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Sovereign default and public debt sustainability

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  • Michel Guillard
  • Hubert Kempf (Ecole Normale de Cachan & université Paris-Saclay)

Abstract

We address sovereign default in a stochastic macroeconomic model with infinite horizon and the presence of a debt recovery rule. Sovereign default is defined as a market event which can be observed when the fiscal policy is constrained by a tax rate ceiling. It occurs when the fiscal authority does not find on the market the funds necessary to reimburse its previous debt net of the primary surplus of the period. We analyze the pricing of public debt in relation with the debt recovery rule and prove the existence of a threshold default. Except in a specific case, this threshold is lower than the traditional solvency ratio. Using the dynamic implications of the model, we clarify the notion of sustainability and we disentangle it by defining a sustainability threshold and an un-sustainability threshold: A public debt is said to be “phi-sustainable” at date t when its trajectory does not reach the default threshold at any future date, assuming that there is no realization of the gross rate of growth lower than "phi". A public debt is said to be phi-unsustainable” at date t when its trajectory reaches the default threshold at some finite date, assuming that there is no realization of the gross rate of growth higher than "phi". When a public debt is neither "phi-unsustainable”, nor “phi-sustainable”, it is in a zone of financial fragility. When a sovereign default occurs, a too high recovery ratio is not able to insure the sustainability of the post-default debt.

Suggested Citation

  • Michel Guillard & Hubert Kempf (Ecole Normale de Cachan & université Paris-Saclay), 2016. "Sovereign default and public debt sustainability," EcoMod2016 9696, EcoMod.
    • Handle: RePEc:ekd:009007:9696
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    References listed on IDEAS

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