“Contagion” is today’s buzzword (de Haan and Mink 2012, Manasse and Trigilia 2011).

• The troika’s bailout of the Greek government and the heavy haircut imposed on private bond holders have failed to reassure markets about Greece’s permanence in the Eurozone.
• The relief brought about by the recent election results waned in a matter of hours.
• Similarly, the decision by the EU to pour about €100 billion into Spanish banks has not proved sufficient to convince investors that the umbilical cord between the State’s and the banks’ balance sheets have been severed.
• In the meantime, confidence on peripheral sovereign bonds and banks has been crumbling, as interest rates and CDS spreads rose in the past weeks.

While proposals for a banking union, Eurobonds (Manasse 2010) and fiscal union still belong to the realm of dreams (or nightmares, depending on who should be footing the bill), the question is whether the flight out of Europe’s periphery will become a flight out of the euro full stop.

Irrationality or delayed realisation? Empirical evidence on contagion

But are financial markets behaving ‘irrationally’ or – following a long period of benign neglect – are they simply rediscovering market fundamentals (Manasse 2011b)? And crucially, what policies should southern Europeans, Italy in particular, implement to maintain market access?

In order to address some of these questions we look at the recent evidence on contagion across EU sovereigns CDS spreads. Our empirical model builds on Bekaert et al. (2009) by using time-varying factor loadings and market indexes in order to proxy the dynamics of common and specific risk factors. In the empirical model the daily change in a country sovereign’s spread depends on four elements:

(Full reading here).