What is the risk of European sovereign debt defaults? Fiscal space, CDS spreads and market pricing of risk

We estimate the pricing of sovereign risk for fifty countries based on fiscal space (debt/tax; deficits/tax) and other economic fundamentals over 2005-10. We focus in particular on five countries in the South-West Eurozone Periphery, Greece, Ireland, Italy, Portugal and Spain. Dynamic panel estimates show that fiscal space and other macroeconomic factors are statistically and economically important determinants of sovereign risk. However, risk-pricing of the Eurozone Periphery countries is not predicted accurately either in-sample or out-of-sample: unpredicted high spreads are evident during global crisis period, especially in 2010 when the sovereign debt crisis swept over the periphery area. We match the periphery group with five middle income countries outside Europe that were closest in terms of fiscal space during the European fiscal crisis. Eurozone Periphery default risk is priced much higher than the matched countries in 2010, even allowing for differences in fundamentals. One interpretation is that these economies switched to a "pessimistic" self-fulfilling expectational equilibrium. An alternative interpretation is that the market prices not on current but future fundamentals, expecting adjustment challenges in the Eurozone periphery to be more difficult for than the matched group of middle-income countries because of exchange rate and monetary constraints. (C) 2012 Elsevier Ltd. All rights reserved.