Was the European sovereign crisis self-fulfilling? Empirical evidence about the drivers of market sentiments

Abstract

International audienceWe investigate the presence of self-fulfilling dynamics during the European sovereign crisis in the light of a theoretical model that we bring to the data. Our empirical framework allows us to empirically test the presence of self-fulfilling dynamics and to identify what may have driven the market sentiment during this crisis. To do so we estimate the probability of default of five European “peripheral” countries during January 2006 to September 2011 with a panel smooth threshold regression. Our estimation results suggest that (1) both the fundamentals and “animal spirit” ignited the European sovereign crisis; (2) we isolate the risk indicator through which investors’ belief coordinate

Credit Market Speculation and the Cost of Capital

“…This result provides a new perspective on the empirical claim in Bruneau et al (2012) that the relationship between fundamental factors and the cost of debt faced by the countries of the Eurozone periphery has undergone a structural shift, and that credit derivatives have facilitated coordination on a high interest equilibrium. The simple model considered here suggests that the effect of derivatives extends beyond the coordination of expectations.…”

“…Furthermore, our finding that pessimistic equilibria exist for a broader range of funding requirements in the presence of unrestricted credit derivatives than in their absence also suggests that firms with traded credit derivatives could experience particularly adverse shifts in the terms of financing under stressed market conditions. Bruneau et al (2012) have recently argued that an abrupt and self-fulfilling change in expectations of default was a key factor in accounting for the sharp rise in interest rates paid by the countries of the eurozone periphery. They argue that the relationship between fundamentals and credit spreads was subject to a structural break around March 2010, indicative of a switch to a different equilibrium with greater pessimism about default.…”

“…Adding credit derivatives to the model completes the market and causes the asset price to decline. We build on this framework but 8 Miller argued that "the very concept of uncertainty implies that reasonable men may differ in their forecasts." Harris and Raviv (1993) and Kandel and Pearson (1995) suggest that divergence of opinions may result from investors having different economic models which lead them to interpret the same event in different ways.…”

“…Our key concern is with the manner in which speculation affects this feedback loop. While credit derivatives have been implicated in coordinating expectations on pessimistic equilibria in the context of the eurozone periphery (Bruneau et al, 2012), their role in affecting the equilibrium set itself, and hence the possibility and severity of crises, has not been explored to date.…”

Increase in home bias in the Eurozone debt crisis: The role of domestic shocks

“…In addition, empirical literature documented the importance of self-fulfilling factors for explaining the Eurozone sovereign debt crisis (De Grauwe and Ji (2013), Bruneau et al (2014), and Schumacher (2014)). These papers -relying on empirical applications to sovereign debt crises of the theoretical literature on second-generation speculative attack models (Obstfeld, 1996) -showed that peripheral Eurozone economies with relatively good fiscal fundamentals faced strong increases in sovereign bonds spreads, due to episodes of exogenous distrust in international financial markets.…”