In the course of 2010, the financial problems of Greece became so severe that the Eurozone countries together with the IMF agreed to provide emergency loans for a total amount of €110 billion, to be disbursed over the period May 2010 through June 2013. In addition, the European Financial Stability Facility was created, which issues bonds fully guaranteed by Eurozone countries and, after an enlargement in 2011, can provide up to €440 billion in financial support to distressed member states. Despite the no-bailout clause in the Maastricht Treaty, these extraordinary measures were deemed inevitable to reduce the risk of contagion. In particular, policymakers feared that since several banks had a high exposure to Greece, a restructuring of Greek debt would lead to a new banking crisis in the EU, and could destabilise other highly indebted Eurozone countries as well.
The threat of contagion from a Greek sovereign default is not undisputed. According to Cochrane (2010):
We’re told that a Greek default will threaten the financial system. But how? Greece has no millions of complex swap contracts, no obscure derivatives, no intertwined counterparties. Greece is not a brokerage or a market-maker. There isn’t even any collateral to dispute or assets to seize. This isn’t new finance, it’s plain-vanilla sovereign debt, a game that has been going on since the Medici started lending money to Popes in the 1400s. People who lent money will lose some of it. Period.
With respect to a Greek default spilling over to other countries, Cochrane argues “[w]e’re told that a Greek default will lead to ‘contagion.’ The only thing an investor learns about Portuguese, Spanish, and Italian finances from a Greek default is whether the EU will or won’t bail them out too. Any ‘contagion’ here is entirely self-inflicted. If everyone knew there wouldn’t be bailouts there would be no contagion.”
There is, as yet, surprisingly limited research on contagion in the current Eurozone debt crisis. We contribute to this literature in a recent paper (Mink and de Haan 2012), performing an event study to analyse the impact of news about Greece and about a Greek bailout on prices of European bank stocks and sovereign bonds. As an innovation to the standard approach, we identify the events as the trading days in 2010 with the largest fluctuations in the price of Greek government bonds, and relate those days to the ‘news’ that caused these fluctuations. This way, we circumvent a major problem of event studies, namely how to identify event days during which there is really an event that is not expected (and therefore not priced in). The news reports, taken from Reuters, were classified into two categories, ie news about Greek public finances and news about the willingness (or lack thereof) of European countries to provide financial support to Greece. This way, we distinguish between market reactions due to fears of contagion from a Greek default and reactions reflecting moral hazard caused by the prospect of a sovereign bailout.
Using data for 48 listed banks included in the 2010 European stress test, our findings indicate that only news about the Greek bailout has a significant effect on bank stock prices, even on stock prices of banks without any exposure to Greece or other highly indebted Eurozone countries. News about the economic situation in Greece does not lead to abnormal stock price returns. These results provide some support for Cochrane’s (2010) argument. However, we also find that the price of sovereign debt of Portugal, Ireland, and Spain responds to both news about Greece and news about a Greek bailout. Still, the finding that news about the economic situation in Greece affects sovereign bond prices of other highly indebted Eurozone countries does not necessarily imply contagion, as it is also in line with the ‘wake-up call’ view. According to this view, a crisis initially restricted to one country may provide new information prompting investors to reassess the vulnerability of other countries, which spreads the crisis across borders (see, for instance, Bekaert et al 2011).
Our results suggest that financial markets’ response to developments in the Greek sovereign debt crisis should not too easily be attributed to contagion, but can also be due to moral hazard and learning effects. The finding that also banks without a direct exposure on Greek sovereign debt benefit from a Greek bailout, illustrates the size of the moral hazard that results from such rescue operations. While hard to avoid in the midst of a financial crisis, preventive measures such as strict financial regulation are needed to keep market players from anticipating rescue operations even in good times. Our finding – that learning effects can play an important role in the simultaneous interest rate increases across Eurozone countries – illustrates that these joint increases are not necessarily inconsistent with efficient price formation in financial markets.
Disclaimer: The views expressed in this column are those of the authors and do not necessarily reflect official positions of De Nederlandsche Bank (DNB).
Bekaert, G, Ehrmann, M, Fratzscher, M and A Mehl (2011), “Global Crises and Equity Market Contagion”, Working Paper no. 1381, European Central Bank.
Cochrane, J (2010), “Greek Myths and the Euro Tragedy”, The Wall Street Journal, 18 May.
Mink, M and J de Haan (2012), “Contagion during the Greek Sovereign Debt Crisis”, Working Paper 335, De Nederlandsche Bank.