International financial markets have been beset by the European sovereign debt crisis during 2010-2012, leading to high volatility of financial market and recession of the economies as well. The reason why the extensive impacts on financial markets could be triggered by the government debt problems from a few relatively small economies causes a heated discuss. In this essay, we intend to discuss the contagion effect of sovereign debt crisis among financial markets by analyzing the prior studies on this issue, especially in foreign exchange markets and stock markets.
The main purposes of our essay can be summarized as follows. First of all, we briefly review the background of the sovereign debt crisis. Secondly, we state the spillover effect of sovereign credit signals in financial markets. At the next part we emphasis on the impact of sovereign debt crisis on foreign exchange market and stock market particularly.
Description of sovereign debt crisis
After the bankrupt of Lehman Brothers in September 2008, governments in the euro area rescued and guaranteed the financial system by committing larger resources (Gerlach et al., 2010). This consequently triggered increasing public debt and higher risk of sovereign default. Bank of England (2010) illustrates that many European banks could collapsed because of a default by Greece or another sovereign. Once domestic banks hold foreign debt, it is likely that the sovereign risk will spillover to financial markets across countries. The fact that sovereign default was the most immediate risk the global economy had to confront (IMF2010a). Meanwhile, sovereign ratings especially for Greece, Portugal, and Ireland, were confronting a downgrading tendency, as a result, fiscal deficit and debt level were raising and economic growth was weakened. These downgrades induce significant spillover effects through countries and financial markets, statistically and economically.
Impacts of sovereign credit rating on financial markets
On 27 th April 2010, the sovereign credit rating of Greece was downgraded from BBB+ to BB+ by S&P, accompanied with negative outlook signal. This explosive event made the financial markets in Europe, UK and the US in a panic, which means banks in other countries holding Greek debt was significantly affected on both the stability and profitability. In this case, impact of sovereign credit signals is highlighted.
Gande and Parsley (2005) research the spillover effects across sovereign ratings during 1991–2000period, for a set of 34 developed and developing economies, implying that contagion effects occur followed by rating event. IMF(2010a) implies that financial instability could be spurred by the announcements of rating agencies. The type of rating news, the origin country confronting the downgrade and the rating agencies where the news comes from determine the spillover effect. In addition, a systematic spillover effects through the euro area could be triggered by the downgrades near speculative grade such as Greece. The own-country equity and bond market was also influenced by negative rating announcements, which leads to a significant spillover effect on other states’ stock and bond markets, on the contrary, positive rating events have limited upgrades or insignificant impact.
Arezki et al. (2011) inspects the spillover effect of sovereign credit news on credit default swap spreads and stock market indices for selected European countries in the period of 2007-2010, indicates that rating downgrades contribute to significant spillovers across countries. For instance, derive from the exposures of Austrian banks, Austrian credit default swap spreads and stock market indices moved dramatically after the downgrades of Baltic countries, while the Austrian sovereign rating stay unvaried (Alsakka and ap Gwilym, 2012). It is also illustrated by Afonso(2011) that “the spillover effect for the yield spreads are asymmetric and are a function of the…