VoxEU Column International Finance

What explains the surge in euro-area sovereign spreads during the financial crisis of 2007-09?

The crisis has raised long-term government bond yield spreads across Europe. This column discusses the causes. Increased risk aversion and concern about public finances explain most of the movements in sovereign bond spreads. Moreover, bank bailouts transferred credit risk from the private sector to governments.

Since the intensification of the financial crisis in September 2008 through March 2009, long-term government bond yield spreads relative to Germany have increased dramatically for most Eurozone countries (Sgherri and Zoli 2009, De Grauwe 2009, Schuknecht 2009).

Figure 1. Ten-year government bond yields of Eurozone countries (monthly averages; percentages per annum; January 2007-March 2009)

Source: Bloomberg and authors’ calculations.

We use a dynamic panel approach to explain the determinants of widening 10-year sovereign bond yield spreads during the period between 31 July 2007 and 25 March 2009. In line with the existing empirical literature, our research finds that sovereign bond yield spreads in the Eurozone reflect concerns about a country’s credit risk and liquidity risk, as well as higher international risk aversion. Higher expected budget deficits and/or higher expected government debt relative to Germany have contributed to higher government bond yield spreads in the Eurozone over the period end-July 2007 to end-March 2009. The results are robust if we restrict the period of analysis to after the crisis has intensified, i.e. the period from end-August 2008 to end-March 2009.

Risk transfer from the private to the public sector

In addition to standard measures of government creditworthiness, we also take into account the impact that the announcements of bank rescue packages have had on government bond yield spreads. Concurrent with the announcement of bank rescue packages in euro-area countries, pressures on the financial sector eased while the opposite occurred at the general government level. This was felt through a sharp increase in sovereign credit default swap premia for most Eurozone countries, whereas the credit default swap premia for European financial corporations (i.e. those covered by the iTraxx financial index)1, reversed their upward trend and started to decline. Figure 2 illustrates these developments and depicts the cumulative changes since mid-September 2008 in the average five-year sovereign credit default swap premia for 11 Eurozone countries and in the credit default swap premia for European financial institutions covered by the iTraxx index.

Figure 2. Cumulative changes in average five-year sovereign credit default swap premia for Eurozone countries and iTraxx financial index (15 September 2008 – 25 March 2009; bps)

Sources: Datastream and ECB staff calculations.

Note: The vertical bars indicate the dates on which bank rescue packages were announced in Eurozone countries. Countries included in the analysis: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Netherlands, Portugal and Spain.

We find that the announcement of bank rescue packages proved to be a robust and statistically significant determinant of the differential between sovereign credit default swap premia and the iTraxx financials over the period of our analysis. That suggests that government commitments to support ailing financial institutions led to a re-assessment of sovereign credit risk from the part of investors, through a transfer of risk from the banking sector to the government. Moreover, we also find that this perception is not influenced by the amount of resources explicitly committed by governments to the bank rescue packages. The size of rescue packages does not have, on average, a statistically significant effect on sovereign bond yield spreads, especially when Ireland is excluded from the analysis. In our view, this can be explained by the fact that investors’ discrimination among sovereign borrowers was triggered by governments’ credible commitment to extend support to the banking sector and not by the mere size of this support. Investors’ perceptions may have been driven by expectations that governments would provide as much support as needed to shore up ailing banks regardless of the amounts explicitly announced in the first place.

We also find that the liquidity of government bond markets has played a role in the widening of sovereign bond yield spreads. Countries with a more liquid bond market seem to enjoy relatively lower bond yield spreads during periods of financial turmoil. Finally, and in line with the existing empirical literature, we find that international risk aversion is an important factor in explaining sovereign bond yield spreads.

Our findings are robust to the use of different time frequencies (daily and monthly), various estimation techniques, and to the inclusion of additional control variables. In this respect, we also found that the reduction in the ECB main refinancing operations rate contributed significantly to narrowing sovereign bond spreads for the period under consideration. Similarly, private external imbalances relative to Germany have an influence on sovereign bond spreads, whereas the expected economic growth rate does not seem to matter for the period covered in our analysis. Controlling for other types of announcements, such as the release of macroeconomic data and lead indicators for the Eurozone, Germany, France, Italy, and the US, does not change our conclusions regarding the impact of announcements of bank rescue packages on sovereign spreads.

We also calculate the relative contribution of each explanatory variable in our sample to the daily change in average sovereign bond spreads relative to Germany. This allows us to gauge the relative importance of each factor in explaining movements in sovereign bond spreads. For the sample as a whole, we find that each explanatory variable contributes to the change in daily sovereign bond yield spreads in the following maximum proportions:

  • international risk aversion (56%),
  • expected fiscal position (expected budget balance and debt) (21%),
  • liquidity proxy (14%), and
  • announcement of bank rescue packages (9%).
Policy lessons

The large relevance of international risk aversion for changes in sovereign bond yield spreads can be explained by the extraordinary severity of the financial crisis during the period of our analysis. Moreover, the fact that fiscally relevant variables account for about one-third of the movements in Eurozone sovereign spreads during the financial crisis points to the importance of preserving the public’s trust in the soundness of public finances. This is essential to anchor market expectations about a government’s ability to meet its future debt obligations. Therefore, an important lesson from the financial crisis is that countries should consolidate during good economic times in order to build a “fiscal cushion” that provides sufficient room for manoeuvre during an economic downturn or a crisis. Many Eurozone countries failed to do so and entered the crisis with high fiscal deficits and debt ratios that limited the scope of their fiscal actions at a time when it was needed the most.

Disclaimer: The views expressed are the authors’ and do not necessarily reflect those of the ECB.


1 The iTraxx financial index contains the credit default swap spreads of 25 European financial institutions, including institutions from the UK and Switzerland.


Attinasi M.G., C. Checherita, C. Nickel (2009), “What explains the surge in Eurozone sovereign spreads during the financial crisis of 2007-09?”, ECB Working Paper no. 1131/2009.

De Grauwe, Paul (2009), “Why should we believe the market this time?”, VoxEU.org, 7 February.

Schuknecht , Ludger, Jürgen von Hagen and Guido Wolswijk (2009), “European government bond spreads in the current crisis”, VoxEU.org, 21 December.

Sgherri, Silvia and Edda Zoli (2009), “Euro-area sovereign risk during the crisis”, VoxEU.org, 17 November.

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