What is the risk of European sovereign debt defaults? Fiscal space, CDS spreads and market pricing of risk

by Joshua Aizenman, Michael M. Hutchison & Yothin Jinjarak

Vox
September 8, 2011

Bond markets provide sleepless nights for even the most powerful of political leaders. This column estimates the pricing of sovereign risk for over 60 countries during the last five years. It finds that fiscal space and other macroeconomic factors are important determinants of market prices of sovereign risk. But when looking at the Eurozone crisis, it finds that the market is excessively pessimistic.

Spiralling risk premiums on sovereign debt has had policymakers complaining about market inefficiency, particularly along Europe’s periphery. Italian Prime Minister Berlusconi, for example, said: "As often happens during a crisis of confidence, the markets overall are not evaluating correctly the merits of credit systems.” Of course, they didn’t complain when markets underpriced sovereign risk in the euro’s first 10 years, but that’s politics. Indeed, as we have seen, the market failures in the 2000s were far more dangerous. A monetary union without centralised fiscal control is fragile and undervalued sovereign risk fosters “excessive” current-account imbalances (Giavazzi and Spaventa 2010).

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