November 30, 2018

News in Charts: Measuring euro area sovereign fragility

by Fathom Consulting.

Fathom’s Sovereign Fragility Index (SFI) aims to provide an objective measure of the underlying risk attached to government debt. Therefore, a comparison of the SFI-implied and observed spreads is one way to observe the effects of unconventional monetary policy and swings in market sentiment.

At present, government bond yields remain significantly below the levels implied by the SFI across most of the euro area periphery with financing conditions relatively benign. Italy, however, remains an exception to this with ten-year yields remaining above the 2.5% predicted by the SFI, amid the political uncertainty generated by the government’s confrontation with the EU.

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Nevertheless, the SFI suggests that Italian spreads have overshot and that the government’s debt is not the riskiest prospect in the euro area. Indeed, the SFI actually predicts higher yields for Spain (3.3%), despite that country having lower public debt. This is because it is the composition, as well as the quantity, of debt that matters for the SFI, with Spain having a higher proportion of debt held externally than Italy does.

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The SFI also suggests that Irish debt is relatively fragile, with an SFI-implied yield of 2.5%. Arguably, even this is too low. As previous Fathom research has shown, official GDP data have a tendency to overstate the size of the Irish economy, arguably flattering the state of the country’s public finances. Indeed, if the SFI is recalculated using Fathom’s Measure of Irish National Income, as opposed to official estimates, then the SFI-implied yield would be above 5%.

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Arguably, markets have been underestimating the fragility of periphery sovereigns for some time, with a combination of Draghi’s “whatever it takes” commitment and the ECB’s quantitative easing programme having succeeded in keeping spreads low. It seems unlikely that this can be maintained indefinitely, especially if the ECB ceases net asset purchases (as expected) in December.

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