Sovereign Credit Risk in the Eurozone

The roots of the Euro area crisis can be traced back to at least the summer of 2007. Although not picked up by the credit rating agencies until much later, the probability of default on sovereign debt increased in parallel with clear macroeconomic misalignments. These misalignments include recession-triggered budget deficits, bailout-motivated fiscal measures,1 as well as country-specific strategies and political risks – i.e. in the case of Portugal, Italy, Ireland, Greece and Spain.2 In the absence of a major restructuring of debt, sovereign credit risk adjustment in these countries can be achieved only through economic growth or an alternative process of financial austerity and/or inflation. Even at the eleventh hour, when looked at externally, various measures can still be taken to reduce sovereign default probability within the Eurozone. In Italy and Spain, for example, better sovereign credit risk rating might still be restored by the new government teams in power raising tax rates or/and reducing government purchases. Greece can do more to inflate away the real cost of sovereign debt via either more business/corporate activity, higher economic growth and/or a bailout. While the trade-off between