Fathom’s Sovereign Fragility Index (SFI) is an objective measure of fundamental sovereign credit risk, updated quarterly. It does not take account of the markets’ appetite for risk, or of the state of the business cycle. It does not capture the impact of unconventional monetary policy measures, or of promises (explicit or implicit), by central banks or other institutions to support or underwrite the value of certain government bonds. Instead, the aim of the SFI is to reveal the fundamental forces that are at work underneath those distortions and temporary influences.
It reveals two broad classes of sovereign credit: economies in the euro area; and everyone else (Japan does not fit into either group). The peripheral economies in the euro area are treated by markets as though they were the same as the core economies, thanks to the ECB.
Comparing the SFI with government bond yields across countries suggests that markets might be pricing in too little sovereign credit risk in Russia — surprising in view of its track record — and perhaps too much in India, though there are cyclical factors in play in both of those economies. India is growing at or close to its trend, but Russia is below trend, while both countries are running similar rates of inflation. The policy rate in India is lower than in Russia
Controlling for these cyclical effects, Russian yields still look a little too low relative to Indian yields — though there may be other factors in play, such as the pick-up in commodity prices, which benefit Russia relative to India. There is also substantially more sovereign credit risk in Ireland than is currently captured in Irish bond yields (even after accounting for the fact that those yields are flattered by QE, as in the rest of the euro area), thanks to mismeasurement of Irish GDP.
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Overall Fathom concurs with the market’s view that the euro area is unlikely to fall apart in the near future. Arguably, there is even some scope for upside risk if Germany and France make progress towards enhancing the durability of the currency bloc’s structural framework — a so-called ‘golden scenario’ for the euro area.
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