The Forces Driving the Euro-Area Sovereign Debt Crisis: International Risk, Fundamentals, Expectations, and Contagion

A year following its onset the euro-area sovereign debt crisis continues unabated. Starting from Greece in autumn 2009, the crisis has since resulted in Greece’s withdrawal from international bonds markets and continues to put the bonds of Ireland, Portugal and Spain under significant pressure. To contain its fall-out, in May 2010 EU/EMU policy makers took extraordinary measures including an unprecedented in size (110 billion) EU/IMF-financed Greek rescue package; and the creation of a European stabilisation mechanism setting aside 750 billion euros for coping with crises similar to the Greek one over the next three years. These measures, however, have so far failed to calm markets, with the ongoing turmoil causing debates ranging from the crisis optimal short-run management to the euro’s long-term sustainability. 

In response to the crisis, economic research has in recent months produced a number of empirical studies. These have reached consensus on two points. First, both the amount and the price of the perceived global risk associated with investments in sovereign bonds other than the safe heavens of US and Germany have substantially increased following the post-2007 global credit crunch. This explains the across-the-board increase in EMU spread values. In this process, the transformation of banking risk to sovereign risk through bank-bail out schemes has been central. Second, intra-EMU differences in spreads’ increases are due to the different degree of exposure of national banking sectors to global financial risk and heterogeneous macro-imbalances among EMU members. These findings have gone a long way towards enhancing our understanding of the factors driving the euro-crisis. Important questions, however, remain unanswered: First, all existing studies are purely empirical. However informative, any study not based on a theoretical background cannot offer a full set of explanations and policy implications relating to the events it aims to analyse. Second, existing studies do not cover the most recent and intense phase of the euro-crisis. Why did the Greek spread escalate so abruptly from 140 basis points in early November 2009 to 250 points by the end of the year and nearly 600 points in late March 2010? Third, why has the Greek spread been so much higher compared to other periphery EMU countries? Is the Greek macro-outlook so much worse than Portugal’s to justify spread values two or three times as high? Fourth, has contagion really taken place? Despite this widely held assumption, the existence of contagion has so far not been tested explicitly. Finally, what is the role, if any, of speculation trading in the market for credit default swaps (CDS) on EMU government bonds? A number of observers, including high-ranking EMU politicians, have blamed speculation as one of the crisis’ principal causes, with subsequent proposals ranging from tighter regulation of the CDS market to an outright permanent ban on naked CDS trading. Are such proposals justified or is the role of CDS speculation overestimated in the ongoing debate?  

In a recent paper titled “The EMU sovereign-debt crisis: Fundamentals, expectations and contagion” we address each of the five questions posed above. Our empirical investigation is based on the theoretical analysis by Arghyrou and Tsoukalas (2010), the main premise of which is that the euro-debt crisis is a currency crisis in disguise. This is caused by systemic macro-risk which in the absence of national currencies is diverted into the markets for sovereign bonds. Arghyrou and Tsoukalas use insights from the literature on currency crises to build a theoretical model of the euro-zone debt crisis offering testable hypotheses relating to all five questions posed above. In Arghyrou and Kontonikas (2010) we put these hypotheses directly to the test. Using monthly data covering the period January 1999 – February 2010 and a range of estimation techniques we reach the following findings: 

First, prior to the global credit crunch (January 1999 – July 2007), with the possible exception of expected fiscal deficits, markets priced neither macro-fundamentals nor the very low at the time international risk factor. Markets, however, have changed drastically their pricing behaviour since August 2007. During the crisis period, markets have been pricing both the international risk factor and macro-fundamentals on a country-by-country basis.

Second, the Greek debt crisis is due to a background of deteriorating macro-fundamentals over 1999-2009 and a double shift in private expectations. Starting from November 2009, Greece was transferred from a regime of fully-credible commitment to future EMU participation under the perception of fully guaranteed (by other EMU countries) fiscal liabilities, to a regime of non-fully credible EMU commitment without fiscal guarantees. This regime-shift not only explains the sudden escalation of the Greek debt crisis in November 2009 but also the difference in spread values observed between Greece and other periphery EMU countries. Compared to Ireland, Portugal and Spain, markets perceive a much higher probability of a Greek voluntary exit from the EMU, and/or a Greek default. In short, Greece’s problems are as much about trust as they are about economics.

Third, the majority of EMU countries have experienced contagion from Greece, most prominently Portugal, Ireland and Spain. The Greek bond yield has now become a proxy for EMU-specific systemic risk, increasing government bond yields in other EMU countries beyond the level justified by international risk and idiosyncratic fundamentals. In short, the Greek problem has become an EMU-wide problem.

Finally, we do not find evidence in favour of the hypothesis that speculation in CDS markets is a major force driving the euro debt crisis. This does not imply that CDS speculation is not taking place or it does not drive EMU spreads at higher data frequencies. But it does imply that in the longer-term perspective captured by our monthly data frequency, EMU spreads are mainly driven by accumulated intra-EMU macroeconomic imbalances and international risk conditions. Although the latter may improve as the global economic environment gradually improves the former is unlikely do so without significant intra-EMU economic/institutional reforms.

Overall, for the pre-crisis period our findings provide support to the “convergence trade” hypothesis according to which markets were discounting only the best-case scenario of full convergence to German fundamentals, even for EMU countries displaying a clear deterioration of their macro-fundamentals. This can be explained on three factors: First, conditions of amble global liquidity and low risk over the best part of the past decade; second, expectations that euro-accession would result in growth-inducing reforms in periphery EMU economies; and third, lack of a mechanism establishing credibility for the “no-bail out” clause of the Maastricht Treaty. With the benefit of hindsight, it can now be argued that markets were operating under a perceived guarantee according to which there was very little default risk associated with investment in EMU sovereign bonds, rendering them a “heads-you-win, tails-you-do-not-lose” bet. Convergence trading, combined with the absence of an effective EU-sponsored mechanism of economic monitoring, relaxed market pressure on EMU governments to improve fundamentals thus resulting into further real divergence. The increasing un-sustainability of this divergence was bound to result into a change in market behaviour. The trigger for the latter was the onset of the global credit crunch in 2007 which prompted markets to switch to a more rational bond pricing model based on international risk and idiosyncratic macro-fundamentals. If this change proves permanent, as it did in the US following the New York debt crisis in 1975, then it will mark the ascent of a new era where markets will be imposing much higher penalties on macro-imbalances. As a result, although a gradual normalisation of the global economic outlook may narrow EMU spreads, as long as intra-EMU macro-imbalances persist, spreads are likely to remain in high, by historical standards, levels.

Our findings have policy implications both at the national as well as the union level. First, for the spreads of EMU-periphery countries to decline a marked improvement in fiscal position and external competitiveness is necessary. Second, periphery EMU countries must pursue a reversal of private expectations to a more favourable status than the present one. EMU-governments must maintain, and in the case of Greece regain, the confidence of markets that they are fully committed to a permanent improvement in macro-fundamentals. This can only be achieved through a credible and realistic strategy of structural reforms, backed by evidence of its determined implementation. Without such evidence markets will continue to doubt the sustainability of these countries’ participation in the EMU, and the risk that these expectations will become self-fulfilling will remain.

At the union level, the crisis has highlighted the necessity of institutional reforms in two directions. First, to prevent future debt crises the EMU must develop effective mechanisms of fiscal supervision and policy co-ordination. Second, if a crisis does occur, it is important to prevent its escalation in the affected country and its contagion to others. This can be achieved through the creation of a permanent EMU-run mechanism of emergency financing reassuring investors that there is no risk of default on EMU sovereign bonds. For such a mechanism to be successful in stabilising expectations, its rules and terms must be transparent and known ex-ante. At the same time, the terms of emergency finance must be such as to eliminate the risk of moral hazard discouraging fiscal discipline and necessary reforms. Identifying rules achieving both objectives simultaneously is a challenging task calling for significant attention from academics and policy-makers alike.  Recent proposals calling for the creation of a European emergency finance mechanism allowing for an orderly default of EMU members that are unable to service excessive debts and to which contributions will be linked to a country’s fiscal position, move towards that direction.


Arghyrou, M.G. and Kontonikas, A. “The EMU sovereign-debt crisis: Fundamentals, expectations and contagion”. Cardiff Economics Working Paper No E2010/9, Cardiff University.  Available at:

Arghyrou, M.G. and Tsoukalas, J. “The Greek debt-crisis: Likely causes, mechanics and outcomes”, forthcoming to The World Economy. Available at: