Is political risk a threat to sovereign debt sustainability?

Samantha Ajovalasit, Andrea Consiglio, Giovanni Pagliardi and Stauros Andrea Zenios

No 25-01, eabh Papers from The European Association for Banking and Financial History (EABH)

Abstract: Political risk is a significant determinant of sovereign debt dynamics. We estimate the sensitivity of bond yields and economic growth to a country-level broad proxy of political risk and develop a stochastic debt sustainability analysis optimization model with both yields and growth channels to show that political risk can render debt unsustainable, triggered by changes in the political rating level, volatility, or both. In contrast, existing models that neglect political risk would incorrectly predict sustainability. Importantly, we uncover political risk effects in developed countries, going beyond the emerging markets of earlier literature. We establish a positive predictive relation of structural reforms to political ratings, and benchmark reforms against a large-scale quantitative easing program and find them comparably effective, highlighting their significance in restoring debt sustainability. We also establish the effect of political risk on the optimal choice of debt financing maturities. We validate the model out-of-sample on the Italian 2014-2019 reforms, showing that it would have predicted the country's debt more accurately than existing models. Likewise, a simulation of the French 2024 snap elections finds a much higher risk of debt unsustainability than that estimated if the political shock is omitted.

Keywords: Debt management; debt sustainability; political risk; structural reforms (search for similar items in EconPapers)
JEL-codes: E52 E62 F30 F34 G15 G18 H62 H63 H68 (search for similar items in EconPapers)
Date: 2025
New Economics Papers: this item is included in nep-ifn, nep-opm, nep-pol and nep-rmg
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Persistent link: https://EconPapers.repec.org/RePEc:zbw:eabhps:317786

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