Transmission of Government Default Risk in the Eurozone

Abstract

The paper develops an easy-to-apply test for contagion. In order to address the main challenge of any contagion test, that of endogeneity, the testing is conducted in the structural vector autoregression (SVAR) framework where we assume the reduced form errors follow a mixed-normal distribution. This distributional assumption enables us to use a recently developed SVAR model identification method with no need to restrict any of the instantaneous linkages between the variables. In the empirical part of the paper, we apply our test to the eurozone's ten years government bond spreads over Germany. In this maturity, the bond spreads mainly reflect governments' default risk. The years we consider are 2005-2010, and we find evidence of contagion in the spreads. Furthermore, it appears that, during the beginning of the euro debt crisis, there was transmission of government default risk from Greece to the other countries. However, Greece was not the only source country of contagion.