Sovereign debt dynamics at the brink of default and the special role of supranational lenders

Compared with the relatively straightforward definition of a default event, assessing sovereign debt sustainability remains a grey area. The interaction between fiscal choices, lenders' expectations and economic uncertainty creates a setting in which-particularly when a default looms-anticipation and coordination can matter as much as analysing economic fundamentals. To explore these rich debt dynamics, we develop a parsimonious model in which a government repeatedly makes fiscal and default decisions, while lenders demand bond yields that compensate for default risk. The model sheds light on when and why governments demonstrate fiscal prudence or even build fiscal buffers. It also illustrates how lenders' beliefs, by selecting the equilibrium outcome, can constrain a government's ability to issue debt-highlighting the influence of actors such as credit rating agencies that help form these beliefs. Notably, besides debt levels and lenders' expectations, the maturity profile of debt emerges endogenously as a key dimension of debt sustainability. Finally, we examine the role of supranational lenders in the international financial architecture. We find that well-designed financial support, whether to avoid crises or remedy the underprovision of commercial lending, constitutes a distinct class of debt, while markets still impose fiscal discipline on the sovereign.