Without a cure, disease will spread

As the debt crisis in Greece matures, it is possible to assess the impact it is having on the eurozone’s peripheral countries as well as highlighting the need for a long-term solution.

In the past few days and weeks, discussion has increased about the possibility of contagion in and emanating from the peripheral eurozone countries: Ireland, Italy, Greece, Portugal and Spain.

By looking at the Thomson Reuters Indices for the peripheral countries and using Greece as the “transmitter” of shocks across the peripheral zone we can identify the extent to which countries are affected by the problems in Greece and if/how they affect each other.

Looking at how the stockmarkets for Greece, Italy and Spain (as well the peripheral countries as a whole) have performed over the past year, it is clear that Greece has fallen away from the others recently. However, if we look at the stockmarket linkage for each peripheral country with Greece more closely it is possible to see where strong indications of contagion are present based upon the country examined.

Before we start the analysis, it is useful to 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. (Trends continues below)

Using market data for the peripheral countries, it is possible to measure cross-border linkages between the peripheral countries and the analysis suggests nothing out of the ordinary, be it five years ago or even 18 months ago. Given these results, there is a baseline showing a lack of contagion that will help determine if over the past 12 months contagion has appeared.

”This depth of cross-border linkages, which did not exist until recently, appears to be fairly well embedded in all three countries”

The next step is to look 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 peripheral stockmarkets and that a longer-term solution to the problems in the eurozone is needed, so some minimum level of health can be restored to the peripheral countries.

The following table shows the likely impact of the Greece financial shocks on other countries’ stockmarkets 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?

The 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 periods, indicating that any significant financial shock in Greece is a propelling factor in the Portuguese and Spanish stockmarkets for many months.

This depth of cross-border linkages, which did not exist until recently, appears to be fairly well embedded in all three countries. The extent of the linkages in time implies that when evaluating either of these country’s stockmarkets, be it Portugal or Spain, events in Greece need to be taken into account and vice versa.

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Italy is a medium case in that shocks from Greece do affect the Italian markets but only at a distance, that is, 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 stockmarket 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 intervals.

Only Ireland among the peripheral countries 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.

This, however, comes with the caveat that like the rest of the peripheral countries, no lasting solution to the eurozone crisis will certainly have an influence on the Irish market. The 16-32-week period reveals the two-way flow, which signals a potential weakness to a partial solution to the peripheral countries’ problems.

If you also test the effect of Greek financial shocks on the French and German stockmarkets you can see 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, what Germany does affects Greece and what Greece does affects Germany across several timescales. And though the results of the Germany-Greece tests look like those of Spain and Portugal, the linkage, unlike those for the other countries, is how things have been for several years. 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.


Andrew Clark is chief index strategist at Thomson Reuters.