EMU sovereign spread widening – Reasonable market reaction or exaggeration?

Sovereign spreads within the euro zone rose sharply between September 2008 and March 2009 as markets began to worry about the fiscal fallout from the global financial crisis. It appears that the country-specific fiscal and external positions were the key drivers in the recent widening of sovereign bond and CDS spreads. However, compared to historical default risk and the assigned default probabilities by external rating agencies, market-implied probabilities of default appear to be too high for most member states. The transformation of banking-sector risk into sovereign risk might partly explain the drastic spread widening of some EMU countries hit by banking-sector distress.