SOAS Research Online

Abstract

We estimate the pricing of sovereign risk for fifty countries based on fiscal space (debt/tax; deficits/tax) and other economic fundamentals over 2005-10. We measure how accurately the model predicts sovereign credit default swap (CDS) spreads, focusing in particular on the five countries in the South-West Eurozone Periphery (SWEAP: Greece, Ireland, Italy, Portugal, and Spain). Dynamic panel estimates of the model suggest that fiscal space and other macroeconomic factors are statistically significant and economically important determinants of market-based sovereign risk. However, risk pricing of the SWEAP countries is not predicted accurately by the model either in-sample or out-of-sample: unpredicted high spreads are evident during global crisis period, especially in 2010 when the sovereign debt crisis swept over the periphery area. We “match” the periphery group with five middle income countries outside Europe that were closest in terms of fiscal space during the European fiscal crisis. SWEAP default risk is priced much higher than the “matched” countries in 2010, even allowing for differences in fundamentals. One interpretation is that these economies switched to a “pessimistic” self-fulfilling expectational equilibrium. An alternative interpretation, consistent with the selective default of Greece in early 2012, is that the market prices not on current but future fundamentals, expecting SWEAP fiscal space to deteriorate markedly and posing a high risk of debt restructuring. Adjustment challenges in the Eurozone may be perceived as economically and politically more difficult for SWEAP than the matched group of middle-income countries because of exchange rate and monetary constraints.