The euro area's common default risk: Evidence on the Commission's impact on European fiscal affairs

Abstract

Sovereign creditworthiness within the euro area hinges upon the credibility of the Stability and Growth Pact (SGP). We analyse whether political events that worsen the SGP's credibility result in a shared default risk premium for all euro members, therefore leading to a joint deterioration of creditworthiness. We especially examine the decisions and statements of the Commission and the Council of Economic and Finance Ministers. Analysing daily data through the 1999-2005 period with an ARMA-GARCH model, we find the Commission plays a decisive role in affecting investor evaluations, where its credibility-strengthening decisions decrease volatility and statements signalling a weakening of fiscal credibility spark uncertainty on financial markets. Our results stress the importance of creating credible fiscal institutions that preserve sovereign creditworthiness within the euro area.