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Risk management for sovereign financing within a debt sustainability framework

Author

Listed:
  • Marialena Athanasopoulou
  • Andrea Consiglio
  • Aitor Erce
  • Angel Gavilan
  • Edmund Moshammer
  • Stavros A. Zenios

Abstract

The mix of instruments used to finance a sovereign is a key determinant of debt sustainability through its effect on funding costs and risks. We extend standard debt sustainability analysis to incorporate debt-financing decisions in the presence of macroeconomic, financial, and fiscal risks. We optimize the maturity of debt instruments to trade off borrowing costs with refinancing risk. Risk is quantified with a coherent measure of tail risk of financing needs, conditional Flow-at-Risk. A constraint on the pace of reduction of debt stocks is also imposed, and we model the effect of debt stocks on the yield curve through endogenous risk and term premia. On a simulated economy, we show that the cost-risk and flow-stock trade-offs embedded in issuance decisions are key determinants of the evolution of debt dynamics and are economically significant. Comparing three alternative optimizing strategies and some simple fixed-issuance rules, we also draw lessons on when and why optimizing matters the most. This depends on the risk tolerance level, the size, cost, and maturity of legacy debt, and the sensitivity of interest rates to debt. Our model quantifies thresholds for the minimum level of refinancing risks and the maximum pace of debt reduction that a sovereign could reach given its economic fundamentals. Going beyond those thresholds is only feasible through adjustments of gross financing needs, and an extension of the baseline model identifies the hot spots for these adjustments, computing their minimum size and optimal timing. Our findings inform policy decisions concerning both official sector borrowing and public finance, with a focus not only on minimizing interest payments but also on managing refinancing risks and increasing debt dynamics.

Suggested Citation

  • Marialena Athanasopoulou & Andrea Consiglio & Aitor Erce & Angel Gavilan & Edmund Moshammer & Stavros A. Zenios, 2018. "Risk management for sovereign financing within a debt sustainability framework," Working Papers 31, European Stability Mechanism.
  • Handle: RePEc:stm:wpaper:31
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    Cited by:

    1. Beetsma, Roel & de Jong, Frank & Giuliodori, Massimo & Hanson, Jesper, 2019. "The Maturity of Sovereign Debt Issuance in the Euro Area," CEPR Discussion Papers 13729, C.E.P.R. Discussion Papers.

    More about this item

    Keywords

    overeign debt; sustainability; debt financing; optimization; stochastic programming; scenario analysis; conditional Value-at-Risk; risk measures;

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques
    • D61 - Microeconomics - - Welfare Economics - - - Allocative Efficiency; Cost-Benefit Analysis
    • E3 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles
    • E47 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Forecasting and Simulation: Models and Applications
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt

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