reaction of defaults. This risk transfer and a repricing of perceived sovereign risk led to increased spreads of "peripheral" versus "central" government bonds within the Euro area (Beirne and Fratscher (2013); Tola and Waelti (2015)). According to D'Agostino and Ehrmann (2014), the increase and variability of the observed spreads overestimated the change in fundamentals and point to a structural change in risk perception before and during the crisis.…”

The Contagion Effect in Europe: A DCC Garh Approach

“…In addition, the existence of studies that prove the occurrence of contagion in the sovereign debt markets of the EA countries, supports in some aspects the possibility of the transmission of shocks also to the stock markets (Alexakis and Pappas, 2018; Finta, Frijns, and Tourani-Rad, 2019;Antonakakis, Gabauer, and Gupta, 2019;Golab and Zamojska, 2019;Pentecost et al, 2019). Tola and Wälti (2015) and Gómez-Puig and Sosvilla-Rivero (2016) have demonstrated the existence of contagion in sovereign debt markets during the sovereign debt crisis. Tola and Wälti (2015) test the existence of contagion in the sovereign debt markets of nine SAP countries during the sovereign debt crisis.…”

“…Tola and Wälti (2015) and Gómez-Puig and Sosvilla-Rivero (2016) have demonstrated the existence of contagion in sovereign debt markets during the sovereign debt crisis. Tola and Wälti (2015) test the existence of contagion in the sovereign debt markets of nine SAP countries during the sovereign debt crisis. The authors demonstrate the occurrence of contagion on a large scale between the bond markets of the countries analysed during the sovereign debt crisis, with around three quarters of the country-specific shocks resulting in contagion to other UM countries.…”