Regime-dependent determinants of Euro area sovereign CDS spreads

We study the determinants of sovereign CDS spreads of five Euro area countries (Greece, Ireland, Italy,
Portugal, and Spain) after the collapse of Lehman Brothers. We find that global and/or European Monetary
Union (EMU)-wide factors are the main drivers of changes in the sovereign CDS spreads in our sample.
However, the impacts of those factors change with market uncertainty. There is a relatively tranquil
regime where market uncertainty is low and a relatively turbulent regime where market uncertainty
is high. The transition from the tranquil regime to the turbulent regime is driven by changes in the
global jump risk, which suggests that contagion from the global financial market significantly affected
the pricing of sovereign credit risk in our sample. Domestic economic and financial indicators have little
impact on the pricing of sovereign credit risk in all sample countries except Italy. But changes in the
sovereign credit risk have significant impacts on domestic economic and financial indicators. Neglecting
the financial contagion and feedback effects from sovereign credit risk to domestic economic and financial
developments leads to spurious results regarding the determinants of sovereign CDS spreads.

1. Introduction
During the European sovereign debt crisis, sovereign credit
default swap (CDS) spreads of the Euro countries drew a lot of pub-
lic attention. The reason is that a country’s CDS spread is usually
taken as an indicator of that country’s sovereign credit risk (OECD,
2012). In an influential early study, Edwards (1984) links countries’
probabilities of default to their sovereign credit spreads and stud-
ies the macroeconomic determinants of sovereign defaults by
investigating their relationships with the sovereign credit spread.
Those macroeconomic determinants are interpreted as proxies
for countries’ ability and willingness to pay its debt. Subsequent
studies extend Edwards’ research line by extending the sample
period and country coverage, adding new potential determinants
of sovereign credit spread to the empirical model, and estimat-
ing the model with new econometric techniques.

While the literature on the macroeconomic determinants of
sovereign credit spread is helpful for a better understanding of
sovereign defaults, it is relatively silent on the nature of sovereign
credit spread during a specific crisis period. This is due to the
low frequency of macroeconomic data. In this paper, we study
the determinants of changes in the sovereign CDS spreads of five
Euro-area countries (Greece, Ireland, Italy, Portugal and Spain) in
the post-Lehman-Brothers period (from September 15, 2008 to
December 19, 2011). Therefore, our focus is to study the determi-
nants of sovereign CDS spreads in a crisis period. We think this topic
is interesting and important for two reasons. First, decision makers
during the crisis have to understand the sources of the sovereign
credit risk to correctly react to the crisis. Second, the determina-
tion process of the sovereign credit risk in a crisis is different from
the process in normal times. Therefore, existing studies using data
from normal times are not helpful for decision-making during the
crisis.