Examining the transmission of credit and liquidity risks: A network analysis for EMU sovereign debt markets

Abstract

The sovereign debt crisis in the euro area revealed that European Monetary Union (EMU) government bond markets interact in a highly synchronised network and that risk particular to a country or sovereign bond yield component cannot be appropriately evaluated in isolation without taking potential risk transmission effects from other countries or sovereign bond yield omponents into consideration. Therefore, in clear contrast with the empirical evidence based on Granger-causality tests, the main contribution of the paper comes from the analysis of the transmission of credit and liquidity risk by examining a broad network of relations between the two risks in nine EMU sovereign debt markets from 2008 to 2018, explicitly examining the net pairwise connectedness among all the possible pairs formed from the 18 sovereign risk indicators. The results of this analysis indicate that, on average, risk transmission goes mostly from credit to liquidity risk (both within and across countries). This finding is crucial for policymakers because it indicates that rising credit risk is the primary driver of yield spread increases, and actions to strengthen the budgetary position of euro-area economies are essential. Finally, our results indicate that sovereign risk transmission is time-varying. Although both liquidity and credit risk were transmitted across countries during the Global Financial Crisis, we mainly observed the transmission of liquidity risk across them during the European sovereign debt crisis, suggesting that investors prefer sovereign debt that is easier to trade when market liquidity dries up.