Contagion in the Euro crisis: capital flows and trade linkages

Against the backdrop of the contagion literature, the paper analyses the impact of financial and trade linkages on sovereign bonds spreads in the Eurozone crisis. Using quarterly data for a sample of EMU countries during the period 2000-2013, we estimate fixed-effect panel models with Driscoll and Kraay standard errors that are robust to general forms of spatial and temporal dependence. Our main results can be summarized as follows. First, we suggest that the "sudden stop" of capital inflow toward the peripheral sovereign debt triggered a re-segmentation of financial markets and economic systems along national borders, with negative implications for risk sharing and the efficient allocation of capital. The "home bias" effect - i.e. the increase in the share of sovereign debt held by domestic banks - worsened the country-specific risk because the twin crisis (sovereign and banking) began to be conceived as more closely intertwined within countries than before. Second, the structure of international trade helps to account for the geographic scope of contagion, even after controlling for macroeconomic and fiscal vulnerabilities. Finally, the potential influence of wider financial spillovers related to the emerging markets' decoupling hypothesis is confirmed by our analysis. However, the "substitution-effect" of public debt securities of stand-alone emerging countries has affected more the sovereign spreads in the core than in the periphery.