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...euro area banks’ balance sheets, provision of guarantees, such as the Irish government bank guarantee scheme (29/09/2008), and outright purchases of assets from banks.8 [Figure 3, 4] Finally, Figures 5 and 6 link present information on credit ratings and their link to the European sovereign debt crisis. We use data on euro area sovereign debt credit rating and credit outlook from each of the three main rating agencies, Standard and Poor’s, Moody’s and Fitch, as well as for the simple average rating calculated using rating scores from all three agencies. Following existing literature (see e.g. Gande and Parsley, 2005; Afonso et al, 2011), we transform sovereign credit rating scores into the linear scale presented in Table A2 in Appendix 1.9 A worse sovereign credit rating should be perceived by the markets as implying higher credit risk, therefore having an upward effect on the yield spread. Indeed, as Figures 5 and 6 indicate, the significant 7 These forecasts are produced by the European Comission’s DG ECFIN twice a year (spring and autumn). 8 Sgherri and Zoli (2009) argue that the discretionary euro-area fiscal stimulus is estimated to have been around 1.1 and 0.9 percent of GDP in 2009 and 2010, respe...

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...f (2008) find that the effect of fiscal performance on EMU sovereign bond yields has weakened following the euro’s introduction. Overall, default risk in the EMU context has been seen in the past, at least before the global financial crisis, to be present but rather subdued (see e.g. Bernoth et al., 2004). Finally, the effect of liquidity risk for the period preceding the global financial crisis is disputed. Codogno et al. (2003), Bernoth et al. (2004), Pagano and Von Thadden (2004), and Jankowitsch et al. (2006) find a limited and declining liquidity effect on EMU spreads. On the other hand, Gomez-Puig (2006), Beber et al. (2009), and Manganelli and Wolswijk (2009) find that liquidity was an important determinant of yields spreads. Liquidity effects are found to be stronger during periods of tightening financial conditions and higher interest rates, during which market participants are willing to trade lower yields for higher sovereign debt liquidity.1 There is a growing literature on EMU sovereign bond during the current period of financial turmoil. More specifically, existing studies share two common findings. First, the observed widening in EMU spreads is largely driven by the increased global ...

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...ds. Liquidity effects are found to be stronger during periods of tightening financial conditions and higher interest rates, during which market participants are willing to trade lower yields for higher sovereign debt liquidity.1 There is a growing literature on EMU sovereign bond during the current period of financial turmoil. More specifically, existing studies share two common findings. First, the observed widening in EMU spreads is largely driven by the increased global risk factor.2 In this process, the role of domestic banking sectors is crucial, as suggested by Candelon and Palm (2010), Gerlach et al. (2010) and Acharya et al. (2011).3 Global banking risk appears to have been transformed into sovereign risk through three 1 Favero et al. (2010), on the other hand, provide theoretical justification and empirical evidence according to which during the early EMU-years liquidity had a smaller effect on sovereign spreads in periods of high risk. This is explained by the fact that in crisis periods investors choose from a reduced set of alterative investment opportunities, limiting their willingness to move away from sovereign bonds. 2 Holló et al (2011) develop a comprehensive indicator of financial st...

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...ansaction volumes and the level of or the share of a country’s debt in global/EMU-wide sovereign debt (see e.g. Favero et al., 2010, Arghyrou and Kontonikas, 2011). The literature on European government bonds for the period preceding the global credit crunch is not unanimous regarding the role of each of the three variables discussed above. Having said so, the balance of reported evidence leads to the following conclusions: First, prior to summer 2007 the international risk factor was an important determinant of bond yields and spreads, as suggested by studies including Codogno et al. (2003), Geyer et al. (2004), Longstaff et al. (2007), Barrios et al. (2009), Sgherri and Zoli (2009), Manganelli and Wolswijk (2009) and Favero et al. (2010). This effect was stronger during periods of tightening international financial conditions (see e.g. Haugh et al., 2009; Barrios et al., 2009) and more prominent in countries with high levels of public debt (see e.g. Codogno et al., 2003). Second, sovereign credit risk was priced in government bond yields, as suggested by Codogno et al (2003), Faini (2006), Bernoth et al. (2004), Bernoth and Wolff (2008), Manganelli and Wolswijk (2009) and Schuknecht et al. (2009). ...