The Cost of Uncertainty: The Effect of Default Probabilities On Euro Area Borrowing Costs During the Crisis

Abstract

This study provides an empirical analysis of the degree to which sovereign default probabilities can explain differences in government bond spreads in the Euro area, dedicating particular attention to changes in yield differentials since the onset of the global financial crisis which began in 2007. I find a strongly positive correlation between CDS spreads and sovereign bond spreads, reflecting the premium associated with higher default probabilities. The influence of CDS spreads on yield differentials appear strongest for the “crisis countries” considered (Spain, Portugal, and Italy), but the effects on “noncrisis” countries remain significantly positive and non-negligible. I find that liquidity and inflation factors, as well as general risk aversion have mostly positive roles in explaining bond spreads as well. I project that greater fiscal integration in the Eurozone, which could be achieved through the common issuance of debt, or Eurobonds, would effectively curb these default probabilities and lower the average cost of borrowing for members of the EMU. I estimate that the greater fiscal integration provided by Eurobonds could lower credit risk in the Eurozone, concluding the interest paid annually on this debt to fall within the range of 3.36-3.56%.