Sovereign Risk with Endogenous Debt Limits

Fernando Arce and Alessandro Villa
Additional contact information
Alessandro Villa: https://www.chicagofed.org/people/v/villa-alessandro

No WP 2026-08, Working Paper Series from Federal Reserve Bank of Chicago

Abstract: Why do countries set sovereign debt ceilings if they keep raising them? This paper shows that debt ceilings can serve as intermediate commitment devices that reduce expected dilution, thereby lowering spreads—and their volatility—even without reducing total borrowing. We propose a new sovereign default model with long-term debt in which each government inherits a previously announced ceiling but may revise it by paying a political or institutional deviation cost. This friction generates a state-dependent form of partial commitment. The ceiling mitigates debt dilution at the expense of fiscal flexibility, leading the government to voluntarily adopt a ceiling that limits the discretion of its future selves. Governments choose rules that are costly—but not impossible—to adjust, trading off lower spreads and volatility through reduced dilution against the option value of fiscal flexibility in bad times. Consistent with this mechanism, we show that emerging-market countries operating under fiscal rules exhibit lower sovereign spreads and lower spread volatility, even though breaches and revisions occur.

Keywords: debt ceiling; endogenous commitment (search for similar items in EconPapers)
JEL-codes: E32 E44 F41 G01 G28 (search for similar items in EconPapers)
Pages: 55
Date: 2026-05
References: Add references at CitEc
Citations:

Downloads: (external link)
https://doi.org/10.21033/wp-2026-08 (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:fip:fedhwp:103455

Ordering information: This working paper can be ordered from

DOI: 10.21033/wp-2026-08

Access Statistics for this paper

More papers in Working Paper Series from Federal Reserve Bank of Chicago Contact information at EDIRC.
Bibliographic data for series maintained by Lauren Wiese ().