The euro area sovereign debt crisis: Identifying flight-to-liquidity and the spillover mechanisms

•We model the euro area sovereign yield relative to the Bund.•Flight-to-liquidity and the spillover from Greece are key risk factors of the crisis.•The spillover effect from Greece is identified using various approaches.•Countries with weaker economic fundamentals tend to be more vulnerable to spillover.•A large fraction of the identified spillover across countries remains unexplained.

Looking at the daily period between January 2006 and December 2012, besides the traditional credit and liquidity risks, which explain the developments of sovereign yields relative to the Bund for Greece, Ireland, Portugal, Spain and Italy, two additional factors have played a key role in the developments of euro area sovereign yield spreads: flight to liquidity benefiting the German Bund and the spillover effect from Greece. The flight to liquidity premium, which is estimated by constructing the spread between a German state guaranteed agency bond and the Bund, is behind the pricing of all euro area spreads and, specifically, is the only factor explaining the sovereign spreads for Finland and the Netherlands. The spillover effect from Greece, which is identified using complementary approaches, has contributed to developments in spreads of countries with weaker fiscal fundamentals, a lower degree of competitiveness and a higher need of foreign financing. However, a large fraction of the spillover across countries remains unexplained.