Sovereign credit risk, macroeconomic dynamics,and financial contagion

We try to understand the nature of Japan's sovereign credit risk by examining the interaction between Japan's sovereign credit default swap (CDS) spreads and its financial indicators of macroeconomic fundamentals. We consider potential contagion from the global financial market and allow for reverse causality between CDS spreads and macroeconomic fundamentals. We find strong evidence of contagion from global stock markets to Japan's credit market when Lehman Brothers collapsed, whereas the European sovereign debt crisis only had temporary effects. We also show that several credit events, such as the 2011 Tohoku earthquake and rating cuts by rating agencies, significantly raised volatility in Japan's sovereign CDS market.

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