Market perception of fiscal sustainability: An application to the largest euro area economies
Debt intolerance may rule out fiscal trajectories which otherwise appear to be sustainable. If fiscal policy lacks credibility, the interest on the sovereign debt may rise sharply and the country may lose market access. Indicators for assessing the market perception of fiscal sustainability should complement the conventional empirical sustainability analysis. I propose an approach for extracting information from sovereign bond data, which provides snapshots of market sentiment. It is based on a multi-borrower default-intensity pricing model, allowing for the cross-section estimation (under a risk-neutral probability measure) of the term-structure of the unobservable default-free interest rates, as well as (for all sovereigns included in the sample) of the probabilities of default (for any horizon deemed relevant) and the associated recovery rates given default. The approach is illustrated by the estimation of the model for Germany, France, Italy and Spain for every Friday from October 2, 2009 to November 25, 2011.
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