The Cost of Sovereign Default: the Impact of the Eurozone Debt Crisis on Domestic Stock Markets an Event Study 

The Cost of Sovereign Default: The Impact of the Eurozone Debt Crisis on Domestic Stock Markets An Event study ROSECARMEN PIERRE LOUIS Student Nr: s1965646 February 2013 ABSTRACT This paper documents the possible sovereign default costs associated with the Eurozone countries confronting sovereign debt crises. Stock market data of 219 companies from Portugal, Ireland, Italy, Greece and Spain (Acronym PIIGS) are analyzed to determine the impact of bail-out announcements on stock returns and liquidity measurements. The findings show that stock markets are mostly affected in the first 20 days following bail-out announcements. They indicate that Greece’s first bail-out announcement might have caused strong anticipation of default by the remaining four countries. Furthermore, the results confirm the Collateral view of market illiquidity during crises. Overall, this paper also documents that countries with relatively better fiscal or economic conditions are more negatively affected by the crisis than countries with relatively worse fiscal or economic conditions. Keywords: sovereign default cost, abnormal returns, liquidity JEL-classification: G0, G1 1. Introduction Throughout history many governments have defaulted on their domestic and external debts, leading their countries into severe debt crises. These types of crises, the consequence of sovereign default, have been associated with a variety of costs. Macroeconomic studies have used a range of variables to identify the potential costs that defaulting governments might cause their countries to suffer. Some have used foreign direct investment (FDI) to look whether creditors’ countries shut their doors to defaulters’ investment abroad (Fuentes and Saravia, 2009). Other studies have analysed factors such as GDP, commodity prices, country short-and long-term interest rates, with the purpose to explore possible negative effects of sovereign default on these variables (Alfaro and Kanczuk, 2005; Boreinszten and Panizza, 2009; De Paoli et. al, 2006; UNIVERSITY OF GRONINGEN, FACULTY OF ECONOMIC AND BUSINESS. DEPARTMENT OF FINANCE. The author would like to take this opportunity to give special thanks to the supervisors: A.van der Made and A.J. Meesters 1 Reinhart and Roggof, 2008). From a microeconomic perspective, the impact on variables such as sovereign risk premium in credit default swaps, returns on asset prices, volume on assets traded, bid-ask spread on assets traded and the price reaction to trading, have been researched, to test the potential cost of sovereign default (Boreinsztren and Panizza, 2009; Chordia et. Al, 2005; Forbes, 2004; Hameed et. al 2010; Noy, 2008; Van Horen et. Al, 2008). However, despite all of the studies conducted, the cost of sovereign default on defaulters’ countries is still difficult to quantify. Specifically, the cost of sovereign default on defaulters’ stock markets has not been given much attention. Sovereign default can be defined as: “The failure of governments to meet a principal or interest payment on domestic or external debt on the due date (or within a specified grace period), or the rescheduling/restructuring of debt into terms less favorable to the lender than those in the original contract” (Reinhart and Rogoff, 2008). In May 2010, the Greek government was officially bailed-out on its external and domestic debts with an 110bn euros rescue package. This bail-out acceptance followed an extended denial process of financial need by the Greek government. The high increase in the country’s debt level made it difficult for the government to service its loan. In March 2012, a second bailout package of 130bn euros was granted by the European partner states and the IMF to Greece. On top of these loans, the majority of Greece’s creditors agreed to write off more than half of the debts owed to them by 1 Athens . In addition, they agreed to replace existing loans with new loans at a lower interest rate. Following Greece’s first bail-out, other financially distressed countries in the Eurozone–Ireland, Italy, Portugal and Spain (acronym IIPS), have also been acknowledging their own need for monetary aid. In this paper, based on the given definition for sovereign default, a bail-out is also considered a debt default. The abovementioned observations have motivated further investigation regarding the possible costs that sovereign default can impose on the secondary financial market of defaulting countries. Recently a number of studies have shared the view that sovereign default can be costly to defaulters’ financial systems. Some papers look at the impact of sovereign default on banks (Yeyati and Panizza, 2011). The premise is that sovereign default may weaken domestic banks, weakening their role as providers of liquidity and credit to the economy. Others have elaborated on contagion 1 Eurozone crisis explained 2012, retrieved from http://www.bbc.co.uk/news/business-13798000 October 1, 2012 2 effects, emphasizing how default caused elsewhere might affect firms around the world (Forbes (2004). However, the majority focuses only on emerging markets. Thus it is still not completely apparent how sovereign default may be costly to developed countries’ financial systems. More importantly, the magnitude of the possible cost of sovereign default on the aforementioned Eurozone countries’ stock markets has not been investigated. The aim of this study is to investigate the cost of sovereign default on the stock markets of Portugal, Ireland, Italy, Greece and Spain (acronym PIIGS). This is done by specifically analyzing investors’ reaction to sovereign bail-out announcements. Different scenarios are considered to analyze investors’ reaction. Firstly, I study whether Greece’s bail-out announcement might have caused possible default anticipation by IIPS investors as suggested in other studies (Boreinszten and Panizza, 2009; Levy-Yeyati and Panizza, 2011). This is because a Greek bail-out acceptance may have caused IIPS’ investors to anticipate a default by IIPS’ governments. Since a bail-out announcement is news, it is assumed to reflect symmetric information. This implies that investors’ reactions to such news might be related. It also suggests that due to the anticipation of default, IIPS’ investors might have taken speculative positions, causing them to start selling their assets, putting the stock market under severe stress. Throughout this paper, I refer to this anticipation process as “the anticipation effect”. Two consecutive scenarios are considered to analyze investors’ reaction. A second scenario analyzes the specific public bail-out announcement dates for PIIGS separately. Here I look at the specific dates on which a bail-out package has been publicly announced to each country. A third approach consists of attempting to observe whether countries’ macroeconomic or fiscal conditions determine how these countries’ stock markets are affected by the crisis. To carry out the analyses, the particular definition of a liquid market must be designated. From Amihud (2002), Bank for International Settlements (1999) and Chordia et. al (2005), a liquid market can be defined as a market where participants can rapidly execute large-volume transactions at low cost. To identify the cost of sovereign default on the stock markets of PIIGS, I employ the insights from the overall literature discussed in this paper and fundamentals regarding negative shocks to the economy. In this paper, a public bail-out announcement is considered to be news and administers a negative shock to the economy (Amihud, 2002; Chordia et. al, 2005; Forbes, 2004; Van Horen et. al, 2008).3 This negative shock is likely to have a negative impact on asset prices (The first cost to be analyzed in this paper). This loss in asset value might be due to an asset recomposition effect. This effect originates from the foundational work of Kiyotaki and Moore (1997) and is referred to as the Collateral view. It is used by several authors to relate liquidity with market returns. According to the Collateral view theory, market participants obtain funding by pledging assets as collateral. During bad economic times, the liquidation value of the collateral can decrease, as potential buyers also confront difficult times. Because of the decrease in collateral value, debt capacity also decreases. This in turn, reinforces the fall of the collateral price as potential buyers become even more cash constrained. During crises periods, market participants can hit their margin constraints (Since asset prices decrease and investors are demanded to deposit more cash or securities to cover losses) and might be forced to liquidate. This, as stated by Van Horen et. al (2008), can induce a wider cost of trading. This cost will make it difficult to provide liquidity exactly when the market needs it. According to Van Horen et. al (2008), net withdrawals are a function of intermediaries’ performance and market liquidity is closely related to intermediaries’ funding needs. A drop in asset value will cause a decrease in short term inflow of funds. This effect forces financial intermediaries to sell, which adds to the price downturn and also generates a spiral fall in some liquidity measures. The liquidity impact is the second cost I disclose in this paper. Liquidity and price impact are determined by using the famous model of Brown and Warner (1980), which allows for measuring the impact of events on securities. With this methodology, I try to empirically observe whether the sovereign debt crisis in the Eurozone caused investors to reassess

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