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Debt Sustainability and the Terms of Official Support

Giancarlo Corsetti (), Aitor Erce () and Timothy Uy

Cambridge Working Papers in Economics from Faculty of Economics, University of Cambridge

Abstract: We study theoretically and quantitatively how official lending regimes affect a government's decision to raise saving as opposed to defaulting, and its implication for sovereign bond pricing by investors. We reconsider debt sustainability in the face of both output and rollover risk under two types of institutional bailouts: one based on long-maturity, low-spread loans similar to the ones offered by the euro area official lenders; the other, on shorter maturity and high-spread loans, close to the International Monetary Fund standards. We show that official lending regimes raise the stock of safe debt and facilitate consumption smoothing through debt reduction. However, to the extent that bailouts translates into higher future debt stocks and countercyclical deficits in persistent recessions, they also have countervailing effects on sustainability. Quantitatively, the model is able to replicate Portuguese debt and spread dynamics in the years of the bailout after 2011. We show that, depending on the composition of debt by maturity and official lending, sustainable debt levels can vary between 50% of GDP and 180% of GDP depending on the state of the economy and the conditions for market access. Longer maturities have a stronger effect on sustainability than lower spreads.

Keywords: Sovereign debt; default; maturity; spread; rollover; bailout (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-opm
Date: 2018-10-31
Note: gc422
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