Transmission of the financial and sovereign debt crises to the EMU: Stock prices, CDS spreads and exchange rates

This paper tests for the transmission of the 2007–2010 financial and sovereign debt crises to fifteen EMU countries. We use daily data from 2003 to 2010 on country financial and non-financial stock market indexes to analyze the stock market returns for three country groups within EMU: North, South and Small. The following results hold for both the North and South European countries, while the smallest countries seem to be relatively isolated from international events. First, we find strong evidence of crisis transmission to European non-financials from US non-financials, but not for financials. Second, in order to test how the sovereign debt crisis affects stock market developments we split the crisis in pre- and post-Lehman sub periods. Results show that financials become significantly more dependent on changes in the difference between the Greek and German CDS spreads after Lehman’s collapse, compared to the pre-Lehman sub period. However, this increase is much smaller for non-financials. Third, before the crisis euro appreciations coincide with European stock market decreases, whereas this relationship reverses during the crisis. Finally, this reversal seems to be triggered by Lehman’s collapse.

► We test for transmission of the financial & sovereign debt crises to EMU equities. ► Significant crisis transmission from US non-financials index to EMU non-financials. ► No crisis transmission from US financials index to EMU financials. ► EMU financials react stronger to Greek CDS spreads after Lehman’s collapse. ► Euro appreciations coincide with positive equity returns during the crisis.