Risk Management for Sustainable Sovereign Debt Financing

Abstract

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.

The risks from climate change to sovereign debt

“…4 Integrating climate risks to sovereign debt sustainability analysis. Source: The author based on European Commission ( 2019 ), IMF ( 2019 ), Zenios et al ( 2021 ) on debt sustainability, and Batten ( 2018 ) and Volz et al ( 2020 ) on the economic effects of climate …”

“…They fit into the DSA model to integrate climate risks into debt analysis. See Zenios et al ( 2021 ) (Sects. 2 and 3 ) for a detailed description of the climate-free stochastic DSA model or Appendix C for an outline.…”

“…Also, multiple IAMs give quite different projections allowing us to highlight the effects of misspecifications. Italy is a country for which DSA is published in the open literature providing a baseline (Zenios et al 2021 ). We emphasize, however, that we are presenting an illustrative example of the effects of climate risk on GDP growth, to show what is possible.…”

“…Methodological commonalities in the analysis of climate risks and debt sustainability enable their integration. Narrative scenarios are a cornerstone of climate analysis (Climatic Change 2014 ), and probabilistic scenarios are at the core of stochastic DSA (Blanchard 2022 ; Zenios et al 2021 ). Also, DSA focuses on tail risk (Zenios et al 2021 ), just like the economics of climate change deal with extreme events (Weitzman 2011 ).…”

“…Narrative scenarios are a cornerstone of climate analysis (Climatic Change 2014 ), and probabilistic scenarios are at the core of stochastic DSA (Blanchard 2022 ; Zenios et al 2021 ). Also, DSA focuses on tail risk (Zenios et al 2021 ), just like the economics of climate change deal with extreme events (Weitzman 2011 ). We bring together these strands of literature to integrate climate risks in DSA using IAM.…”