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

Joshua Aizenman, Yothin Jinjarak, Michael Hutchison

08 September 2011



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).

New research on sovereign debt mispricing

In recent research (Aizenman et al 2011) we investigate systematically the degree of market mispricing of the Eurozone-periphery sovereign debt before and during the euro and the global financial crisis.

During 2000 to 2006, the OECD and most emerging markets experienced a remarkable decline in macroeconomic volatility and the price of risk. This period turned out to be the tail end of the Great Moderation, a precursor of the turbulences leading to the global financial crisis of 2008-09, the consequent increase in risk premiums, and the focus on fiscal challenges and the importance of fiscal space in navigating future economic challenges. The latter stages of the crisis, unfolding in 2010, focused attention on the heterogeneity of the euro block, and the unique challenges facing the Eurozone-periphery countries.


Our research aims to determine whether the perception of relatively high sovereign-default risk of the fiscally distressed Eurozone countries, as seen in market pricing of credit default swap (CDS) spreads,1 may be explained by existing past or current fundamentals of debt and deficits relative to tax revenues – which we term de facto fiscal space – and other economic determinants.2 

To this end, we develop a pricing model of sovereign risk for 60 countries, including many in Europe, before and after the global financial crisis, based on fiscal space and other economic fundamentals including the foreign interest rate, external debt, trade openness, nominal depreciation, inflation, GDP per capita, and economic growth.

We use this dynamic-panel model to explain CDS spreads and determine whether the market pricing of risk is comparable in the affected European countries and elsewhere in the world.

By this methodology, and using in-sample and out-of-sample predictions, we can determine whether there are systematically large prediction errors for the CDS spreads during the global financial crisis and in 2010 when the sovereign debt crisis in Europe intensified.

Systematically large prediction errors may be due to:

  • Mispricing of risk, 
  • Expectations of a future decline in fundamentals that lead to higher default risk.

We also “match,” on the basis of similar fiscal space, each of the five Eurozone-periphery countries (Greece, Ireland, Italy, Portugal, Spain) with a corresponding middle-income country. This provides additional information on the market pricing of risk between Eurozone-periphery countries and countries with similar fiscal conditions but, unlike Eurozone-periphery countries, with histories of debt restructuring.

The key role of fiscal space

Our investigation reveals a complex and time-varying environment in the market for sovereign-default risk. We find a key role of fiscal space in pricing sovereign risk, controlling for other relevant macro variables. The link is economically and statistically strong, and robust to the time dimension of the CDS premium, sample period, included control variables, and estimation technique.

We find that risk of default in the five Eurozone-periphery countries appeared to be:

  • Somewhat underpriced relative to international norms in the period prior to the global financial crisis; and
  • Substantially overpriced during and after the crisis, especially in 2010, with actual CDS values much higher than the model would predict given fundamentals.

In addition, compared to the matched group, controlling for fiscal space and macroeconomic conditions,

  • All of the five Eurozone-periphery countries have much higher default risk assessments measured by CDS premiums;
  • During the crisis, pricing of risk is largely decoupled from our two fiscal space measures.

The ability of the model to explain CDS spreads drops from around 70%-80% in the tranquil period to 45%-60% during the crisis.

Although explanatory power of fiscal space measures drop during the crisis, the TED spread, trade openness, external debt, and inflation play a larger role. Given turbulent conditions during the crisis period, markets apparently did not focus on current fiscal fundamentals.

  • One interpretation is that the markets simply overreacted and mispriced the risk of default.
  • Another interpretation is that markets may have placed more emphasis on expectations of future deterioration in fiscal space that were not fully reflected in current economic conditions.

The emergence of the TED spread as a key pricing factor in the crisis also suggests that expectations of market volatility jumped during the crisis and that this pushed up CDS spreads. In particular, possible default implies that the payoff to creditors is weakly concave (fixed payoff in good times, declining with an adverse shock above a threshold in bad times), suggesting that higher volatility will reduce the expected payoff in countries exposed to higher volatility during a crisis for a given debt-to-tax or debt-to-GDP ratio and thereby increasing CDS spreads. This also explains the impact of the end of the Great Moderation – countries with greater exposure to volatility, other things equal, are facing higher spreads.

To gain further insight, we “match” the five Eurozone-periphery countries with five middle-income countries that in 2010, at the peak of the European crisis, were closest in terms of fiscal space (2010 debt-to-tax ratio). The matches, shown in Figure 1, are Spain – South Africa, Greece – Panama, Ireland – Malaysia, Italy – Mexico and Portugal – Colombia.

Figure 1 suggests that sovereign risk in five Eurozone-periphery countries is overpriced in comparison with corresponding middle-income countries.

Figure 1. Fiscal space and prediction error on the sovereign CDS 5-Year tenor – Greece, Ireland, Italy, Portugal, and Spain and the matched middle-income group

Notes: Figure 1 shows a cluster diagram of the prediction errors during these two periods, depicting the size of debt/tax by circles. The prediction errors are based on the in-sample prediction errors from our regression equations. The circle size is proportional to the 2005-07 pre-crisis public debt-to-tax base ratio.

In our paper we pursue this further by comparing the characteristics of the five Eurozone-periphery countries and the matched countries. We find that the five Eurozone-periphery countries had lower foreign reserves than the matched middle-income countries. Given the euro status of five Eurozone-periphery countries, however, it is uncertain what would be the role of the reserves (compared to a precautionary rationale for reserves hoarding of the emerging markets). Nonetheless, in all cases the five Eurozone-periphery countries had larger external debt (%GDP) and government bond markets that performed worse in 2010 than the matched middle-income countries.


In summary, we found strong evidence that high market-default-risk assessments in the five Eurozone-periphery countries are partly attributable to deteriorating fundamentals but that a large component is unpredicted.

  • Actual CDS spreads in the five Eurozone-periphery countries are much higher than what the model predicts given actual fundamentals.
  • In terms of our model, these spreads may be mispriced.

One possibility is excessive pessimism on the part of market participants about the Eurozone-periphery countries or expectations of the further deterioration of fundamentals.

This point is well illustrated by a comparison of five Eurozone-periphery countries with middle-income countries with similar fiscal conditions. In every case, risk pricing of the five Eurozone-periphery countries is comparatively high given current economic conditions.


Aizenman, Joshua, Michael Hutchison, and Yothin Jinjarak (2011), “What is the Risk of European Sovereign Debt Defaults? Fiscal Space, CDS Spreads and Market Pricing of Risk”, September, SCIIE working paper.

Aizenman, Joshua, and Yothin Jinjarak (2011), “The Fiscal Stimulus in 2009-10: Trade Openness, Fiscal Space and Exchange Rate Adjustment, forthcoming in NBER International Seminar on Macroeconomics 2011, Jeffrey Frankel and Christopher Pissarides, organizers.

Fontana, Alessandro, and Martin Scheicher (2010), “An Analysis of euro Area Sovereign CDS and their Relation with Government Bonds”, ECB Working Paper No. 1271 (December).

Giavazzi, F, and L Spaventa (2010), "Why the Current Account May Matter in a Monetary Union: Lessons from the Financial Crisis in the euro Area", unpublished paper.

Packer, Frank, and Chamaree Suthiphongchai (2003), “Sovereign Credit Default Swaps”, BIS Quarterly Review (December).

1 See Packer and Suthiphongchai (2003) and Fontana and Scheicher (2010) for discussions of sovereign CDS markets.

2 Our measure of fiscal space is from Aizenman and Jinjarak (2011).  



Topics:  Europe's nations and regions International finance Macroeconomic policy

Tags:  sovereign risk, Eurozone crisis, fiscal space, CDS spreads

Dockson Chair in Economics and International Relations, USC, and Research Associate, NBER

Associate Professor, School of Economics and Finance, Victoria University of Wellington, New Zealand

Professor of Economics, University of California Santa Cruz