Is There Contagion Among Peripheral Eurozone Countries?

Includes: FXE
by: Andrew Clark

In the past few days and weeks, discussion has picked up about the possibility of contagion in and emanating from the Peripheral eurozone (PE) countries; Portugal, Spain, Ireland, Italy, and Greece. By looking at the Thomson Reuters Indices for the individual PE countries and using Greece as the “transmitter” of shocks across the PE zone we can identify the extent to which countries are affected by the problems in Greece and if/how they impact each other. The graph below shows us how the stock markets for Italy, Spain, and Greece, [as well the PE countries as a whole] have performed over the past year, and how Greece has fallen away from the others recently. However, we will look at the stock market linkage for each PE country with Greece more closely and see where strong indications of contagion are present based upon the country examined.

Greek, Italian, Spanish, and PE Stock Index Prices, Weekly Basis, Last 61 Days

(Click charts to expand)

Source: Thomson Reuters Indices

Before we start our analysis, let’s define contagion. The most common definition is: contagion is an increase in cross-market linkages across borders, especially in the presence of financial shocks. So an increase in cross-border linkages needs to have occurred before we can say there are indications of contagion. Using Thomson Reuters Indices data for the PE countries, we measured cross-border linkages between the PE countries and found nothing out of the ordinary be that five years ago or even 18 months ago. Given these results, we have a base line showing a lack of contagion, which will help us determine if over the past 12 months contagion has appeared.

We then looked for evidence of contagion across a variety of weekly time intervals. From this investors and analysts can see that if contagion exists, it is not limited to a daily or even a weekly phenomenon but is or could be a potential threat to each country at longer-time intervals. This would argue that the trouble in Greece, which has been going on for 18 months, is beginning to have a deeper effect on other PE stock markets and that a longer-term solution to the problems in the eurozone is definitely needed so some level of health can be brought back to the PE countries.

The following table shows us the likely impact of the Greek financial shocks on other country stock markets in the short, medium and long term. In other words, have financial shocks originating in Greece caused adverse market movements in other countries during the successive weeks and months after the shock?

Table 1: Possible Signs of Contagion Using Weekly Thomson Reuters Indices Data with Greece Index Data as the Transmitter of Shocks

Source: Thomson Reuters Indices

Our test results indicate that Portugal and Spain have the strongest cross linkages to Greece - so much so that the shocks in either country are transmitted both forward and back. The shocks also occur across various time periods indicating that any significant financial shock in Greece is a propelling factor in the Portugese and Spanish stock markets for many months. This depth of cross-border linkages, which did not exist until recently, now appear to be fairly well embedded in all 3 countries. The extent of the linkages in time implies that when evaluating either of these country’s stock markets, be it Spain or Portugal, events in Greece need to be taken into account and vice versa.

Italy is a medium case in that shocks from Greece do affect the Italian markets but only at a distance, i.e. a shock in Greece has been felt in the Italian markets after two months or more have passed. From these results it seems the Italian stock market can be valued on its own and/or within the context of the eurozone troubles in general. This could be because the turmoil in the Italian government is the predominant influence on Italian stock prices, outweighing the influence of Greek shocks except at longer time intervals.

Only Ireland amongst the PEs seems to be relatively free of the shocks that Greece transmits. Ireland’s response to Greek financial shocks suggests that Irish stocks can be valued on their own without reference to Greece. The author says this with the caveat that like the rest of the PE countries, no lasting solution to the eurozone crisis will certainly have an influence on the Irish market. All one has to look at is the 16 – 32 week time period where the two-way flow signals a potential weakness to a partial solution to the PE problems.

Table 2: Possible Signs of Contagion Using Weekly Thomson Reuters French and German Indices Data with Greece Index Data as the Transmitter of Shocks

Source: Thomson Reuters Indices

We also tested the affect of Greek financial shocks on the French and German stock markets [see Table 2 above] and found that France’s exposure is the same as Ireland’s and like Irish stocks, French stocks look like they can be valued on their own and/or in the context of the general eurozone situation. Also like Ireland, France is signaling a potential weakness to a partial solution to the eurozone problems as it has the same 16 – 32 week exposure.

Finally, in Germany, given its dominance, both political and financial, in the eurozone, what Germany does affects Greece and what Greece does affects Germany across several time scales. And though the results of our German-Greece tests look like those of Spain and Portugal, the linkage in Table 2, unlike those for the other countries, is how things have been for several years now. This implies there are no strong indications of contagion.

The German government has probably been right to step forward and press the eurozone to act for the benefit of Greece. Not just because it will benefit the Germans themselves, which it clearly will, but because contagion could spread beyond the Peripheral eurozone countries to the rest of the eurozone if a comprehensive solution to the Greek crisis is not found and implemented.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.