Abstract

This work estimates a reduced model of the determinants of the 10-year yield spreads relative to Germany for 10 Eurozone countries. Results show that since the inception of the 2007 crisis, spreads have exhibited a rising time-dependent component. Country specific estimated responses to financial turmoil highlight three major results: core countries have not been affected by financial contagion during the subprime crisis, and from 2011 onwards, they have benefited from government yield spreads that are lower than what is explainable by the underlying fundamentals. Peripheral member countries (except Italy) - which from the outset of the EMU benefited from underpricing of their economic and fiscal fragility due to the implicit bailout insurance - have suffered from a revision of market expectations since 2010. Italy, penalized by its historically high debt to GDP ratio, has been hit by a rising contagion effect since 2010, which is estimated to account for 180 b.p. of the spread observable in the 1st semester of 2012.