The Greek financial crisis: Growing imbalances and sovereign spreads

We discuss the origins of the Greek financial crisis as manifested in the growing fiscal and current-account deficits since euro-area entry in 2001. We then extend a model typically used to explain risk premia to assess the extent to which credit ratings captured these premia. Next, we estimate a cointegrating relationship between spreads and their long-term fundamental determinants and compare the spreads predicted by this estimated relationship with actual spreads. We find that spreads were significantly below what would be predicted by fundamentals from end-2004 up to the middle of 2005; by contrast, since May 2010, actual spreads have exceeded predicted spreads by some 400 basis points.

► We discuss the origins of the Greek financial crisis.
► Growing fiscal and external imbalances were the main causes of the crisis.
► We extend a standard model that is used to explain risk premia to assess the extent to which credit ratings captured Greek premia.
► We estimate a cointegrating relationship between spreads and their long-term determinants.
► We find that since mid-2010 spreads were well above the levels predicted by the fundamentals.