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Ever since the collapse of Lehman Brothers, contagion has become the stuff of policymakers' nightmares. In recent weeks, with the very real prospect of default by European countries, the sleepless nights are returning. This column provides evidence that markets are bundling all European countries together. They believe that if Italy defaults, it would mean the end of the euro and no country would be left unscathed.

Since the financial crisis began in 2008, economists like Carmen Reinhart, Barry Eichengreen, Daniel Gros, Paul de Grauwe, and Charles Wyplosz warned of a nightmare scenario.1 The scenario is easy to describe since it is unfolding now in the daily headlines – a domino effect where Greece, Ireland, Portugal, Spain, and finally Italy collapse and bring down the EZ banking system. Yet most observers got the ordering wrong. The crisis arrived in Italy before Spain.

The reason is political.

  • Spanish Prime Minister José Luis Rodríguez Zapatero – realising he had lost the political backing necessary for difficult reforms – announced last April that he would not run for re-election.
  • Silvio Berlusconi, who faced similar economic challenges, tried to keep his seat.

Berlusconi lost that battle when he resigned last weekend – but only after he had let the Italian economic crisis fester for months. Ultimately, financial markets and the spectre of a default dethroned him (Manasse 2011b).

Italy’s problems are homemade – contagion is a sideshow

We have argued on this site (Manasse and Trigilia 2011) that the current Italian troubles are largely homemade – they are not the result of contagion from Greece – so that weak economic fundamentals, more than Berlusconi’s lack of credibility, are key (Manasse 2011a). This is why financial markets, after a brief toast, did not rally when President Napolitano asked Professor Monti to form a new government. The spread of Italian bonds is still around 500 points and the Italian Treasury just sold three billion 5-year bonds at a yield of 6.29%, almost one percentage point higher than in October. Monti’s task will be a formidable one. He will need the support of a recalcitrant and bitterly divided parliament to pass painful reforms.

This column argues that after period of “risk decoupling”, with markets increasingly discriminating between European sovereigns, we are now back to the era of “euro-risks”. In other words, financial markets are pricing under the notion that an Italian collapse, given the huge amount of debt involved (1.9 trillion) and its wide circulation (about 44% held by non-residents), would mean the end of the euro and would not leave anyone unscathed. We offer three pieces of evidence.

Euro risk: The aggregate EZ risk factor in country-specific sovereign risks?

How relevant is “EZ aggregate risk” in explaining country-specific sovereign risks? Figure 1 depicts the “Eurozone Risk” that can be extracted from national CDS spreads. Technically, the EZ risk factor is calculated as the share of the variance of daily Eurozone sovereign spreads that is explained by their first principal component, computed at rolling overlapping samples of 200 observations. The salient points are:

  • At the height of the Greek crisis in early 2010, aggregate EZ risk accounted for more than 80% of total variance.
  • The aggregate EZ risk component fell steadily up until August 2011. In other words, the markets were increasingly distinguishing between the riskiness of different EZ members’ debt.
  • From August 2011, however, the EZ risk factor was back where it started; once again markets are bundling EZ members as one in terms of riskiness.

Figure 1. Eurozone risk

Source: authors’ calculations on Data Stream data

Note that this development can be related to the political crisis which saw Italian spreads skyrocket (see Figure 2).

Figure 2. Yield spreads

Source: Data Stream

Country correlations with EU risk

Next, we look at the reverse linkage by asking how much does each country contribute to EZ-wide risk?

Figure 3 displays the “factor loadings” (the weights) of individual CDS sovereigns in our Eurozone risk measure. The weights answer the following question: How correlated are specific country risks with euro-wide risk?

Our calculations reveal the following:

  • As of May 2011, Greece, Portugal, and Ireland (the recipients of EU-IMF bailout loans) decoupled from the other countries; their weights fell sharply, suggesting that their developments were becoming progressively “orthogonal” to EZ risk.

This suggests that the risk of systemic contagion was limited at the time.

  • As of August 2011, however, Greece, Portugal and Ireland have seen a spectacular ‘comeback’ in influence on CDS spreads.

Since these troubled countries’ spreads did not improve, this mean that the “safer” countries have increasingly worsened, as shown by the progressive rise in the Italian component.

Figure 3. Countries' weight in EU risk

Source: authors’ calculations on Data Stream data

Italy and other EZ members

The last piece of evidence shows the evolution of the bilateral (rolling) correlations between Italy’s and other countries’ risks (Figure 4). The co-movement with Ireland, Spain, Germany, and Greece starts to fall from October 2010, but from January 2011 it gradually climbs back close to unity (Ireland being the exception). Today, it seems that markets perceive that little diversification can be achieved by investing in the debt of different EZ countries.

Figure 4. Bilateral correlations

Source: authors’ calculations on Data Stream data


The evidence from CDS spreads supports the view that markets once again are bundling European countries all together, with Italy possibly becoming the largest source of contagion and other EZ sovereign bonds providing little diversification opportunities.

If this trend continues and the Italian crisis does not find a solution, France’s and Germany’s ratings will be at risk along with the financial stability of the EZ as a whole. This is why Italians and Europeans (and the US) should exert the utmost pressure to make sure that the Monti experiment does not end in failure. What Italians will do for Italy, bad or good, they will also do for Europe.


Baldwin, Richard (2010), “Vox’s annual break and some holiday reading tips”, VoxEU.org, 25 December.
De Grauwe, Paul (2010), “How to embed the Eurozone in a political union?”, VoxEU.org, 17 June.
Eichengreen, Barry (2010a), “The euro: Love it or leave it?”, VoxEU.org, 4 May.
Eichengreen, Barry (2010b), “Drawing a line under Europe’s crisis”, VoxEU.org, 17 June.
Gros, Daniel (2010), “Eurozone crises left to fester”, VoxEU.org, 21 December.
Manasse, Paolo (2011a), “Credibility is not everything”, VoxEU.org, 9 November.
Manasse, Paolo (2011b), “Can Mario Monti Rescue Italy?”, Foreign Affairs, 15 November.
Manasse, Paolo and Giulio Trigilia (2011), “The fear of contagion in Europe”, VoxEU.org, 6 July.
Wyplosz, Charles (2010), “The Eurozone’s levitation”, VoxEU.org, 17 June.

1 See for example De Grauwe 2010, Eichengreen (2010a, 2010b), Gros 2010, and Wyplosz 2010. For a summary of contributions to the debate dating back to 2007, see Baldwin 2010.


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