The Euro and European Equity Market (Dis)Integration

Sandro C. Andrade University of Miami Vidhi Chhaochharia University of Miami

First Version: October 2010 This Version: June 2012

Abstract We document a striking 2007-2011 reversal in the long-term trend towards equity market integration in Europe. We link this equity market disintegration to three mutually reinforcing Eurozone crises: a competitiveness/growth crisis, a sovereign debt crisis, and a banking crisis. To that end, we use earnings yields dierentials to measure relative changes in equity valuation levels, and sovereign spreads to describe time series and cross-sectional variation in the severity of the triple crisis. We nd that increases in Eurozone sovereign spreads are signicantly associated with decreases in equity valuation levels in the Eurozone relative to the rest of Europe, particularly for: i) nancial rms, especially banks holding large amounts of distressed sovereign debt; ii) non-nancial rms that are vulnerable to disruptions of local credit markets. Our conclusions are buttressed by two event studies investigating the impact of sudden changes in sovereign debt nancing conditions and banking sector resilience on equity valuation levels. Paradoxically, while the Euro was in part conceived to further integrate European nancial markets, it set the stage for the triple crisis which resulted in a reversal of European equity market integration.

Keywords: Euro crises, equity market integration, earnings yield, sovereign spread
This paper has been spun o our paper "How Costly is Sovereign Default? Evidence from Financial Markets". We thank Stijn Claessens, Sudipto Dasgupta, Robin Greenwood, Cam Harvey, Elaine Henry, Narayana Kocherlakota, George Korniotis, Alok Kumar, Alexandre Lowenkron, Manuel Santos, Rik Sen, Stephan Siegel (especially), Frank Warnock, and Alex Wilson for helpful comments and discussions. We are also grateful to seminar participants at Miami, Tilburg, HKUST, PUC-Rio, Brazilian Finance Society Annual Meeting, and Darden International Finance Conference. We thank Fred Hood, Emanuel Kohlscheen, Chris Lundblad, Stephan Siegel, and Konstantinos Tzioumis for generously sharing their data. This paper has been partially funded by a U.S. Department of Education Title VI Grant. All errors are ours. Please address correspondence to Sandro C. Andrade at sca@miami.edu.

Introduction

Recent research documents a multi-decade long trend towards the integration of global equity markets, as evidenced by the convergence of equity valuation levels around the world (Bekaert, Harvey, Lundblad, and Siegel 2011). Focusing on Europe in particular, Bekaert, Harvey, Lundblad, and Siegel (2012), henceforth BHLS, conclude that equity valuation convergence is to a large extent driven by membership in the European Union. Membership in the EU is associated with the removal of barriers for mobility of capital, goods, and people, and with the harmonization of rules and regulations across countries. In turn, rule harmonization and barrier removal would lead to cross-border equalization of economic growth opportunities and nancial risk-premia, thus resulting in convergence of equity valuation levels across Europe.1 This paper documents that over the 2007 to 2011 period there is a spectacular reversal of the multi-decade trend towards European equity valuation convergence. Figure 1 illustrates the evolution of equity market segmentation (i.e., lack of integration) in Europe from 1987 to 2011. We plot our version of BHLS s pairwise segmentation measure, based on absolute dierences of industry-level earnings yields. Later in the paper we provide details on the construction of this measure. Note that the 2007-2011 period displays a sharp reversal of the long-term trend towards lower segmentation in Europe. As of December 2011, equity market integration in Europe is at the same level as of the early 90s.
Bekaert, Harvey, Lundblad, and Siegel (2011,2012) measure equity valuation levels using earnings yields at the industry level. Using a simple dividend discount model, earnings yields can be expressed as r-g, where r is a discount rate and g is the growth rate of earnings. Financial and economic integration equalize both r and g in the same industry across dierent countries, leading to convergence of valuation levels.
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Figure 1: Pairwise Equity Market Segmentation in Europe

1987-2011

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.04

.06

.08

Jan 85

Jan 90

Jan 95

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Jan 05

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Interestingly, the recent equity market disintegration occurs even though Europe has seen neither a reinstatement of previously removed barriers for trade and factor mobility nor a reversal in the harmonization of rules and regulations. That is, it appears that the drivers of the 2007-2011 divergence in equity valuation levels are dierent from the drivers of the multi-decade long convergence before 2007. We argue that the 2007-2011 divergence of equity valuations in Europe results from the Euro s three mutually reinforcing crises: a competitiveness/growth crisis, a banking crisis, and a sovereign debt crisis (Shambaugh, 2012; Acharya, Drechsler, and Schnabl, 2011). Ultimately, these crises appear to stem from the loss of exchange rate and monetary autonomy associated with the introduction of a common currency in a region not ripe for it, as forewarned by Obstfeld (1997) and many others (Jonung

and Drea, 2009). Paradoxically, while conceived in part to further integrate European nancial markets, the monetary union set the stage for a sharp reversal of existing equity market integration. In Section 2 we discuss the competitiveness/growth crisis, the banking crisis, and the sovereign debt crisis, their mutually reinforcing mechanisms. We also explain the channels through which the Euro s crises foster equity market disintegration in Europe. Our empirical analysis provides several results consistent with the Euro s triple crisis narrative for equity market disintegration in Europe. To that end, we use sovereign CDS spreads as summary statistics of time-series and cross-sectional variation in the severity of the Euro s triple crisis.2 Building on BHLS (2011, 2012), we measure equity valuation levels using industry-level earnings yields. The valuation levels of Eurozone rms are measured relative to comparable rms in the non-euro Western Europe (UK, Switzerland, Denmark, Sweden, and Norway). We begin by showing that equity valuation levels in the Eurozone are strongly correlated with sovereign spreads. Higher spreads are associated with lower equity valuations. The strong positive correlation holds both at the value-weighted aggregate stock market and at the rm level. Our rm-level results include controls for leverage, size, and protability, as well as rm and time xed eects. Our narrative associates the disintegration of European equity markets in 20072011 to the Euro s triple crisis. An alternative narrative downplays the role sovereign and banking crises, and posits that high levels of government debt resulting from scal pro igacy are to blame for relatively lower growth perspectives in the Eurozone s
2 Alternatively we could have dened a pre- and a post-crisis period and pursue a dierence-in-dierences methodology. Note, however, that this alternative methodology cannot take into account time variation of the severity of the crisis within the crisis period (e.g., September 2008 is better than September 2009 and both are worse than September 2011).

periphery.3 These lower growth perspectives translates to relatively lower equity valuations in the Eurozone s periphery. The association between lower equity valuation levels and higher sovereign spreads documented by us would thus be spurious, as both variables are caused by high government debt. According to this view, a high public debt burden would lead to lower economic growth and hence lower valuation levels even if the probability of sovereign default was zero.4 We explore cross-sectional variation in the association between sovereign spreads and equity valuation dierentials in order to dierentiate our narrative from the alternative narrative mentioned above. First we show that, for a given increase in sovereign spreads, valuations of nancial rms decrease by much more than valuations of non-nancial rms. This is consistent with our story that puts sovereign and banking crises at the center of the of recent European equity market disintegration, while the alternative story does not provide cross-sectional predictions for the relationship between sovereign spreads and equity valuation levels. Moreover, we use detailed data on sovereign debt holdings to link valuation levels to holdings of sovereign debt directly.5 We nd that European banks holding more distressed sovereign debt experience larger decreases in valuation levels associated with increases in sovereign spreads. These results indicate a link between the Euro s sovereign debt crisis and equity valuations, over and above the eect of high government debt in constraining growth.
Nobel laureate Robert Mundell (2011) writes: "The scal crisis of some Eurozone countries should not be called the euro crisis. The socialist governments went into a scal binge under the protection of the euro." Reinhart and Rogo (2010) and Cecchetti, Mohanty, and Zampolli (2011) argue that high levels of public debt (above 85% or 90% of GDP) constrain economic growth. Therefore, also else equal, countries with public debt to GDP ratios above 90% would be expected to have weaker economic growth than countries with more moderate ratios. 4 Japan has very low sovereign CDS spreads even though its public debt to GDP ratio is above 200%, much larger than that of any Eurozone country (Cottareli, 2011). 5 Our results in the equity space conrm those of Acharya, Drechsler, and Schnabl (2011) in the CDS space. These authors link bank CDS spreads directly to their holdings of distressed sovereign debt.
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Second, focusing on Eurozone non-nancial rms, we nd that rms that are more vulnerable to disruption in credit markets (younger rms, rms with higher debt rollover needs, and rms with less tangible assets) experience larger decreases in valuation levels for a given increase in sovereign spreads. These results indicate that disruptions in local credit markets play an important role in explaining lower equity valuations in countries in which sovereign spreads are higher, and therefore in explaining equity market disintegration in Europe. Again, these results conrm that sovereign and banking crises play a central role in explaining why equity valuation levels diverge in Europe. Third, we nd that Eurozone periphery s non-nancial rms that are likely to benet from an exchange rate depreciation associated with a potential Euro exit (rms with high fraction of exports and low fraction of imports of intermediate inputs) in fact experience increases in valuation levels associated with sovereign spread increases. This results shows that potential foreign exchange depreciations associated with exits from the monetary union, a reinforcing loop of the euro s triple crisis, play a role in explaining divergence of equity valuations in Europe. Finally, we provide two event studies that highlight the importance of sovereign debt and banking crises for the dispersion of valuation levels in the Europe. These event studies focus on sudden improvements in sovereign debt nancing conditions and in banking sector resilience. To the extent that other determinants of equity market valuation levels (e.g., high levels of public debt) are xed in the very short window around these sudden improvements, they help us establish a causal eect going from sovereign and banking crises to equity valuations. The rst event study investigates nancial markets response to the announcement of the creation of the European Financial Stability Fund (EFSF) in May 2010.
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The EFSF fund would provide more favorable debt nancing conditions for distressed Eurozone countries. We nd that such announcement leads to a strong positive reaction of Eurozone s sovereign debt and equity markets relative to non-Euro Europe, and that the equity market eect is stronger for nancial rms. The second event study investigates market s response to the August 2011 announcement of a merger of Greece s second and third largest banks, coupled with an injection of further capital from Qatar. We nd that no reaction in sovereign debt markets, but a strong positive reaction in Greece s equity market, particularly for nancial rms (excluding those participating in the merger). In sum, we document a striking reversal in the long-term trend towards equity market integration in Europe, and link this recent disintegration in equity markets to the Euro s triple crises. The rest of the paper proceeds as follows. In Section 2 we discuss the Euro s triple crises, and how it aects valuation levels. In Section 3 we describe our data. In Section 4 we use aggregated data to document the reversal in Europe s equity integration trend. In Section 5 we explore how sovereign spreads - our summary statistics for time series and cross-sectional variation in the severity of Europe s triple crisis - relate to equity level dierentials in Europe. Section 6 concludes the paper.

The Euro s three crises and stock valuations

In this section we discuss the Euro s three crisis, and their mutually reinforcing mechanisms. We also detail the channels through which the Euro triple crisis foster equity market disintegration in Europe. Figure 2 illustrates this section s discussion. Competitiveness/growth crisis The introduction of the Euro set the stage for a gradual loss of international competitiveness in Greece, Ireland, Italy, Portugal, and Spain (henceforth the GIPSI). In hindsight, the Eurozone s one-size-ts-all monetary appear to have been too lax for the GIPSIs before 2008.6 Relative to the rest of the Eurozone, Germany in particular, these ve countries experienced large wage and price in ation from the introduction of the Euro to 2008 (De Grauwe 2011, Shambaugh 2012). In ation gradually eroded the GIPSIsinternational competitiveness, as evidenced by the accumulation of large and growing current account decits in the GIPSIs, mirrored by growing current account surpluses in other Eurozone countries, most notably Germany (Obstfeld 2012). Trapped in a monetary union, the GIPSIs cannot depreciate their currencies in order to lower the relative prices of its products and thereby spur demand for them. The loss of competitiveness alone, associated with the impossibility of quick correction through instantaneous exchange rate depreciation, is su cient to generate some dispersion across equity valuations within Europe. This is because growth opportunities in the GIPSIs would diverge from growth opportunities in the rest of Europe, which leads to a reduction in GIPSI stocks valuation levels relative to the
Using a standard Taylor Rule, Nechio (2011) shows that while the ECB s monetary policy appears adequate for the the coreEurozone until 2008, it was too lax for the Eurozone s periphery. The di culty of establishing of a one-size-ts-all monetary policy for the GIPSI and the rest of the Eurozone was predicted by Bayoumi and Eichengreen (1993). They nd that, while supply shocks in the core Eurozone are of similar magnitude and as coordinated as the supply shocks across the U.S. geographical regions, the GIPSIs experience larger and more idiosyncratic supply shocks.
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comparable stocks in the rest of Europe. Thus, long-term loss of competitiveness is associated with higher earnings yields in the GIPSIs relative to those in the rest of Europe. However, we argue that stock valuation levels in Europe diverge in 20072011 by much more what would be warranted by the loss of competitiveness the GIPSIs accumulated from 1999-2008 alone. The valuation divergence is amplied by the closely intertwined sovereign debt crisis and banking crisis in the Eurozone.

Sovereign debt crisis and banking crisis In addition to setting the stage for the GIPSI s loss of competitiveness, and precluding quick corrections via exchange rate depreciations, the introduction of the Euro exacerbates the "nancial fragility" of public debt markets. This increases the likelihood of sovereign debt crisis. Since Calvo s (1988) seminal analysis, it is known that public debt is vulnerable to multiple equilibria and self-fullling expectations. If lenders believe public debt is sustainable, then interest rates are low and public debt turns out to be sustainable. Instead, if lenders question the willingness or ability of a government to fulll its debt obligations, then interest rates are high and public debt is unsustainable.7 Importantly, for reasons not fully understood thus far, sovereign debt markets appear to be much more "fragile" (unstable, prone to self-fullling crises) when a government cannot control its own currency.8 The increased instability of public debt markets associated with membership in a currency union opens up room for small changes in fundamentals to have disproportionately large eects on debt pricing. This is because small changes in fundamentals may set in motion self-reinforcing changes in beliefs, amplifying the eect of the initial shock because beliefs can be self-fullling. In the Eurozone case, the lower growth prospects in the GIPSIs resulting from loss of competitiveness set in motion disproportionately large increases in sovereign spreads
Note that there is no quick and dirty method to evaluate a government s capacity and willingness to pay back its debt. As Rodrik (2010) writes, they "depend on almost innite number of present and future contingencies. They depend not just on its tax and spending plans but also on the state of the economy, the external conjuncture, and the political context. All of these are highly uncertain, and require many assumptions to reach such form of judgment about creditworthiness . Using Allen and Gale s (2004) terms, the di culty in assessing fundamental, "intrinsic" uncertainties related to sovereign sustainability allows "extrinsic uncertainties" (expectations/condence) to play a large role, and thus increases "nancial fragility". See Calvo (1988), Cole and Kehoe (2000), and Corsetti and Dedola (2011) for models of selffullling crises in government debt markets. 8 For discussions on why membership in a currency union increases the nancial fragility of public debt markets, see De Grauwe (2011), Wolf (2011), Krugman (2011), Wren-Lewis (2011), and Portes (2012).
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and a full- edged sovereign debt crisis. There are three channels through which a sovereign debt crisis can aect stock valuation levels. First, an increase in the probability of sovereign default signals impending domestic banking crisis which would result in a large disruption in domestic credit markets. This is consistent with evidence in Arteta and Hale (2008) and Kohlscheen and O Connel (2007). Recent theories of sovereign default identify a domestic banking crisis as the main cost of sovereign default.9 The mechanism operates through two well-known "home-bias" phenomena associated with domestic banks: domestic banks are responsible for a disproportionate large fraction of lending to domestic non-nancial rms; and domestic banks hold disproportionate large amounts of domestic sovereign debt. Because of practical di culties, governments cannot selectively default on foreign debtholders (Broner, Martin, and Ventura, 2010). Therefore, sovereign default would necessarily reduce domestic bank capital and hence disrupt domestic credit markets.10 The impending disruption of domestic credit markets upon sovereign default reduces valuation levels through reduced growth opportunities and an increase in risk. Second, even before the occurrence of sovereign default per se, higher probability of sovereign default leads to bank deleveraging and an associated credit crunch through higher bank funding costs and capital ight. Higher probability of sovereign default increases the risk of lending to domestic banks, since these banks would suffer large losses if sovereign default materializes. This increased risk raises domestic
See Brutti (2011), Gennaioli, Martin, and Rossi (2011), Bolton and Jeanne (2011), and Acharya, Drechsler, and Schnabl (2011). See Panizza, Sturzenegger, and Zettelmeyer (2009) and Levy-Yeyati and Panizza and (2011) for empirical evidence and illuminating discussions of the shortcomings of traditional theories of sovereign default. 10 As an example of the large impact of sovereign default on bank s capital, we note that the IMF estimates that Greek government bond holdings of the largest Greek banks represent more than 100% of their Tier 1 capital (IMF 2011).
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bankscurrent funding costs (Corsetti et al. 2012). In response to increased funding costs, banks reduce lending activity. Bank deleveraging due to higher funding costs thus reduces corporate investment and hence aects valuation levels through reduced growth opportunities. Third, governments response to the sovereign debt crisis may exacerbate the competitiveness/growth crisis. If the cost of servicing public debt increases, governments may want to increase current and prospective primary budget surpluses in order to signal that their debt to GDP ratios are sustainable over time. In the face of a depressed economy with idle resources, reduced government spending may lead to lower economic growth (De Long and Summers 2012).11 Therefore, governments front loaded austerity response to a sovereign debt crisis may reduce valuation levels through lower growth opportunities. Banking crisis and sovereign debt crisis Above we discussed how sovereign debt crisis can lead to lower valuation levels through an impending banking crisis and through current bank deleveraging caused by high bank funding costs. Here we explore how a banking crisis may lead to a sovereign crisis, as pointed out by Acharya, Drechsler, and Schnabl (2011). As mentioned before, the Eurozone s one-size-ts-all monetary policy appears to have been too lax for the GIPSIs from the introduction to the euro to 2008. This created wage and price in ation in these ve countries. In two of these ve countries, Ireland and Spain, overly lax monetary policy may have contributed to real estate booms not justied by fundamentals. The real estate burst after 2008
See also discussions in Acconcia, Corsetti, and Simonelli (2011), Cottarelli (2012), Shambaugh (2012), and Krugman (2012). Acconcia et al. (2011) write: "The message from this new strand of empirical literature [on scal multipliers] is thus straightforward. Fiscal expansions and contractions do aect economic activity above and beyond their size".
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left Irish and Spanish banks with a large number of potentially underperforming real estate loans. In order to avoid severe disruptions associated with failures of large banks, governments may bail out these bankscreditors, by taking over a large fraction of banks private debt into their balance sheets. Therefore, bank bailouts may increase public debt by potentially large amounts, and contribute to a sovereign debt crisis. The sovereign debt crisis aects growth perspectives and valuation levels as previously discussed. Euro exit reinforcing loop The introduction of a single currency in a region not ready for it is the root cause for the triple crises. Markets participants then conjecture that the ultimate solution to the crises consists of exits from the monetary union. Such exits would necessarily be associated with instantaneous and large real foreign exchange devaluations, particularly for the GIPSIs. Large devaluations would lead to immediate insolvency not only of sovereigns but also of most local banks, whose liabilities would be denominated in euros and assets in the new local currencies. Therefore, market participants correctly anticipate that exits from the monetary union for periphery countries would most likely be associated with forced re-denomination of liabilities from euros to local currencies at non-market exchange rates. The possibility of Euro exits thus leads to capital ight from peripheral countries, and associated increases in sovereign debt spreads and bank funding costs (Levy-Yeyati et al., 2010; King, 2012). Therefore, the Euro exit loop associated with the triple crises reinforces both sovereign and banking crises. The euro exit loop leads to lower valuation levels for most rms in distressed countries. A large fraction of corporate earnings in distressed countries is generated locally, and thus would be denominated in the new, devalued local currencies upon an
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Euro exits. Therefore, the possibility of euro exit and large real currency depreciation thus leads lower stock valuation levels in distressed countries because stock prices are currently denominated in euros. Note that, strictly speaking, this euro exit channel aecting stock valuations (i.e., earnings yields) is neither a discount rate eect (r ) nor a growth rate of earnings eect (g ). Interestingly, a few stocks in distressed economies may actually benet from an euro exit. Consider for example an hypothetical rm located in one of the GIPSIs which exports 100% of its production to Germany. Therefore, its revenues are "denominated" in euros, even though the rm is located in a GIPSI. Moreover, assume this hypothetical rm only uses local inputs, and thus have all its costs denominated in local currency. In principle, a large real currency depreciation upon Euro exit would thus result in a decrease in production costs, and a resulting increase in earnings denominated in euros. Later in the paper we nd evidence consistent with a benecial eect of euro exit for these kind of GIPSI rms.

Data

Most of our analysis relies on two basic variables: earnings yields dierentials on the left-hand side (either rm-level or country aggregates) and sovereign spreads on the right-hand side. In this section we describe the construction of these variables.

3.1

Earnings yield dierentials

We compute a monthly stock-based Earnings Yield Dierences for each of the Eurozone countries. Our sample period is from January 2005 to December 2011. Our sample of countries contains 11 Eurozone countries (Austria, Belgium, Finland, France,
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Germany, Greece, Ireland, Italy, Netherlands, Portugal and Spain) and 5 Western European countries that are not in the Eurozone (Denmark, Norway, Sweden, Switzerland, and the UK). We rst compute an earnings yield for each European stock in each month of our sample. We use analysts earnings forecasts from I/B/E/S and stock price data from Datastream. I/B/E/S tickers are matched to Datastream identiers in three steps: rst by ISIN, then by SEDOL, and nally by name (hand-matched).12 Both earnings forecasts and stock prices are as of the third Thursday of each month, because this is when I/B/E/S computes its summary statistics of earnings forecasts across analysts. We use earnings forecasts rather than historical earnings to reduce measurement errors, because realized earnings are equal to forecasted earnings plus noise. Liu, Nissim, and Thomas (2002) compare earnings yields of individual U.S. companies with their industry mean and nd that the dispersion of earnings yields calculated from historical earnings is nearly twice that of earnings yields calculated from analyst forecasts. Additionally Liu et al. (2007) show that earnings forecasts substantially outperform historical earnings in describing valuations of European rms. Similarly, Kim and Ritter (1999) nd much smaller IPO valuation errors using analyst earnings forecasts rather than historical earnings. In our baseline results, we compute the earnings yield using the average earnings forecast for the scal years t, t+1, and t+2. We don t use earnings forecasts after scal years t+2 for two reasons. First, because many stocks don t have forecasts beyond scal year t+2. Second, because we want estimates of current earnings that are uncontaminated by long-term earnings growth. In robustness tests we repeat our analyses using either one-year forward earnings or using only t+2 earnings forecasts.
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We will post the I/B/E/S-Datastream match on the corresponding author s webpage.

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These alternative choices reduce the sample as there is a (small) drop in coverage from t to t+1 and t+2. Following BHLS (2007, 2010, 2011), we discard negative earnings and earnings yields above 100% per year. Finding comparable stocks Our methodology requires us to identify a set of comparable stocks for each Eurozone stock in our sample. The closest comparable sample for our Eurozone stocks are non- Euro Western European stocks. The countries in our comparable sample include Denmark, Norway, Sweden, Switzerland and the United Kingdom. Following BHLS (2007, 2010, 2011), we group rms by ICB Level 4 industries. There are 39 such industries. BHLS (2007, 2010, 2011) postulate that, in integrated markets, stocks in the same industry have the same expected earnings growth rate and fundamental risk exposure. This would make their earnings yields comparable. Furthermore, grouping rms by industry is by far the most common way to perform cross-sectional comparisons of stock multiples (e.g., Baker and Ruback, 1999; Kim and Ritter, 1999; Lie and Lie, 2002; Purnanandam and Swaminathan, 2004; Liu, Nissim, and Thomas, 2002 and 2007; Bris, Koskinen, and Nilsson, 2009). To account for potential dierences in nancial risk (as oppose to business risk), in our rm-level analysis we further group stocks in the same ICB Level 4 industry into (net) leverage quartiles. Our rm-level results are robust to not-matching by leverage in addition to industry. For non-nancial rms, we dene leverage as total debt minus cash divided by total assets as of the previous scal year. For nancials, we dene leverage as total liabilities divided by total assets as of the end of the previous scal year. The leverage quartiles are based on breakpoints computer by industry-month

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pairs and using both Eurozone and comparable stocks. Each Eurozone stock is then matched to "comparable" stocks in the same industry and the same leverage quartile. Table I provides information on our sample of Eurozone rms and the comparablerms. Panel A, Table 1 shows that, on average each month, we have a total of 1316 Eurozone stocks and a total of 1254 comparablestocks. Eurozone stocks and comparablesare similar in terms of average market capitalization. Specically, over our sample period the average market capitalization is $ 4304 mil for Eurozone stocks and $ 3353 mil for comparablestocks. Panel B of Table 1 presents the average monthly number of rms per industry in our sample. On average across industries, each month we have 31 Eurozone stocks and 25 comparablestocks. sample.

TABLE 1

For each of the Eurozone stocks and for each month, we compute the earnings yield of the comparablestocks in the same industry and the same leverage quartile. So, for each stock j in a Eurozone country at a given point in time, we have its own earnings yield EYtEZ;j and its comparable earnings yield EYtcomp;j . In our rmlevel analysis, the dierential earnings yield EYtEZ;j EYtcomp;j is the main dependent variable. In total, across all Eurozone countries and all months, we have 108837 observations of rm-level earnings yield dierentials. Aggregation Following BHLS (2007, 2010, 2011), we do not match by leverage quartile in addition to industry and use value-weighted averaging to aggregate EYtEZ;j and EYtcomp;j up to the country-level at each point in time. We show our country-level results are robust to matching at the rm-level by both industry and leverage, rather than
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just by industry. Our aggregation produces a country-level earnings yield EYtEZ and a country-level comparable earnings yield EYtcomp for each Eurozone country at each point in time. Finally, we compute the country-level earnings yield dierential
EYtEZ EYtcomp . Pooling across all of the 11 Eurozone countries and 84 months, our

country-level data has 924 observations. Table 2 contains summary statistics of our aggregate sample. The average Eurozone earnings yield in our sample is 0.093. The average "comparable" earnings yield is 0.091. Not surprisingly, those earning yields are highly positively correlated (correlation=0.83). The average earnings yield dierence is 0.002.

TABLE 2

3.2

Sovereign spreads

We use the 10 year CDS spreads (CR restructuring clause) denominated in Euros as our measure of the sovereign debt spread. To match with the earnings yield data from I/B/E/S summary statistics, we use spreads measured as of the third Thursday of each month. We obtain the CDS data from Markit until September of 2010, and from Thomson Reuters from October 2010 to December 2011. We compute the Log Spread as log (1+CDS spread). Later we will use the Square Root Log Spread, dened as the squared root of log spread. This monotonic and concave transformation of Log Spread is the main dependent variable in our analysis. This is because we observe that the relationship between Log Spread and earnings yield dierences is notably concave. Because we later interact spreads with rm characteristics, it is much simpler to use a concave transformation of Log Spread than to carry over two

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Figure 3: 10-year CDS spreads in the Eurozone

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France Italy

terms (level and square) for the spread throughout our analysis. Table 2 provides summary statistics on our sovereign spread variables. The average spread for the Eurozone sample of countries is 0.0107. Additionally there is high variability in the spread as shown by the standard deviation of the spread which is 0.0355. Note the spread, the log spread. and the square root of the log spread are positively correlated with the earnings yield dierences. Figure 3 plots the evolution of CDS spreads over time. Note that CDS spreads are uniformly small across the Eurozone prior to 2008. Then spreads strongly diverged. In this paper we use CDS spreads as summary statistics of time series and crosssectional variation in the severity of the Euro s triple crisis.

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Equity Market Integration Over Time

In this section we document that over the 2007 to 2011 period there is a spectacular reversal of a multi-decade trend towards European equity valuation convergence. Following BHLS (2012), we compute pairwise measures of equity market segmentation (i.e., lack of integration). We start with rm-level earnings yields each month, computed as before. Our sample period is 1987 to 2011. Using value-weighting, we aggregate such rm-level earnings yields industry-country pairs (EYtcountry=industry ). In principle, we could have 39 x 16 industry-country pairs, because we have 39 industries and 16 European countries (11 Eurozone, 5 other), disregarding the fact that some countries do not have stocks in all 39 industries. Then, for each pair of countries (say, A and B) we dene its pairwise segmentation as the value-weighted absolute dierence between the industry-level earnings yields:
P airwise Segmentation of Countries A and B = X
A;B;i wt EYtA;i

EYtB;i

industries i

i;A;B Following BHLS (2012), we set a value-weight wt equal to zero if one of the

countries does not have stocks in industry i. Still following BHLS (2012), we calculate the weights for non-missing pairs using the sum of the industry-level market capitalizations of countries A and B. Finally, we average this pairwise segmentation measure across all country pairs at each point in time. Figure 1 in the Introduction plots this average pairwise market segmentation measure from 1987 to 2011. Note that, consistent with BHLS (2011, 2012), there is a clear trend towards convergence of equity market valuations from 1987 to 2007. But in summer of 2007 there is a sharp reversal of this trend and equity market segmentation starts to increase, i.e., valuations start to diverge across dierent European countries.
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Figure 4: Pairwise Equity Market Segmentation

1987-2011
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Figure 4 shows that the disintegration trend is essentially an European rather global phenomenon. In the rst panel we plot the average pairwise segmentation across developed countries in the rest of the world (North America and Asia-Pacic), along with the European average pairwise segmentation plotted before in Figure 1. Details about this global sample are on Table CC in the Appendix. Note that the cross-border divergence of equity valuations after the summer of 2007 is more pronounced in Europe than in the rest of the developed world. In the second panel we show that, within Europe, the equity market disintegration is essentially an Eurozone phenomenon. We plot the average pairwise segmentation across the 11 Eurozone countries and the 5 Western European non-Euro countries. The graph shows much larger increase in segmentation in the Eurozone than in the rest of developed Europe after the summer of 2007.
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Figure 5: Average Eurozone minus Non-Eurozone Earnings Yield Differentials and 10-year CDS spreads

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Jan2012

France Italy EY_difference

Figure 5 plots signed as opposed to absolute (non-signed) dierences of valuation levels, along with Eurozone CDS spreads. The gure shows that, on average, valuations levels decreased in the Eurozone relative to the 5 non-Euro Western European countries from 2005 to 2011. We plot the dierence between the average earnings yield in the Eurozone and the average earnings yield in the rest of developed Europe, after aggregating industry earnings yields to the country level via value-weighting. We use equally-weighted averages across countries in the Euro and non-Euro groups. Results are similar when we use value-weighted averages of countries in each group before taking the dierence. Note that there are two interesting patterns in Figure 5. First, the decrease in Eurozone equity valuations relative to European non-Euro valuations in 2007-2011 is economically large. From 2005 to the summer of 2007, average valuations levels in
22

-.01

.01

.02

the Eurozone are almost identical to those in the non-Euro countries. On average in that period, the dierence in earnings yields is just -0.004. But in the last quarter of 2011 the dierence increases to 0.018. Given that the average earnings yield in the two country groups in the 2005 to 2011 period is about 9% (see Table 2), the dierence in earnings yields at the end of 2011 amounts roughly 24% of rm values (0.018-(-0.04) 0.09). Second, the time series pattern of the (average) earnings yield dierential is similar to the time series patters on Eurozone CDS spreads.

On the drivers of European equity market (dis)integration

In this section we explore cross-sectional and time series variation in earnings yield dierentials in order to shed light on the drivers of the 2007-2011 European equity market disintegration.

5.1

Are earnings yield dierentials correlated with spreads? Countrylevel

In this section we present linear regressions of the earnings yield dierences on sovereign debt spreads to investigate whether equity market valuations and sovereign spreads are at all correlated. We report Driscoll-Kraay (1998) standard errors with 12 lags. These standard errors are robust to heteroskedasticity, autocorrelation with 12 lags within each cluster, and contemporaneous cross-sectional correlation across clusters.

TABLE 3

23

Table 3 presents our linear regression results of country level earnings yield dierences on spreads. The data are comprised of 84 months for each of the 11 Eurozone countries, totalling 924 data points. We regress the country level earnings yield differences onto the log spread and other control variables. In column (1) we regress country level earnings yield dierences on log spreads. First we nd that the spreads and valuation dierentials are signicantly positive correlated. In column (2) we add the square of the log spread to investigate whether there is a non-linear relation between the spreads and earnings yield dierences. We nd that square term is negative and statistically signicant at the 10% level indicating that there is a concave relation between the earnings yield dierences and spreads. Using the maximum spread in the sample and the estimated coe cients, we nd that the relationship between earnings yield dierentials and spreads is increasing at all points in the sample. To simplify our analysis we use a monotonic and concave transformation of the log spread as our main independent variable. This is because we later interact spread coe cients with a number of rm characteristics. It is much easier to interpret the sign of the interaction terms when we have only one spread variable, than if we had to use both log spread and its square. In column (3) we report regression results of the square root of the log spread on country level earnings yield dierences. As expected, we nd that the square root of the log spread is signicantly positively associated with the earnings yield dierences. Specically the coe cient on the square root of the log spread is 0.095 which is statistically signicant at the 1% level. In terms of economic signicance, the coe cient on the square root log spread in column (3) translates to a 1 standard deviation increase in the square root of the log spread is associated with an increase of the earnings yield dierence of 0.5 standard deviations. Alternatively an increase in 100 basis points in the spread from
24

the sample average translates into a valuation discount of 4.6% or an increase in earnings yield dierence of 0.4%. Therefore the relation between the spread and valuation dierences is economically and statistically large. In Column (4) we add country xed eects and in Column (6) we add month-year xed eects and in column (7) we add both country and time eects together. Additionally, below column (7) we report our results where we cluster by both country and time. The square root of the log spread remains economically and statistically signicant at the 5% level in all these regressions. To ensure that the spread is capturing the worsening of the crises in the Eurozone we add additional control variables to check whether the spread is just proxying for worsening macroeconomic growth prospects or worsening competitiveness or high debt/GDP ratios in some of the Eurozone countries. In column (5) we add the dierence slope yield curve as measure of macroeconomic growth prospects of the Eurozone relative to the non- Eurozone Europe. Specically the dierence slope yield curve is the dierence between the slope of the riskless yield curve in the Eurozone and the slope of yield curve in the non-Eurozone countries. The slope is calculated as the dierence between a 10-year and 3-month rates. In the Eurozone the 3-month rate is the yield of a 3-month German government bond and the 10-year rate is the yield of a 10-year German government bond less the 10-year German CDS spread. In the non-Eurozone we calculate the slope for each of the 5 countries and aggregate by value-weighting where the stock market capitalizations of the individual countries are used as weights. We nd that the spread remains statistically signicant at the 1% level. It is important to note that the increase in sovereign spreads is also to some extent capturing the worsening of macroeconomic growth prospects in the Eurozone and we cannot disentangle this eect entirely.
25

In column (8) we add the government debt/GDP and the unit labor costs as additional control variables. Government debt and labor cost data are collected from Eurostat. The government debt is measured as the total government debt scaled by GDP at constant prices. We linearly interpolate the quarterly data to give us data at a monthly frequency. We use the debt as a measure of the high debt burdens for the Eurozone countries. The unit labor costs are measured as the ratio of the compensation per employee and labor productivity where labor productivity is measured as GDP at constant prices scaled by the total number of persons employed. We use this as a proxy of erosion of competitiveness in the Eurozone countries on account of being locked into a currency union. The spread remains statistically signicant in this regression indicating that the spread to some extent might be capturing the worsening crisis in these countries. In column (9) we recreate the country level earnings yields to match Eurozone and non-Eurozone stocks by both industry and leverage. We check the robustness of the relation between the spread the earnings yield dierences after controlling for leverage dierences between countries. As noted by BHLS, 2011 leverage dierences between rms can cause divergence in valuations. To rule out the eect of leverage we regress leverage matched country level earnings yield dierences on spread and nd that the coe cient is statistically and economically large. Lastly in column (10) we report regression results for the change in the spread on the change in earnings yield dierences. Again we nd the eect of positive and statistically signicant at the 5% level. In sum, we nd that at the country level there is a statistically and economically large positive association between earnings yield dierences in the Eurozone and the sovereign debt spreads. In other words higher sovereign spreads are associated with
26

lower equity market valuations in the Eurozone area, relative to valuations in the non-Euro Western European countries.

5.2

How are earnings yield dierentials correlated with spreads? Firmlevel

By aggregating up to the country level we can study overall associations between sovereign spreads and earnings yields dierences but in the process we lose much of the richness of rm level data which we could potentially exploit. We explore the cross sectional variation in the association between sovereign spreads and equity market valuations to distinguish from the view that a high debt burden can lead to lower economic growth and hence lower valuation levels. Another advantage of rmlevel data is the possibility to use rm-level xed-eects, which control for unobserved variation at the rm-level.
TABLE 4

Table 4 provides summary statistics for rm level characteristics. Our sample consists of rm level monthly observations from January 2005 to December of 2011. Leverage-matched earnings yield dierences at the rm level are created as the difference in the earnings yield of Eurozone rms and comparable earnings yield differences in Non-Eurozone Europe. The Comparables earnings yield is calculated by value-weighting earnings yields of the Non Europe European rms in the same industry (ICB level 4) and the same leverage quartile within each industry. Additionally, leverage is measured as net debt (i.e., debt cash) scaled by assets for non-nancials, and as total liabilities scaled by total assets for nancials. The average leverage-matched earnings yield dierences for our sample of rms is 0.006.

27

There is signicant variability in the rm level earnings yield dierences as indicated in high standard deviation (0.059). The average spread at the rm level is 0.059. In Panel B of Table 4 we report summary statistics for earnings yield dierences and rm characteristics for non-nancial rms only. On average we nd that the average leverage-matched earnings yields are 0.005 which is very close to the overall sample average.
TABLE 5

Table 5 contains results of our rm-level regressions. As a rst step we replicate our country level analysis at the rm level. We include rm level controls for assets and protability. Additionally all rm level regressions include rm and time xed eects. Column (1) of Table 5 reports regression results of leverage-matched earnings yield dierences on the log spread. The coe cient on the spread is 0.233 which is statistically signicant at the 1% level. To account for the concave relation between earnings yield dierences and spread we use the square root of the log spread as our main independent variable. Column (3), of Table 5 reports regression results of the valuation dierential on the square root of the log spread. Again we nd a strong positive association between earnings yield dierences and the spread indicating that higher earnings yield dierences in the Eurozone relative to Non-Eurozone European countries is associated with an increase in sovereign debt spreads. Next we explore the cross sectional variation in the association between the sovereign spread and equity market valuation dierentials in order to highlight the role of the sovereign and banking crisis in the Eurozone area.

28

Financials vs. non-nancials Financial rms are directly aected by sovereign debt crisis because they hold domestic sovereign bonds. We conjecture that, for a given change in sovereign spreads, the nancial sector as a whole experiences a larger decrease in equity market valuations as compared to the non-nancial sector. In columns (4) and (5) of Table 5 we test this hypothesis. We interact the square root of the log spread with a dummy for the nancial and include it as an additional regressor in our rm level regressions. Column (4) shows that the coe cient on the interaction is 0.131 and is statistically signicant at the 1%. This indicates that the nancial sector is disproportionately more aected as compared to other sectors. In Column (5) we attempt to show that we are not just capturing the fact that nancial rms just tend to have higher exposures to systematic risk. To that end, we include an interaction term of the spread with a rm level beta as an additional regressor. We nd that this interaction term is not signicant indicating that the spread interacting with the nancial sector dummy is not merely capturing some element of higher exposure to systematic risk. Direct holdings of sovereign debt In the paragraph above we claim that nancial rms are directly aected by sovereign debt crisis because they hold domestic sovereign bonds. Here we follow Acharya, Drechsler, and Schnabl (2011) and provide direct evidence of this channel using data on bank holdings of sovereign debt from the 2010 and 2011 stress tests. The stress tests have date on about 100 banks in the Eurozone. This sample is reduced to 28 banks once we require: (i) banks have to participate in both the 2010 and 2011 stress tests; (ii) banks need to be in our sample of earnings yields data both in 2010 and 2011.

29

Following Acharya, Drechsler, and Schnabl (2011), we scale a bank s sovereign debt holdings by the ratio of the bank s Tier 1 capital in both 2010 and 2011, and compute a spread-weighted and scaled exposure to sovereign debt for both 2010 and 2011. Finally, we compute the change in this spread-weighted exposure for each of the 28 banks from 2010 to 2011. The formula is: Holdingscountry Country Spread countries T ier 1 Capital P

In Table 6 we correlate the change in sovereign debt holdings dened above with the rm-level change in earnings yields over the same 2010 to 2011 period. We nd that an increase in the spread weighted sovereign debt holding of banks in the Eurozone is associated with a signicant decrease in equity market valuation of these banks as compared to the non-Eurozone European banks. Specically in column (1) we regress the change in the spread weighted sovereign debt holdings on a change in the bank earnings yield and nd that these banks experience as decrease in valuation of 0.882 which is statistically signicant at the 1% level and economically large. This result is robust to inclusion of additional control variables like log assets, average earnings yields and country xed eects (columns (2) to (4) of Table 6).
TABLE 6

To mitigate the potential eect of outliers in our small sample we also run median regressions. These results are reported in columns (5) (8) of Table 6. We nd that the eect is qualitatively similar to the ordinary least square regression results. These

30

results conrm a direct link between sovereign debt holdings and equity valuation levels. Non-nancials with higher vulnerability to credit market disruptions Table 7 provides evidence consistent with the idea that non-nancial rms that are more vulnerable to disruption in credit markets experience larger decreases in valuation levels for a given increase in the sovereign spread. We measure vulnerability to credit market disruptions in three alternative ways: rms with higher debt rollover needs (high net leverage), rms with less pledgeable hard collateral (low asset tangibility), and rms less likely to have a long credit history (younger rms).13 All regressions include assets, protability, rm and time xed eects as controls. In column (1) of Table 7 we interact the sovereign spread with a dummy for high leverage. The dummy for high leverage takes a value 1 if rm leverage at time t is higher than median leverage for the sample of Eurozone rms at time t. We nd that rms with higher leverage experience larger valuation discounts for a given level of the sovereign spread. Specically the coe cient on the interaction term of the spread and high leverage is 0.100 and is statistically signicant at the 1% level. Given the nite maturity of debt, rms with high leverage are more likely to need to roll over their debt and therefore would have to access the external markets. Such rms would be more aected on account of a banking crisis.

TABLE 7

In column (2) we interact a dummy for low asset tangibility with the sovereign spread. Asset tangibility data is collected from Worldscope and is dened as property,
13

See Almeida and Campello (2007) and Chava and Purnanandam (2011).

31

plant and equipment scaled by assets. We nd that the coe cient on the interaction term is signicant positive indicating that these rms are more likely to experience an increase in their earnings yields on account of an increase in the sovereign spread. In column (3) we interact a dummy for low rm age with the sovereign spread. We collect information on the age of the rm from OSIRIS. Age is dened in years from the date of incorporation of the rm. Our sample size drops on account of rms that could not be matched to OSIRIS. We nd that for a given level of the spread rms with low age in the Eurozone are more likely to experience a decrease in their valuation of 0.067 as compared to rms in non- Eurozone Europe. This eect is statistically signicant at the 5% level. In column (4) we include both the interaction with net leverage and the interaction of asset tangibility, We want to check whether the eect on rms with low asset tangibility is coming from a high leverage eect. It is not. We nd that both interactions are positive and statistically signicant. Similarly, in column (5) we add the interaction of leverage with the spread together with the interaction of low rm age with the spread. We nd that both interactions remain statistically signicant. In sum, Table 7 provides evidence that disruptions in local credit markets appear to play a crucial role in explaining lower equity market valuations in countries when sovereign spreads are high. Non-nancial rms and potential foreign exchange depreciation Table 8 provides evidence that there is foreign exchange depreciation channel over and above the aforementioned channels. This depreciation would immediately follow an exit from the Eurozone. An exit from the Euro would translate into signicant currency depreciations of many of the member countries of the Eurozone especially

32

for the GIPSI countries. In such an event it is possible to identify rms that might potentially benet from a currency depreciation and therefore might experience an increase in equity market valuations as the sovereign spread increases. Firms that have a high fraction of foreign sales coupled with low fraction of intermediate input imports are rms that could benet from the Euro exit. These rms are earning most of the revenue from export earnings and are using domestic inputs for production.

TABLE 8

In Table 8 we interact the sovereign spread with a dummy for rms that have high foreign sales and low intermediate input imports. We obtain foreign sales data from Datastream and supplement the data with OSIRIS. Foreign sales is dened as the fraction of total sales that come from foreign markets. Since rm level data on intermediate imports is not available we use industry level data on intermediate input imports. We obtain this data from OECDstat Extracts and is dened as the contribution that imports make in the production of exports of goods and services in the mid-2000 s. Column (1) of Table 8 has the sovereign spread interacted with the dummy for high foreign sales and dummy for low intermediate input imports. We nd that for a given level of the spread, rms in the Eurozone with high foreign sales and low intermediate input imports experience an increase in their valuation levels (the coe cient 0.118 is positive). This eect is statistically signicant at the 1% level. In column (2) and (3) of Table 8 we break up our sample into the GIPSI and non-GIPSI countries and run the same regression on the two subsamples. Countries like the GIPSI are more likely to experience larger currency depreciation as com33

pared to Germany for example. Therefore it is reasonable to conjecture that the aforementioned foreign exchange eect should be more pronounced in rms in the GIPSI countries. Conrming our conjecture, we nd that rms in the GIPSI that have high foreign sales and low intermediate input imports experience a valuation increase of 0.184 which is statistically signicant at the 1% level. In contrast the non-GIPSI rms with the same characteristics do not experience a signicant value increase.

5.3

Event studies

Because our focus has been on equity market valuation dispersion and its relation with the sovereign spread in the Eurozone we cannot ignore the fact that could be many alternative determinants that could be aecting both equity market valuations and causing sovereign spreads to be increasing. Most notably, the major alternative narrative for Euro crisis is predicated upon high levels of debt to GDP ratios causing slower economic growth. In that case, even if the probability of sovereign default was near zero (e.g., Japan), high debt levels would reduce equity valuation levels because of reduced growth opportunities. It could be the case, therefore, the high sovereign debt levels cause both low valuations and high sovereign spreads, and that the correlation of spreads and valuations is spurious. Endogeneity issues as the one described above are notably di cult to fully address in nancial economics. It is hard to nd unequivocally clean instrument variables or natural experiments. Nonetheless, we attempt to mitigate concerns about endogeneity using two event studies, described below.

34

Announcement of EFSF fund creation As Claessens, Tong, and Zuccardi (2011), we use the May 2010 announcement of the creation of the European Financial Stability Facility (EFSF) as a quasi-natural experiment generating a sudden improvement in debt nancing conditions for troubled Eurozone economies. On Saturday May 8 2010, European governments announced a 750 billion euro rescue package for distressed countries. The package amounted to contingent credit lines to countries which would allow distressed countries to lengthen the maturity of their debts and pay below market interest rates. Importantly, the package did not contemplate debt reduction itself. Therefore, it is unlikely that any observed price reaction in stock markets and in the sovereign debt market was triggered by a direct eect of a reduction in high debt-to-GDP ratios for example. We use daily data to evaluate the market reaction to the announcement of the creation of the EFSF fund. Note that over these very short windows of time other determinants of equity market valuations are less likely to change substantially. The change in sovereign spreads is calculated as the change in the 10-year CDS spread between May 10 and May 7th of 2010. We calculate stock returns on May 10, 2010 using daily data from Datastream ICB Level 4 Industry stock indices for all sample countries. We rst compute the value-weighted stock return in each of the Eurozone countries. Then we subtract the comparable stock return in the comparables sample to dene industry- adjusted Eurozone stock return. The calculation of the comparable stock return in non-Eurozone countries is analogous to our previous analysis. That is, we rst calculate the value-weighted return in each of the 39 industries for pooled Non- Eurozone countries on May 10, 2010. Then we multiply this vector of comparable industry returns by the vector of Eurozone value-weights to nd the
35

comparable May 10, 2010 stock return in each of the Eurozone countries. Table 9, Panel A presents our results.

TABLE 9

Table 9 shows that, on average, we nd that for all 11 Eurozone countries there is a large positive reaction in sovereign debt and stock markets. The average sovereign spread between May 7 and May 10, 2010 decreases by 72 basis points and the industry-adjusted stock market returns are equal to 2.9% on May 10th, 2010. Additionally, note that nancial rms experience a larger stock return increase equal to 6.4%, as compared to 2% for non-nancials. Notably all markets except Germany experience an unequivocal increase in stock returns for that day. Quite remarkably, the magnitude of contemporaneous stock returns and sovereign spread changes around the EFSF announcement is in line with our panel date estimates in Column 10 of Table 3. More specically, if we assume no change in (short-term) earnings forecasts from May 7th to May 10th, we are able to compute an imputed change in earnings yield dierentials associated with the stock returns in Table 9. We can correlate such imputed change with the contemporaneous change in the square root of log spreads. Figure 6 shows the outcome of this exercise. On the x-axis we plot the change in square root log spread for each Eurozone country from May 7th to May 10th. On the y-axis we plot the correspondent (imputed) change om earnings yield dierentials, assuming no change in short-term earnings forecasts. The slope of the best t line is equal to 0.057. This slope is remarkably close to the 0.046 slope in Column 10 of Table 3. This indicates that are regression results in Table 3 appear to be driven
36

mostly by variation in spreads rather than by variations of a third, omitted variable. Alpha Bank and EFG Eurobank merger announcement Alpha Bank and EFG Eurobank are respectively the second and third largest banks in Greece. On August 29th, 2011 an almost overnight merger agreement was reached between these two banks. Of the two banks Alpha bank was in considerably better shape as compared to EFG Eurobank and a merger between them would make the banking sector in Greece more resilient. Importantly, the merger was also associated with a capital injection of $ 500 million from Qatar into the merged bank. Remarkably, the overall Greek stock market went up by 12.5% on August 29th, 2011, upon the merger announcement. The one-day stock market performance was particularly spectacular among nancial rms. Excluding the stocks of Alpha Bank and EFG Eurobank themselves, nancial rms increase by a whopping 22.3%
37

in a single day adjusting for contemporaneous returns in other industries across the Eurozone. Non-nancial rms went up by 8%. On the other hand, the 10-year CDS spread of Greece decreased by just 12 basis points, an statistically insignicant outcome (t-stat=0.21). This event study indicates that stock valuation levels are depressed in Greece due to a potential banking crises resulting from a sovereign debt crisis. The sudden increase in the perceived resilience of the banking sector reduces the expected magnitude of the banking crisis, even though it does not change the probability of sovereign default.

Conclusion

This paper documents a striking 2007-2011 reversal in the long term trend towards equity market integration in Europe. This equity market disintegration is on account of three mutually reinforcing crises in the Eurozone: a growth/competitiveness crisis, a sovereign debt crisis, and a banking crisis. The root cause for this triple crisis is introduction of a single currency in a region not ripe for it. Paradoxically, while conceived in part to further integrate European nancial markets, the monetary union set the stage for a sharp reversal of existing equity market integration. Our empirical analysis provides several results consistent with the Euro triplecrises narrative for equity market disintegration in Europe. To that end, we use sovereign debt spreads as summary statistics for time-series and cross-sectional variation in the severity of the triple crises. First, we nd that equity valuation levels (more precisely, industry-level earnings yields) in the Eurozone are strongly correlated with sovereign debt spreads. Second, we show that, for a given increase in
38

sovereign spreads, valuations of nancial rms decrease by much more than valuations of non-Financial rms. We provide further evidence by focusing on a sample of European banks for whom we have sovereign debt holdings data. We show that banks holding more distressed sovereign debt experience larger decreases in valuation levels associated with increases in sovereign spreads, wich demonstrate a direct link between the Euro s sovereign debt crisis and equity valuations. Third, focusing on Eurozone non-nancial rms, and nd that rms that are more vulnerable to credit market disruptions (younger rms, rms with higher debt rollover needs, and rms with less tangible assets) experience larger decreases in valuation levels for a given increase in sovereign spreads. Fourth, we show that Eurozone s periphery non-nancial rms that are likely to benet from an exchange rate depreciation associated with a potential Euro exit (rms with high fraction of exports and low fraction of imports of intermediate inputs) actually experience valuation levels increases associated with sovereign spread increases. Finally, we provide two event studies that highlight the importance of sovereign debt and banking crises for the growing dispersion of valuation levels in the Europe. These event studies focus on sudden improvements in sovereign debt nancing conditions and in banking sector resilience. To the extent that other determinants of equity market valuation levels (e.g., high levels of public debt) are xed in the very short window around these sudden improvements, they help us establish a causal eect going from sovereign and banking crises to equity valuations.

39

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Analysts Journal 63, 56-64. Mendoza, E.G., Yue, V.Z. 2011. A General Equilibrium Model of Sovereign Default and Business Cycles. Maryland Working Paper. Mundell, R. 2011. The European Fiscal Reform and the plight of the euro. Global Financial Journal, forthcoming. Nechio, F. 2011, Monetary Policy when one size does not t all. Federal Reserve Bank of San Francisco Economic Letter 2011-18, June 2011 Obstfeld, M. 2012 Financial ows, nancial crises, and global imbalances. Journal of International Money and Finance 31, 469-480. Obstfeld, M. 1997. Europe s Gamble. Brookings Paper on Economic Activity vol 1997 (1), pages 241-317. Pan, J., Singleton, K.J., 2008. Default and Recovery Implicit in the Term Structure of Sovereign CDS Spreads. Journal of Finance 63, 2345 2384. Panizza, U., Sturzenegger, F., Zettelmeyer, J., 2009. The Economics and Law of Sovereign Debt and Default. Journal of Economic Literature 47, 651-698. Portes, J. 2012. Is austerity self-defeating? Of course it is. National Institute of Economic and Social Research. http://www.voxeu.org/index.php?q=node/7863 Purnanandam, A., Swaminathan, B. 2004. Are IPOs Really Underpriced? Review of Financial Studies 17, 811-848. Reinhart, C.M., Rogo, K.R. 2010. Growth in a Time of Debt. American Economic Review 100, 573-578. Rodrik, D. 2010. The market condence bugaboo. Commentary, Project Syndicate, July 12, 2010. 44

Shambaugh, J.C. 2012 The Euro s Three Crises. Brookings Papers on Economic Activity, Spring 2012.

Wolf, M. 2011 Managing the eurozone s fragility. Financial Times, May 4, http://www.ft.com/intl/cms/s/0 75ab-11e0-80d5-00144feabdc0.html#axzz1wO7d4Hzc. Wren-Lewis. S. 2011.The case against austerity today. Institute for Public Policy Research Working Paper. October 2011. http://www.ippr.org/images/media/les/publication/2011/10/thecase-against-austerity-today_Oct2011_8033.pdf

45

Table I Country and Industry Characteristics Panel A reports average number firms each month in our sample for our sample countries. Our sample period is from January 2005 to December 2011. Panel B report the industry composition of the Eurozone and Comparables (non Eurozone Europe) sample. We report the average number of firms each month for each of the industries. We use the ICB Level 4 industry classification. Panel A: Sample Countries
Eurozone Austria Belgium Finland France Germany Greece Ireland Italy Netherlands Portugal Spain TOTAL Mkt. Cap. Av. 41 71 86 324 339 63 30 157 84 31 90 1316 4304 TOTAL Mkt. Cap. Av. 1254 3353 Comparables Denmark Norway Sweden Switzerland United Kingdom 64 97 146 147 800

Mkt. Cap. Median 533

Mkt. Cap. Median 335

46

Panel B: Industry Classification

Industry Aerospace & Defense Alternative Energy Automobiles & Parts Banks Beverages Chemicals Construction & Materials Electricity Electronic & Electrical Equipment Financial Services Fixed Line Telecommunications Food & Drug Retailers Food Producers Forestry & Paper Gas, Water & Multiutilities General Industrials General Retailers Health Care Equipment & Services Household Goods & Home Construction Industrial Engineering Eurozone 9 18 34 54 8 37 72 27 53 57 13 13 23 14 20 25 43 40 32 88 Comparables 16 5 7 45 6 21 51 14 46 75 9 9 33 8 8 17 60 36 31 68 Industry Industrial Metals & Mining Industrial Transportation Leisure Goods Life Insurance Media Mining Mobile Telecommunications Nonlife Insurance Oil & Gas Producers Oil Equipment, Services & Distribution Personal Goods Pharmaceuticals & Biotechnology Real Estate Investment & Services Real Estate Investment Trusts Software & Computer Services Support Services Technology Hardware & Equipment Tobacco Travel & Leisure Average Eurozone Comparables 23 33 20 8 78 4 9 21 12 6 32 29 43 34 139 51 51 2 42 31 7 35 9 10 66 27 7 26 20 18 13 40 50 15 113 130 37 2 62 25

47

Table II Summary Statistics on Country level Characteristics: 2005-2011 The table reports summary statistics for country level earnings yields, sovereign bond spreads and other country level characteristics. The earnings yield is firm-level earnings yield aggregated up to the country level by value-weighting. The comparable earnings yield uses the value-weighted average of each industry in the comparables sample. The sample consists of monthly observations from 2005-2011. Country level earnings yield differences measures the earnings yield of the Eurozone countries relative the non-Eurozone European countries. Sovereign spreads are measured by the 10 year CDS spreads denominated in Euros. The difference slope yield curve is the difference the slope of the yield curve of the Eurozone and non-Eurozone European countries. Unit labor costs are measured as the ratio of the compensation per employee and labor productivity. The government debt is measured as total government debt scaled by GDP at constant prices. Both unit labor cost and government debt data are collected from Eurostat. Panel A reports summary statistics and panel B reports correlations among the different variables. Panel A: Summary Statistics
Country Level Comparable Earnings Yield Earnings Yield Difference 0.091 0.002 0.087 0.0001 0.016 0.013 924 924 Square Difference Root Log Slope Yield Spread Log Spread Spread Curve 0.0107 0.010 0.073 1.058 0.0029 0.003 0.054 1.363 0.0355 0.029 0.069 0.788 924 924 924 924

Mean Median Std Dev N

Earnings Yield (Eurozone) 0.093 0.088 0.022 924

Unit Labor Costs 104.8 105.9 9.7 891

Government Debt 73.33 68.10 27.77 924

Panel B: Correlations
Country Level Earnings Yield Comparable Earnings Yield (Eurozone) Earnings Yield Difference 1 0.83 0.70 0.38 0.40 0.53 -0.43 0.17 0.15 1 0.18 0.14 0.16 0.32 -0.25 0.08 0.19 1 0.48 0.49 0.53 -0.43 0.19 0.01 1 0.99 0.83 -0.33 0.14 0.41 Square Difference Root Log Slope Yield Spread Log Spread Spread Curve

Unit Labor Costs

Government Debt

Earnings Yield (Eurozone) Comparable Earnings Yield Country Level Earnings Yield Spread Log Spread Square Root Log Spread Difference Slope Yield Curve Unit Labor Costs Government Debt

1 0.87 -0.36 0.15 0.44

1 -0.66 0.23 0.55

1 0.01 -0.32

1 -0.08

48

Table III Are earnings yield differences correlated with sovereign spreads from 2005-2011 in the Eurozone? The table reports regressions of monthly country- level earnings yield differences on sovereign debt spreads. Country level earnings yield differences measures the earnings yield of the Eurozone countries relative the non-Eurozone European countries. Sovereign spreads are measured by the 10 year CDS spreads denominated in Euros. Column (1) reports OLS regression of the log spread on country level earnings differences. Column (2) includes the squared term of the log spread along with the log spread in the regression. In column (3) we report regression results using the square root of the log spread. In column (4) we include the square root of the log spread and country fixed effects and in column (5) we include the difference of the slope yield curve as an additional explanatory variable. In column (6) we include the square root of the log spread and time fixed effects and in column (7) we include country and time fixed effects together and lastly in column (8) we additionally include controls for overall government debt and unit labor costs. In column (9) we report results where the earnings yields for each of the Eurozone firms are matched to Non-Eurozone European firms based on an industry and leverage quartile match. In column (10) we transform the square root of the log spread and earnings yield differences into their first differences. All standard errors are Driscoll-Kraay standard errors adjusted for 12 lags and are reported in parentheses below the coefficients. In column (7) we additionally report standard errors clustered by country and time. ***, **,* represent significance at the 1%, 5% and 10% respectively.
Leverage-Matched Country Level Country Level Earnings Yield Earnings Yield Difference Difference (9) (10)

Dependent Variab le: (1) Log Spread Log Spread Squared Square Root Log Spread Difference Slope Yield Curve Government Debt (%) Unit Labor Costs (%) Square Root Log Spread Country Fixed Effects Time Fixed Effects N R2 2-way clustering (country & time) N N 924 0.243 N N 924 0.262 (2) 0.207 *** 0.316 *** (0.027) (0.071) -0.346 * (0.170)

Country Level Earnings Yield Difference (3) (4) (5) (6)

(7)

(8)

0.095 *** (0.007)

0.108 *** 0.096 *** 0.070 *** (0.006) (0.009) (0.012) -0.001 * (0.001)

0.089 *** (0.011)

0.112 *** (0.014)

0.097 *** (0.013)

-0.020 ** (0.006) 0.060 ** (0.019) 0.046 ** (0.017) N N 924 0.279 Y N 924 0.543 Y N 924 0.546 N Y 924 0.326 Y Y 924 0.578 0.089 ** (0.035) Y Y 891 0.582 Y Y 924 0.592 Y Y 913 0.163

49

Table IV Summary Statistics on Firm level Characteristics: 2005-2011 The table reports summary statistics for leverage-matched firm level earnings yields, sovereign bond spreads and other firm level characteristics. The sample consists of monthly observations from 2005-2011. Sovereign spreads are measured by the 10 year CDS spreads denominated in Euros. Panel A reports summary statistics for all firms in the sample and panel B reports summary statistics for non-financials.

Panel A: All firms

Leveragematched earnings yields differences 0.006 -0.001 0.059 110586

Mean Median Std Dev N

Log Assets 13.64 13.39 2.25 110586

Profitability 0.102 0.099 0.093 108837

Log Spread 0.059 0.049 0.049 110586

Beta 1.005 0.949 0.949 96495

Panel B: Non-financials

Mean Median Std Dev N

Leveragematched earnings yields differences 0.005 -0.001 0.055 92268

Log Assets 13.29 13.11 2.00 92268

Profitability 0.113 0.109 0.091 91600

Leverage Tangibility 0.104 0.234 0.137 0.184 0.272 0.194 92268 92215

Age 47 28 45.510 72935

Foreign Sales (%) 49.07 50.84 28.25 70733

Intermediate input imports 0.234 0.236 0.129 91413

50

Table V Are earnings yield differences of Financials more affected by sovereign spreads than Non-Financials? The table reports regressions of monthly firm level leverage matched earnings yield differences on sovereign debt spreads. The earnings yield differences are based on a leverage and industry match of firms from the Eurozone sample with the non-Eurozone European sample. Sovereign spreads are measured by the 10 year CDS spreads denominated in Euros. Column (1) reports OLS regression of the log spread on firm level earnings differences. Column (2) includes the squared term of the log spread in the regression. In column (3) we report results for the square root of log spread. In column (4) we include an interaction of the spread with a financial sector dummy. In column (5) we report regression we include an interaction of the spread with firm level betas. All regression specifications include controls for assets, profitability firm and time fixed effects. Standard errors are clustered at the firm level and are reported in parentheses below the coefficients. ***, **,* represent significance at the 1%, 5% and 10% respectively.
Dependent Variable: Log Spread Log Spread Squared Square Root Log Spread Square Root Log Spread * Financial Sector Square Root Log Spread * Beta Log Assets Profitability Firm Fixed Effects Time Fixed Effects N R2 0.003 (0.003) 0.002 (0.009) Y Y 108837 0.529 0.003 (0.003) 0.004 (0.009) Y Y 108837 0.530 0.003 (0.003) 0.004 (0.009) Y Y 108837 0.531 0.003 (0.003) 0.005 (0.009) Y Y 108837 0.532 Leverage-matched Firm Level Earnings Yield Difference (1) (2) (3) (4) (5) 0.233 *** (0.043) 0.531 *** (0.089) -0.830 *** (0.205) 0.174 *** (0.025) 0.151 *** (0.025) 0.131 *** (0.041) 0.122 *** (0.039) 0.142 *** (0.041) 0.014 (0.031) 0.002 (0.003) 0.005 (0.010) Y Y 95012 0.522

51

Table VI Are earnings yields changes of banks holding more distressed sovereign debt more affected by sovereign spread changes? The European stress test banks: 2010-2011 The table reports regressions of change in bank level earnings yield between 2010 and 2011 on the change of sovereign debt holdings of banks in the Stress tests of European banks and our sample. The sovereign debt for each of the bank in our sample is calculated as the country spread weighted sovereign debt holdings at time t scaled by their Tier 1 capital at time t-1. In column (1) we report regression results of the earnings yield change on the change in sovereign debt holdings of banks. Column (2) we include country fixed effects. In Column (3) we include the average earnings yields of the banks over 2010-2011 as an additional control variable. In column (4) we include log assets as an additional control as well. In columns (5) to (8) we report median regressions for the OLS regressions reported in columns (1) to (4). Standard errors are heteroskedasticity consistent and are reported in parentheses below the coefficients. ***, **,* represent significance at the 1%, 5% and 10% respectively.
Dependent Variable: (1) Spread Weighted Sovereign Debt Holdings Average Earnings yield (2010-2011) Log Assets 0.882 *** (0.219) (2) Bank Earnings Yield Change (2011-2010) OLS Median Regressions (3) (4) (5) (6) (7) 0.883 *** (0.258) 0.455 (0.311) 0.859 *** (0.265) 0.435 (0.336) -0.003 (0.005) N Y Y Y N Y Y 1.09 ** (0.424) 0.588 *** (0.087) 0.662 *** (0.158) 0.105 (0.157)

(8) 0.712 *** (0.171) 0.209 (0.173) -0.004 (0.003) Y

0.672 *** (0.148)

Country Fixed Effects

N R2 (Pseudo - R2)

28 0.218

28 0.628

28 0.688

28 0.693

28 0.089

28 0.151

28 0.177

28 0.205

52

Table VII Are earnings yield differences of firms with higher refinancing needs or financially constrained more affected by sovereign spreads? The table reports regressions of monthly firm level leverage matched earnings yield differences on sovereign debt spreads and firm characteristics for a sample of non-financial firms. Column (1) reports OLS regression of the log spread and its interaction with the high leverage dummy. Column (2) adds the interaction of the log spread with the low tangibility dummy. In column (3) we report regression results where we interact log spread with the low age dummy. In column (4) we include the interaction of the spread with low tangibility and high leverage together. In column (5) we include the interaction of the spread with low age and leverage high together. All regression specifications include controls for assets, profitability firm and time fixed effects. Standard errors are clustered at the firm level and are reported in parentheses below the coefficients. ***, **,* represent significance at the 1%, 5% and 10% respectively.
Leverage (1) Square Root Log Spread Square Root Log Spread * High leverage High leverage Square Root Log Spread * Low tangibility Low tangibility High leverage * Low tangibility Square Root Log Spread * Low age Low age High leverage * Low age Log Assets Profitability 0.001 (0.003) 0.019 * (0.009) Y Y 91564 0.544 0.0003 (0.003) 0.017 * (0.009) Y Y 91600 0.545 -0.0003 (0.004) 0.016 (0.011) Y Y 71465 0.537 0.001 (0.003) 0.019 ** (0.009) Y Y 91564 0.547 0.067 ** (0.032) -0.003 (0.005) 0.084 *** (0.026) 0.100 *** (0.024) -0.002 (0.002) 0.119 *** (0.027) -0.008 *** (0.003) Tangibility (2) 0.143 *** (0.026) Firm Age (3) 0.121 *** (0.031) Leverage & Tangibility (4) 0.039 (0.026) 0.126 *** (0.025) -0.005 ** (0.002) 0.140 *** (0.029) -0.011 *** (0.003) 0.002 (0.003) 0.076 ** (0.033) -0.003 (0.005) -0.001 (0.003) -0.001 (0.004) 0.019 * (0.011) Y Y 71436 0.538 Leverage & Firm Age (5) 0.042 (0.036) 0.097 *** (0.029) -0.001 (0.003)

Firm Fixed Effects Time Fixed Effects N R2

53

Table VIII Are earnings yields of firms with high foreign sales and low imports of intermediate inputs less affected by sovereign spreads? The table reports regressions of monthly firm level leverage matched earnings yield differences on sovereign debt spreads and firm characteristics for a sample of non-financial firms. Column (1) reports OLS regression of the log spread with the high sales dummy and the dummy for low intermediate inputs imports. In column (2) and column (3) we break up the sample into GIIPS and non-GIIPS countries respectively. All regression specifications include controls for assets, profitability firm and time fixed effects. Standard errors are clustered at the firm level and are reported in parentheses below the coefficients. ***, **,* represent significance at the 1%, 5% and 10% respectively.
Leverage-matched Firm Level Earnings Yield Difference GIIPS (2) 0.122 *** (0.046) -0.184 *** (0.053) 0.004 (0.007) 0.001 (0.009) 0.019 (0.032) Y Y Non-GIIPS (3) 0.235 *** (0.063) -0.037 (0.042) 0.000 (0.003) -0.001 (0.004) 0.031 *** (0.012) Y Y

Dependent Variable:

(1) Square Root Log Spread 0.177 *** (0.034)

Square Root Log Spread * High Foreign Sales * Low int. input imports -0.118 *** (0.029) High Foreign Sales * Low int. input imports Log Assets Profitability 0.003 (0.003) 0.000 (0.004) 0.029 *** (0.011) Y Y

Firm Fixed Effects Time Fixed Effects

N R2

67281 0.580

16409 0.614

50872 0.566

54

Table IX Event Studies Panel A reports event study results for the announcement of the ESFS creation in on May 10, 2010 and Panel B reports event study results for the Greek bank merger on 29th August 2011. We report the difference between returns in the Eurozone and comparable results in the Non-Euro European countries, adjusted for industry composition (ICB Level 4 classification). In parentheses below the coefficients we report the industry-adjusted return differential on the event day divided by volatility of daily industry-adjusted return differentials in the previous year. . ***, **,* represent significance at the 1%, 5% and 10% respectively. Panel A: May 10th 2010: EFSF creation
10-y CDS spread (in bps) May 7 Austria Belgium Finland France Germany Greece Ireland Italy Netherlands Portugal Spain Average 88 111 33 83 63 863 243 219 58 394 230 217 May 10 ( May10- May7) 74 90 32 71 55 493 176 151 49 233 165 144 -13 ***
(-4.10)

Industry adjusted stock returns differentials All 0.020 **

(2.35)

Financials 0.031 **
(2.54)

Non-Financials 0.012
(1.44)

-20 ***
(-7.15)

0.031 ***
(3.97)

0.099 ***
(5.83)

0.015 **
(1.98)

-1
(-0.82)

0.023 **
(2.51)

0.045 ***
(4.07)

0.020 **
(2.09)

-12 ***
(-5.43)

0.033 ***
(5.90)

0.083 ***
(8.85)

0.022 ***
(3.95)

-8 ***
(-4.73)

-0.017 **
(-2.29)

-0.014
(-1.52)

-0.017 **
(-2.24)

-370 ***
(-20.48)

0.022
(1.16)

0.038
(1.33)

0.011
(0.80)

-68 ***
(-10.57)

0.027 ***
(2.69)

0.097 **
(2.01)

0.021 **
(2.29)

-68 ***
(-13.02)

0.037 ***
(5.48)

0.066 ***
(6.49)

0.024 ***
(3.68)

-9 ***
(-3.33)

0.018 ***
(2.94)

0.110 ***
(6.09)

0.002
(0.29)

-161 ***
(-15.13)

0.052 ***
(5.76)

0.036 **
(2.23)

0.055 ***
(6.43)

-65 ***
(-9.91)

0.069 ***
(-9.14)

0.107 ***
(8.29)

0.051 ***
(7.79)

-72

0.029

0.064

0.020

55

Panel B: Aug 29th 2011: Alpha Bank and EFG Eurobank merger

10-y CDS spread (in bps) Aug 26 Greece 2239 Aug 29 2227 ( Aug 29- Aug 26) 12
(0.21)

Industry adjusted stock returns differentials All Financials Non-Financials 0.080 ***
(6.14)

0.125 ***
(7.61)

0.223 ***
(8.29)

56

AppendixTable:VariableDescription

Firm-level Earnings yield

Country level earnings yield difference

Description Ratio of earnings per share to stock price, available at the monthly frequency and at the firm level. Earnings are the average of earnings forecasts for fiscal period t, t+1 and t+2. Negative forecasts are treated as missing. Prices are official closing prices. The earnings forecasts data are matched to prices on the date I/B/E/S releases the summary statistics of earnings forecasts (the third Thursday of each month). Earnings yields above 1 are treated as missing. Value-weighted average of the difference between the firm-level earnings yield of Eurozone firms and the comparable earnings yield in Non-Eurozone Europe. The comparable earnings yield for each Eurozone firm is calculated by value-weighting earnings yields of Non-Euro European firms in the same industry, based on ICB Level 4 industry classification. This variable is available for each Eurozone country at the monthly frequency. For financials leverage is measured as total liabilities scaled by total assets and for non-financials it is measured as net debt (debt cash) scaled by assets. This variable is available at the annual frequency. Difference of earnings yield of Eurozone firms and comparable earnings yield in NonEurozone Europe. The comparable earnings yield is calculated by value-weighting earnings yields of Non-Europe European firms in the same industry (ICB Level 4) and the same leverage quartile within each industry. This variable is available at the monthly frequency for each Eurozone firm. Value-weighted average Leverage-matched firm level earnings yield difference. This variable is available at the monthly frequency for each Eurozone country. Sovereign spreads is the 10 year CDS spreads denominated in Euros (CR docclause). We use the spreads as of the third Thursday of each month, to match with the earnings yield data. The log spread is measured as ln (1+spread). The Square Root Log Spread is the square root of ln(1+spread). These variables are available at the monthly frequency for each country. We use Markit data until September 2010, and Thomsom Reuters data on Datastream thereafter. The difference between the slope of the (riskless) Yield curve in the Eurozone and the slope of the (riskless) yield curve in Non-Eurozone countries. The slope is calculated as the difference between 10-year and 3-month rates. In the Eurozone, the 3-month rate is the yield of a 3-month German government bond, and the 10-year rate is the yield of a 10-year German bond minus the 10-year German CDS spread. In the NonEurozone we aggregate similarly calculated slopes across countries by value-weighting using stock market capitalizations. Available at a monthly frequency, and measured in percentage points.

Source I/B/E/S and Datastream

Time Period 1987-2011

I/B/E/S and Datastream

1987-2011

Leverage Leverage-matched firm level earnings yield difference

Worldscope I/B/E/S, Datastream and Worldscope I/B/E/S, Datastream and Worldscope Markit and Datastream

2005-2010 2005-2011

Leverage-matched country level earnings yield difference Spread/Log Spread/Square root of Log Spread

2005-2011 2005-2011

Difference Slope Yield Curve

Datastream and Markit

2005-2011

57

AppendixTable:VariableDescription

Unit Labor Costs Government Debt Beta The ratio of the compensation per employee and labor productivity. Labor productivity is measured as GDP at constant prices scaled by the total number of persons employed. Available at the monthly frequency for each country. The government debt is measured as total government debt scaled by GDP at constant prices. Available at the quarterly frequency for each country, and we linearly interpolate within each quarter to obtain monthly data. Firm level betas are created for each firm in the Eurozone based on a market model using monthly returns in the five year period from 2002 to 2007. Market returns are created as value weighted returns for all firms in the sample. Firms with less than 12 observations are deleted. Log assets are measured as the log of total assets and winsorized at the 1% and 99% levels. Available at the annual frequency for each firm. Profitability is measured as the EBITDA scaled by total assets and is winsorized at the 1% and 99% levels. Available at the annual frequency for each firm. Tangibility is measured as the PPE scaled by total assets. Available at the annual frequency for each firm. Measures the age of the firm in years from the date of incorporation. Available at the annual frequency for each firm. Foreign sales are measured as the fraction of sales of a firm that are from abroad. Available at the annual frequency. The primary data source is Worldscope.Worldscope data are augmented using Amadeus. This data is available at the annual frequency for each firm. Dummy variable that takes a value 1 if the leverage for a firm at time t is higher than the median leverage of Eurozone firms at the same time and 0 otherwise. Dummy variable that takes a value 1 if the asset tangibility for a firm is lower than the median tangibility of Eurozone firms at the same time and 0 otherwise. Dummy variable that takes a value 1 if the age for a firm at time t is lower than the median age of Eurozone firms at the same time and 0 otherwise. Dummy variable that takes a value 1 if the foreign sales for a firm is higher than the median foreign sales of other firms in the same country and 0 otherwise. The contribution that imports make in the production of exports of goods and services in the mid-2000s. Specifically, Import contents of export = u Am (I-Ad)-1 EX / EX where Am and Ad are the input-output coefficient matrices for imported and domestic transactions, respectively, I is the identity matrix, u denotes an 1xn vector each of whose components is 1 for corresponding import types, and EX is the export vector. This variable is available at the industry level for different countries. We assigned the industry number to all firms in the same industry. For more details see: http://stats.oecd.org/Index.aspx?DataSetCode=STAN_IO_M_X Eurostat Eurostat Datastream 2005-2011 2005-2011 One crosssection using 2002-2007 data. 2005-2010 2005-2010 2008-2010 2005-2010 2005-2010

Log Assets Profitability Asset Tangibility Age Foreign Sales

Worldscope Worldscope Worldscope OSIRIS Worldscope and Amadeus Worldscope Worldscope OSIRIS Worldscope and Amadeus OCEDstat Extracts

High Leverage Low Tangibility Low Age High Foreign Sales Intermediate Inputs Imports (Import Content of Exports)

2005-2011 2005-2011 2005-2011 2005-2011 One crosssection using Mid 2000s data.

58

AppendixTable:VariableDescription

Low intermediate inputs of imports Dummy variable that takes a value 1 if the Import Content of Exports for a firm is higher than the median Import Content of Exports of other firms in the same country and 0 otherwise. Change of spread-weighted sovereign debt holdings (scaled by Bank Tier 1 capital) from 2010 to 2011. Industry-adjusted return difference Difference between value-weight stock return in the Eurozone country and the valueweighted return of Non-Euro European countries, adjusted by industry composition. OECDstat Extracts One crosssection using Mid 2000s data. One crosssection using 2010 and 2011 data Event studies

Spread-weighted sovereign debt holdings

EBA 2010 and 2011 Stress Tests, Markit, and Datastream Datastream

59