Debt Intolerance: Threshold Level and Composition

Fiscal vulnerabilities depend on both the level and composition of government debt. This study examines the role of debt thresholds and debt composition in driving the nonlinear behaviour of long‐term interest rates through a novel approach, a panel smooth transition regression with a general logistic model. The main findings are threefold. First, the impact of the expected public debt level on interest rates rises exponentially when the share of foreign private holdings exceeds approximately 20% of government debt denominated in local currency. Second, if the public debt level exceeds a certain level, an increase in foreign private holding of government debt could raise interest rates, offsetting the downward pressure from higher market liquidity. Third, out‐of‐sample forecasts of this novel non‐linear model are more accurate than those of previous methods.