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The purpose of the working paper, titled 'Sovereign CDS spreads in Europe: The role of global risk aversion, economic fundamentals, liquidity, and spillovers', is to determine what has been behind movements in sovereign CDS spreads in the CESEE region during the 2007–12 period. Specifically, what has been the role of global risk aversion, specific macroeconomic fundamentals, liquidity conditions in the CDS market, and spillovers from other countries in explaining the divergent movements in CDS of different countries witnessed during this period?
The results indicate that while spreads in the CESEE region are primarily driven by changes in the global investor sentiment, country specific macroeconomic fundamentals and CDS market liquidity conditions play an important role as well. Among the fundamental factors, growth prospects and forward looking fiscal indicators (e.g. one year ahead fiscal deficit forecasts) appear particularly important. The role of fundamentals is particularly strong for high debt and low growth countries. The impact of liquidity conditions is very prominent during the global liquidity shock in the 2008/09 crisis, but has been much smaller afterwards.
The results in this paper suggest that the improvement in CESEE country-specific fundamentals (including the reduction in fiscal deficit, and sharp narrowing of current account balance, as well as a gradual acceleration in growth) has been a key reason why CDS spreads in the CESEE region were relatively less affected by the euro area crisis. Spillovers of the euro area crisis to the region largely occurred through the impact of the crisis on global risk aversion, while the negative impact on CESEE CDS spreads are partially offset by much improved fiscal and current account balances compared to the 2008/09 crisis period.
An out of sample forecast based on the panel results suggest that the sharp drop of CDS spreads across the board in the second half of 2012 following the ECB’s OMT announcement was to a large extent due to a drop in risk aversion as country specific fundamentals remained on average broadly unchanged or (in the case of growth prospects) deteriorated somewhat.