The sharp increase of sovereign debt internationally, since the 2008 global financial crisis, decisively contributed to several sovereign debt crises. The current COVID-19 pandemic and the fact that public debt remains high globally, have prompted a renewed interest in debt sustainability analysis (DSA) and in policy discussions concerning the most appropriate variables. We develop a normative DSA model to manage tail risk and optimize debt-financing decisions with sustainability conditions on debt stock and flow, under macroeconomic, financial, and fiscal uncertainty. We show that a risk management view alters a government’s debt-financing policy to manage tail risk better. Many uncertain variables confound the problem, and portfolio optimization using stochastic programming on scenario trees provides a versatile and effective tool to achieve sustainable debt dynamics. The model is an essential building block of the European Stability Mechanism framework to assess debt sustainability of eurozone member states, including the repayment capacity of crisis countries under €295bn assistance programs.
We develop a model of debt sustainability analysis with optimal financing decisions in the presence of macroeconomic, financial and fiscal uncertainty. We define a coherent measure of refinancing risk, and trade off the risks of debt stock and flow dynamics, subject to debt sustainability constraints and endogenous risk and term premia. We optimize both static and dynamic financing strategies, compare them with several simple rules and consol financing to demonstrate economically significant effects of optimal financing, and show that the stock-flow tradeoff can be critical for sustainability. We quantify the minimum refinancing risk and the maximum rate of debt reduction that a sovereign can achieve given its economic fundamentals, and extend the model to identify optimal timing for debt flow adjustments that allow the sovereign to go beyond these limits. We put the model to the data on three real-world cases: a representative euro zone crisis country, a low-debt country (Netherlands) and a high-debt country (Italy). These applications illustrate the use of the model in informing diverse policy decisions on sustainable public finance. The model is part of the European Stability Mechanism toolkit to assess debt sustainability and repayment capacity of member states in the context of financial assistance.
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