Sovereign Risk in the Euro Area: Is it Mostly Fiscal or Financial?

We study the role of fiscal and financial conditions as determinants of movements of 10-years sovereign bond spreads (over the Bund benchmark) in the Eurozone from 2000 to 2009, relying on cross-country quarterly data panel analysis. We find that financial conditions, namely aggregate and idiosyncratic risk factors, are fundamental drivers of sovereign risk. In line with the literature, we show that risk factors directly determine spreads’ dynamics. As original contribution of the paper, we identify also an indirect channel: the mid-2007 structural break in financial markets volatility strengthened the role of fiscal variables as drivers of sovereign risk, but also widened the set of macroeconomic determinants. In particular, the latter are shown to be mainly related to the dynamics of explicit and implicit government liabilities (e.g., level and structure of outstanding debt; fiscal balance; banking sector level, structure, and credit quality of assets; short-and-medium term growth perspectives). Our results are consistent with part of the literature documenting parameters’ instability in sovereign-spreads econometric models.

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