European Sovereign Risk: The Knock-on Effects of Default Risk across the Public and Financial Sectors

Sanae Ohno
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Sanae Ohno: Professor, Department of Economics, Musashi University

Public Policy Review, 2013, vol. 9, issue 1, 139-170

Abstract: The European financial situation is so serious that it is reminiscent of the so-called "Lehman Shock" (the downturn that followed the bankruptcy of the Lehman Brothers) in 2008. Member countries of the Europe may be more susceptible to ripple effects triggered by outbreak of a credit crisis in one part of the region because of the following reasons. Europe has the dominant share of financial transactions within in the region, and regional sovereign risk may spread to neighboring countries through securities investment and lending. There is also concern that financial system instability may harm the fiscal health of those countries as a result of tax revenue reduction due to economic slowdown caused by credit crunch, public fund injection into financial institutions, and so on. The foundation of the European Financial Stabilization Mechanism meant the creation of an additional route through which a fiscal crisis breaking out in one country in the region might spread to the entire European region. In this paper, we take into consideration the mutual interdependence among the countries, as well as between the financial and public sectors, and examine the features of the knock-on effects of crisis within the European region. Since the foundation of the European Financial Stabilization Mechanism, the knock-on effects among the Eurozone's core countries have been dramatically heightened, and our research suggests that these knock-on effects have been amplified through concerns about the instability of the financial system. On the other hand, we cannot detect knock-on effects from the Greek sovereign CDS, or Credit Default Swap, which showed an extraordinary rise, which we attribute to shrinking market liquidity against the background of tighter regulations on CDS transactions and confusion regarding the certification of credit events. Even among the core countries, the knock-on effects of the sovereign risk on the CDS of German financial institutions were light, and we may attribute this to the "flight-to-quality" phenomenon having an impact of lowering the German sovereign CDS premiums.

Date: 2013
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