Fragmentation Risks Have Dialed Down On Multiple Fronts #1

As long as the Eurozone lacks the fully fledged architecture of a single currency area - notably full banking union (including mutualised deposit insurance) and a centralised fiscal authority (with permanent risk-sharing and cross-border fiscal transfers) - fragmentation risks will never be fully eradicated. However, the ECB's ever expanding toolkit and frequent policy innovations have mitigated short-term pressures. In the following charts we present evidence of a containment of fragmentation risks on multiple fronts since the sovereign debt crisis.

• Most references to fragmentation refer explicitly to the bond market which has provided the most visible signs of stress between the core and periphery. On this front, the current situation is a world away from the sovereign debt crisis and notably less stressed than when the Italian government squared off against Brussels in 2018 over the proposed expansionary fiscal budget.
• While uncertainty over how and when the ECB will activate the Transmission Protection Instrument may partly explain why periphery-core spreads remain elevated, the mere existence of the tool has arguably prevented spreads widening further. As we suggested in our review of the July ECB meeting "the ECB now has a tool unlimited in size, that it can use with complete discretion, with activation criteria that are deliberately vague, and everybody around the table supports it".
• Following in the footsteps of the TLTROs, OMT, APP and PEPP, the TPI marks the latest evolution of the ECB's toolkit which has anchored spreads since the sovereign debt crisis.
• The relative improvement in risk premia over the past decade is also reflected in CDS prices and implied default probabilities. In Fig 2, we provide estimates of the 5-year implied default probability under the assumption of a 40% recovery rate and near-zero risk-free rate. As the chart shows, implied default probabilities are a fraction of what they were at the height of the debt crisis.