Fathom’s Sovereign Fragility Index (SFI) gauges sovereign risk based on fundamental economic drivers of sovereign yield spreads. Besides government debt, this includes domestic bank assets, for which the government may ultimately become liable in the event of a banking crisis. It does not consider market pricing, and therefore provides an independent assessment of what government yield spreads ought to be, irrespective of the market’s perception of sovereign risk.
We have recently updated the Index for 2018 Q4: the biggest movers were Argentina and Turkey. Both their SFI scores shot up, and Argentina again reached the maximum reading of 10. An SFI score above 3 implies that a government’s debt is fundamentally ‘junk’ — Argentina has been above this threshold since 2016 Q2.
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The main driver of the deterioration in our model’s assessment of Argentinian and Turkish government debt is the steep rise in inflation which accompanied sharp falls of the peso and lira in the second half of last year.
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These latest readings highlight the risks for a country’s currency that unsustainably large current account deficits can bring. These are also risks for the sovereign ― especially when it is heavily indebted in foreign currency. Not only should this increase the credit risk premium on a sovereign’s debt, but the subsequent overshoot of inflation far above its target should drive up the inflation risk premium, too.
However, yields on Turkish government debt peaked in August of last year and have continued to fall since. Argentinian yields also remained broadly flat throughout the second half of 2018, potentially under-pricing the risks that remain in these two economies.
Turkey and Argentina contrast with developments in other markets, where the outlook is relatively rosier ― amongst the other risky countries in the SFI are Brazil, Russia and Portugal, which all continued to see an improvement in their implied level of risk.
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