Measuring Public-Sector Vulnerability : A Composite Macro-Financial Framework for Sovereign Market Instability in the Euro Area

Sammanfattning

This thesis develops a Public Sector Vulnerability Index (PSVI) and examines how public-sector vulnerability relates to sovereign market instability in the euro area. Public-sector vulnerability is defined as a multidimensional macro-financial condition that may weaken a government’s ability to finance itself on stable and sustainable terms. The index combines indicators from four transmission channels: sovereign market conditions, banking-sector conditions, macroeconomic developments, and fiscal sustainability. The empirical analysis uses a monthly panel of 19 euro-area countries from 2005 to 2024. The main outcome is sovereign yield volatility, measured as the 12-month rolling volatility of monthly changes in 10-year government bond yields. The index is constructed through sign alignment, z-score standardisation, and block-level aggregation. Two versions are central to the analysis: a hybrid index, which includes both market-based and fundamental indicators, and a fundamental index, which excludes direct sovereign market-pricing variables. The results show a strong and robust positive relationship between the index and sovereign yield volatility after controlling for country and time fixed effects. The relationship remains robust across alternative index-construction checks including complete-case and PCA-based specifications. Channel and timing results show that market-based indicators are most closely related to contemporaneous volatility, while banking, macroeconomic, and fiscal fundamentals become more informative over short-to-medium horizons. The fundamental index remains positively related to yield volatility, indicating that the relationship is not only driven by direct market pricing. Heterogeneity analysis shows that the relationship is strongest during the 2008-2012 crisis period, when sovereign risk was actively repriced, while the evidence is weaker or less precise in calmer periods and in small higher-stress country subsamples. External validation against the ECB’s Composite Indicator of Systemic Stress supports the economic relevance of the PSVI, while predictive diagnostics show that it does not materially improve short-run forecasts beyond autoregressive benchmarks. The PSVI is therefore best interpreted as a transparent monitoring and analytical framework, not as a mechanical crisis-prediction model.