Debt Sustainability and the Terms of Official Support

53 Pages Posted: 5 Nov 2018

See all articles by Giancarlo Corsetti

Giancarlo Corsetti

University of Cambridge; University of Rome III - Department of Economics; Centre for Economic Policy Research (CEPR)

Aitor Erce

UPNA

Timothy Uy

Deloitte LLP

Date Written: November 2018

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. As a result, the effect of official loans is nonlinear in their size. As the threshold for safe debt rises, the maximum debt level the country finds it optimal to sustain when markets price rollover risk falls.

This result unveils a fundamental trade-off in the provision of official loans, in turn rooted in a basic form of moral hazard.

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: Bailouts, Debt maturities, default, Rollover Risk, Sovereign debt, Spread

JEL Classification: F33, F34, F45, H12

Suggested Citation

Corsetti, Giancarlo and Erce, Aitor and Uy, Timothy, Debt Sustainability and the Terms of Official Support (November 2018). CEPR Discussion Paper No. DP13292, Available at SSRN: https://ssrn.com/abstract=3278667

Giancarlo Corsetti (Contact Author)

University of Cambridge ( email )

University of Rome III - Department of Economics ( email )

via Ostiense 139
Rome, 00154
Italy
+39 06 5737 4056 (Phone)
+39 06 5737 4093 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Aitor Erce

UPNA ( email )

Pamplona
Spain

Timothy Uy

Deloitte LLP ( email )

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New York, NY 10112
United States

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