No. 2025-24 - Dynamics of sovereign debt: credit risk and sustainability analysis

Abstract:

We propose an empirically grounded quantitative framework for modeling sovereign credit risk and evaluating the sustainability of sovereign debt. We study the impact of fiscal and public investment policies on the sovereign’s borrowing cost and credit risk in the presence of stochastic output shocks and credit-sensitive funding from investors, with a focus on the dynamics of liquidity flows and the sustainability of sovereign debt. The model is able to replicate a range of empirical observations on sovereign credit risk and sovereign defaults, in particular Argentina’s 2001 default and Greece’s 2012 debt restructuring events, with realistic dynamics for debt, spreads and credit ratings conditional on output. The framework is useful for debt sustainability analysis and to estimate the impact of fiscal policy on debt and output. Finally, we propose a transparent methodology for sovereign credit ratings based on this approach.