Sentiments in sovereign risk crises: a set-identified Markov-switching approach

Since the 2011-12 sovereign debt crisis many euro-area countries have experienced economic slowdown and deflation, in a period with large government debt overhang. This scenario creates the conditions for financial market distress, with sovereign spreads surges and large fluctuations in agents' expectations. This article investigates the historical determinants of Italian sovereign risk, using a Markov-switching VAR on 1990-2018 data. It aims to identify the triggers of sovereign crises and study fundamental versus regime-dependent sentiment drivers. The latter become relevant during a crisis regime, when a negative sentiment shock triggers adverse macro effects and sharp increases in sovereign spreads. Debt, supply and demand shocks are expansionary and unable to explain episodes of sovereign risk surges, neither during normal nor during crisis times. Counterfactual simulations demonstrate the role of regime-dependent dynamics characterizing the historical evolution of sovereign risk premia and evidence strong reversals in spreads cyclicality.