by Don Alexander, MBA
Associate, RSD Solutions Inc.
The majority of analysts suggest that Greece is insolvent. The issue for investors and risk managers is whether Greece’s troubles are contagious. The authors lay out a framework to test whether Greece’s troubles can cause contagion.
Investors and policymakers are split into two views on dealing with Greece: the bail-in-ers want a coercive (but soft) restructuring of Greek debt while bail-out-ers favor procrastination with continued EU-IMF lending to Greece. There is no disagreement about whether Greece is broke. The argument among in-ers and out-ers hinges on the fear of contagion or spill over into other markets. There is concern that investors could over-react and flee Spanish and Italian debt forcing a European sovereign debt and banking crisis. This could force the choice between a full-blown monetization and/or a break-up of the euro.
The first test the authors perform is to look at the volatility of five-year European peripheral country Credit Default Swaps (CDS) spreads breaking it into a euro-wide and country wide spread component. The euro-wide spread component has been declining for most of 2011 indicating a lower degree of “EU-bundling” of sovereign risk. A second test looks at the factor weight of Greek CDS spread in a Euro-wide component. The factor weighting has declined significantly in the Euro-wide spread this year. The last test shows that the correlation between Italian and Greek CDS spreads has declined steadily since late 2010.
The evidence suggests that contagion has become less likely today than the past couple of years. Markets bundled EU sovereign risks together for a long-time, but recently financial markets are starting to discriminate more. There are two potential conclusions: the orderly restructuring of Greek debt should not produce an investor panic out of EU debt and second the fate of other problematic countries such as Italy rest in their own hands. Risk managers need to be cautious, but the research suggests that fear of contagion may be overdone.
For more on this issue, click on the link to VOX :The fear of contagion in Europe”, Manesse & Trigilia: http://tinyurl.com/6ep63ha
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