Fiscal austerity, growth prospects, and sovereign CDS spreads: The Eurozone and beyond

• We examine the role of fiscal austerity in the pricing of sovereign CDS.
• Fixed-effects panel models are employed to account for unobserved heterogeneity.
• A dynamic simultaneous equations model is used to address endogeneity issues.
• Austerity practice generally lowers CDS spreads for indebted sovereigns.
• Output growth prospects and public debt loads are shown to be important factors.
• The behavior of CDS spreads tends to be affected considerably by time trends.

This paper applies both conventional panel data models and a dynamic simultaneous equations model to analyze the impact of fiscal austerity and growth prospects along with other macro fundamentals on the pricing of sovereign credit default swaps (CDS) for a panel of 36 countries including the Eurozone. We find that austerity practice generally leads to an expectation of improved fiscal situations, which tends to help the CDS market grow more confidence in indebted sovereigns׳ ability to service their debt. The public debt to GDP ratio and projected future output growth also play an important role in determining the prices of sovereign debt insurance. Our analyses further show that the behavior of CDS spreads is considerably affected by common time trends over the sample period.