Debt Intolerance: Threshold Level and Composition

Abstract

Fiscal vulnerabilities depend on both the level and composition of government debt. This study investigates this threshold level of debt and its composition to understand the non-linear behavior of the long-term interest rate by developing a novel approach: a panel smooth transition regression with a general logistic model (i.e., a generalized panel smooth transition regression). Our main findings are threefold: (i) the impact of the expected public debt on the interest rate would increase exponentially and significantly as the foreign private holdings ratio exceeds approximately 20 percent; otherwise, strong home bias would mitigate the upward pressure of an increase in public debt on the interest rate; (ii) if the expected public debt-to-GDP ratio exceeds a certain level that depends on the funding source, an increase in foreign private holdings of government debt would cause a rise in long-term interest rates, offsetting the downward effect on long-term interest rates by expanding market liquidity; and (iii) out-of-sample forecast of our novel non-linear model is more accurate than those of previous methods. As such, the composition of government debt plays an important role in the highly non-linear behavior of the long-term interest rate.