Measuring Bilateral Spillover and Testing Contagion on Sovereign Bond Markets in Europe

Abstract

.

The global financial crisis rapidly spread across borders and financial markets, and also distressed EU bond markets. The crisis did not hit all markets in the same way. We measure the strength and direction of linkages between 16 EU sovereign bond markets using a factor-augmented version of the VAR model in Diebold and Yilmaz (2009). We then provide a novel test for contagion by applying the multivariate structural break test of Qu and Perron (2007) on this FAVAR detecting significant sudden changes in shock transmission. Results indicate substantial spillover, especially between EMU countries, with Bel- gium, Italy and Spain being key markets during the financial crisis. Contagion has been a rather rare phe- nomenon limited to a few well defined moments of uncertainty on financial assistance packages for Greece, Ireland and Portugal. Most of the frequent surges in market co-movement are driven by larger shocks rather than by contagion. Ó 2014 Elsevier B.V. All rights reserved. 1. Introduction Losses on subprime loans in US banks have had global conse- quences, as uncovered debt positions created a snowball debt effect that brought down major financial institutions in both the US and Europe. The ensuing financial crisis called for policy inter- vention, not just by central banks, but also out of the deep pockets of the tax payer. Massive public aid in support of the financial sector, together with falling tax revenues and spending on recovery plans to withstand the economic fall-out of the financial collapse, unleashed a sovereign debt crisis. Turbulence on European bond markets is just the latest chapter in this string of events. Rising sovereign spreads set off a sequence of fiscal bailouts, further trouble in the banking system, the down- grading of all EMU countries but Germany, and de facto IMF inter- ventions in several EU countries. These events demonstrate the strong intertwining of European financial markets. Empirical stud- ies confirm that sovereign bond yield spreads in EMU countries are driven by international financial market conditions, and dominate idiosyncratic risk factors such as default, liquidity and exchange rate premia. Attributing spread movements to international factors under- lines the importance of financial integration, but gives an unsatis- factory answer as to what causes those market developments in the first place. Even international developments must eventually be driven by events in some domestic market that then transmits to all other markets, and feeds back to the source market. The flaw of most studies is to proxy the external risk factors with an aggre- gate measure that is supposedly exogenous to domestic events, and affects all markets in a similar way. However, linkages are not equally strong between all markets simultaneously (Kaminsky and Reinhart, 2000). Those studies therefore have little http://dx.doi.org/10.1016/j.jbankfin.2014.05.011 0378-4266/Ó 2014 Elsevier B.V. All rights reserved. ⇑ Corresponding author. Tel.: +420 224414427; fax: +420 224414278. E-mail addresses: peter.claeys@eui.eu (P. Claeys), borek.vasicek@cnb.cz, borek. vasicek@gmail.com (B. Vašícˇek). Journal of Banking & Finance 46 (2014) 151–165 Contents lists available at ScienceDirect Journal of Banking & Finance