Shaking things up: geopolitics and the euro credit risk measure

Gravitational model offers novel way of assessing national and regional risks in new world order

Global political allegiances are forming and re-forming daily. It’s a geopolitical kaleidoscope, in which the implications for Europe – politically and economically – take a new shape with every turn.

In the eurozone, with its annual public debt turnover of approximately €1 trillion ($1 trillion), these changes alternately strengthen or weaken the likelihood of its continuance – and that of its currency. As the balance of global power shifts, it seems fitting that we should start to measure that likelihood with a model normally used to measure trade balance dynamics.

Here, I describe how the novel application of this gravitational model to credit risk acts as a barometer of how these financial-geopolitical dynamics may play out – a new quantitative model of eurozone fragmentation risk based on credit default swap data.

To understand the model, it is necessary to explain the origins of credit risk metrics in Europe.

At the start of 2012, the eurozone member states unanimously signed a treaty enshrining the European Stability Mechanism (ESM).

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One of its clauses requires any newly issued debt with a maturity of more than 12 months to explicitly include a provision that prevents the application of lex monetae. In signing the treaty, countries renounced the option to redenominate any new European government bond (EGB) debt into their legacy or ‘home’ currency.

So, as of 2014, two types of EGBs were being traded in financial markets: those that can be redenominated into another currency in the event of default – and those that can’t.

Naturally, financial markets account for this distinction through positive yield spreads that reflect the risk of redenomination. In 2014, the International Swaps and Derivatives Association also published new standards for documenting credit default swaps (CDSs) – the 2014 Isda credit derivatives definitions – that revised its 2003 market standard definitions and served to align trades documented under the new standard with the evolving risk profile of EGBs.

As of 2014, financial markets therefore started quoting two distinct contractual standards for CDSs: those documented under Isda’s 2014 definitions – which hedge the risk of redenomination – and those under the 2003 definitions that don’t.

The differential between the spreads of CDSs documented under the two standards represents a market estimate of a member country’s redenomination risk – which has become known as the Isda basis.

An analysis of the trends in this metric for the four largest eurozone member countries reveals that, in 2017, the previously cautious wait-and-see approach to the market’s assessment of redenomination risk was decisively disrupted (see chart below).

 

Indeed, between 2017 and 2018, a eurosceptic storm swept through Europe, making itself felt though various national election results. In May 2017, this was seen in the robust performance of the Front National – later renamed Rallye National – in France, and in June that year in Spain’s referendum on independence for Catalonia. The mood continued in May 2018, when Italy’s Movimento 5 Stelle – having already made a strong showing in the previous year’s local elections – returned the largest individual party vote.

From 2017 onwards, financial markets have therefore systematically quoted the risk of redenomination – reflecting the fact that decisions made by leading European Union nations, by the EU and by the European Central Bank either support or diminish a risk-sharing architecture for the eurozone – as a spread. When these decisions are favourable to the European project, the spread narrows, but when they favour risk segregation among member states, it widens.

Given that Germany, France, Italy and Spain all hold significant economic influence that could threaten the very stability of the euro project – and considering the positive interdependence of credit risk trends across these countries – it is possible to estimate, through the use of multivariate copulas, the contribution of each of the four countries to the potential break-up of the euro (see chart below).

 

We can easily spot the peaks in this probability measure. After the first major peak in 2017, we observe another in 2018 with the establishment of the first eurosceptic government in Italy – the Movimento 5S/Lega coalition – then the Covid-19 pandemic of 2020 and Russia’s invasion of Ukraine in 2022. It’s also important to note how the easing of the energy crisis and the advent of the NextGenerationEU project – which resulted in the first Eurobond issuance – sparked a downward trend in the probability of the euro’s break-up, consistent with the view that risk-sharing equals a spread reduction.

This trend began to stabilise in June 2024, when the European Stability and Growth Pact was reactivated. In the context of an unstable European financial framework, this agreement reinstated the strict fiscal rigidity of the EU’s Fiscal Compact, signalling adherence to a risk segregation approach.

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It’s also interesting to note how markets appear to differentiate between national economic difficulties and eurosceptic orientations. Specifically, the assessment of Germany’s contribution to the risk of a euro break-up remains unchanged, despite the crises of the past four years. Meanwhile, a moderate increase is observed for France, reflecting the rise of the eurosceptic Rallye National, and, as of summer 2024, surpassing that of Spain, where – for now – the impact of the independence movement in Catalonia seems to be diminishing.

Both these statistical representations highlight that the largest contribution to eurozone credit risk comes from Italy.

Given the positive dependency of the credit risks (net of redenomination risk) of the four member countries quantified by Isda’s 2003 credit derivatives definitions, it is possible to observe how these spreads are components and determinants of Italy’s credit risk, including the redenomination risk reflected by the 2014 definitions.

By plotting the trend of this variable alongside that of the 2003 definitions for these four countries, it’s easy to see how Italy’s risk qualifies what financial markets identify as the reference level for the others.

In other words, the sum of the net credit risks of redenomination for the four member countries determines the extent of Italy’s credit risk, including redenomination risk (see chart below).

 

It is evident that Italian economic policy, in relation to its ability to shape a risk-sharing framework for Europe – as with NextGenerationEU – is the determining factor for the credit risk of the eurozone.

This is therefore an opportunity – and a responsibility – for the Italian government to redefine its national agenda and to support the risk-sharing approach of the European project through proactive solutions – ratifying the ESM and creating common European debt capable of replacing national debt.

It is also important to note how this statistical observation has a limit whenever extreme events occur that intensify the specific appreciation of credit risks for a given member country – as happened, for the reasons described above, in 2017, during the pandemic and in recent months in France.

The kaleidoscope of global politics will no doubt continue to colour these observations.

Editing by Louise Marshall