Dynamics of Sovereign Credit Contagion

Abstract

This article explores the dynamics of sovereign credit contagion. The recent European debt crisis is direct evidence of default clustering for sovereign nations and shows that credit contagion among countries is an important subject in financial analysis. We examine abnormal changes in Credit Default Swaps (CDS) spreads in one country in response to credit rating shocks in another, and observe that negative shocks prompt more extreme reactions in the CDS market than do positive events. We find stronger contagion effects for non-event countries located in the same geographic region with economic development levels similar to those of the event country. This greater contagion effect is also observed in non-event countries with stock market dynamics that are highly correlated to those of the event country. Finally, the credit contagion effect is weaker for non-event countries with better macroeconomic performance and political governance.