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Deciphering financial contagion in the euro area during the crisis

Tola, Albi and Wälti, Sébastien (2012): Deciphering financial contagion in the euro area during the crisis.

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Abstract

Financial market interdependence has been at the epicenter of the crisis in the euro area. This paper tests for the existence of financial contagion during this crisis, defined as the international transmission of country-specific shocks beyond the normal channels of financial interdependence. Since contagion relates purely to country-specific shocks, we combine the standard contagion test of Favero and Giavazzi (2002) with an innovative narrative approach to separate out global and euro area shocks from country-specific shocks. Financial contagion has been widespread during the crisis in the euro area. About 80 percent of country-specific shocks are contagious. We also find significant evidence of flight-to-safety effects between the core and the periphery of the euro area. Global and euro area shocks have been important drivers of sovereign bond yields in the euro area.

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