ECB policy and Eurozone fragility: Was De Grauwe right?

Paul De Grauwe's Eurozone fragility hypothesis states that sovereign debt markets in a monetary union without a lender-of-last-resort are vulnerable to self-fulfilling dynamics fuelled by pessimistic investor sentiment that can trigger default. We test this contention by applying an eclectic methodology to a two-year window around Mario Draghi's “whatever-it-takes” pledge that can be understood as the implicit announcement of the Outright Monetary Transactions (OMT) program. A principal components analysis reveals that the perceived commonality in default risk among peripheral and core Eurozone sovereigns increased after the announcement. An event study reveals significant pre-announcement news transmission from Spain to Italy, France, Belgium and Austria that clearly dissipates post-announcement. Country-specific regressions of CDS spreads on systematic risk factors reveal frequent days of large adverse shocks affecting simultaneously those five Eurozone countries, but only during the pre-announcement period. Altogether these findings support the fragility hypothesis and endorse the OMT program. •We test the effect of ECB's LOLR stance on Eurozone sovereign debt markets.•ECB's policy change (via OMT) increases the commonality in Eurozone credit spreads.•The link between Eurozone credit risk and fundamentals strengthens.•Self-fulfilling dynamics in Eurozone debt markets lessens.•The evidence supports De Grauwe's Eurozone fragility hypothesis.