December 2, 2010

Bad News Spreads

When government debt is downgraded, the ill effects can be felt across countries and financial markets

THE recent European sovereign debt crisis was concentrated in a few countries, but its effects were felt in financial markets throughout the euro area. Following downgrades of credit ratings for countries such as Greece, Ireland, Portugal, and Spain, sovereign bond spreads widened, the costs of insuring sovereign debt (as measured by credit default swap—CDS—spreads) rose, and stock markets well beyond the affected countries felt the pressure (see chart).

The resulting debate over the role of credit rating agencies during crises and the interdependence of different financial markets has focused on changes in sovereign debt ratings. These measure the likelihood that a government will fail to meet its financial obligations and whether these changes have spillover effects across countries and markets in a highly integrated environment, such as the euro area, which includes 16 European economies.

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