Is the Maastricht debt limit safe enough for Slovakia?

We study the interactions among fiscal policy, fiscal limits and sovereign risk premia. The fiscal limit, which measures the government’s ability to service its debt, arises endogenously from dynamic Laffer curves and is a random variable. A nonlinear relationship between sovereign risk premia and the level of government debt then emerges in equilibrium. The model is calibrated to Slovak data and we study the impact of various model parameters on the distribution of the fiscal limit. Fiscal limit distributions obtained via Markov–Chain–Monte–Carlo regime switching algorithm depend on the rate of growth of government transfers, the degree of countercyclicality of policy, and the distribution of the underlying economic conditions. We find that it is considerably more heavy–tailed compared with the one usually obtained in the literature for advanced economies, and is very sensitive to the size and rate of growth of transfers. The main policy message is that the Maastricht debt limit is not safe enough for Slovakia: although in the equilibrium the chance of country default is 10 percent when the debt is 60 percent of GDP, it increases dramatically to approximately 40 percent in bad times (when productivity falls by almost 8 percent). A well-designed fiscal policy involving a deceleration in the growth of transfers can reduce the chance of default significantly.