Spillover Effects between Greece and Cyprus: A DCC Model on the Interdependence of Small Economies

Abstract

This paper discusses the volatility spillovers between the Greek debt crisis and the Cypriot financial crisis. Cyprus was in the spotlight of financial markets due to significant problems stemming from the banking sector, which were dealt with by EU regulators with a bail-in on bank deposits. The current analysis aims to shed light on the reasons behind implementing this novel approach to bank distress. The study uses a Dynamic Conditional Correlation model on the returns of the stock markets of the two countries, which shows strong spillover effects during the period leading up to the 2013 Cypriot crisis, but a significant decrease of these effects from then on. The results confirm the close interdependence of the Greek and Cypriot economies before 2013 and show that this interdependence was limited from that point onwards. This would indicate that since the risk of contagion to the Eurozone had diminished, regulators could test the bail-in solution in Cyprus in 2015. The current work contributes to the discussion on the interdependence of European economies. The paper’s findings can also be applied to other emerging European economies.