Identifying financial fragmentation: do sovereign spreads in the EMU reflect differences in fundamentals?
Published: 23 May 2023
We present a metric for financial fragmentation in the Economic and Monetary Union (EMU), based on the higher moments of the distribution of sovereign spreads relative to macro-financial fundamentals. We apply fixed parameter and rolling regressions to allow for time variation in this relationship, while controlling for market sentiment. The metric shows that the observed moments of the spread distribution occasionally overshot the fundamentals-based benchmark until 2018. Since then, the moments of observed spreads have generally not exceeded the fundamentals-based moments, also not in the most recent period, despite the increase in interest rates. The latter may be attributed to backstop facilities of the European Central Bank (ECB), such as the Transmission Protection Instrument (TPI).
Keywords: Monetary policy; Quantitative Easing; Sovereign risk; Sovereign spreads
JEL codes E52; E58; G12
Working paper no. 778
778 Identifying financial fragmentation: do sovereign spreads in the EMU reflect differences in fundamentals?
Research highlights:
- We present a metric for financial fragmentation in the EMU, based on higher moments of sovereign spreads relative to the moments of macro-financial fundamentals.
- The metric exploits the cross-country and cross-time information in the distribution of sovereign spreads.
- We find that most of the time the moments of the sovereign spread distribution can be explained by macro-financial fundamentals. The main exceptions are 2012 (euro area debt crisis) and 2015 (Greek default).
- Since 2018, the moments of observed spreads have generally not exceeded the fundamentals-based moments, also not in the most recent period, despite the increase in interest rates. This may be partly attributed to ECB backstop facilities for sovereign risk.
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