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Title: Debt Sustainability and the Terms of Official Support

Author(s): Giancarlo Corsetti, Aitor Erce and Timothy Uy

Publication Date: November 2018

Keyword(s): Bailouts, Debt maturities, default, Rollover Risk, Sovereign debt and Spread

Programme Area(s): International Macroeconomics and Finance

Abstract: We study theoretically and quantitatively how official lending regimes affect a government's decision to raise saving as opposed to defaulting, and its implication for sovereign bond pricing by investors. We reconsider debt sustainability in the face of both output and rollover risk under two types of institutional bailouts: one based on long-maturity, low-spread loans similar to the ones offered by the euro area official lenders; the other, on shorter maturity and high-spread loans, close to the International Monetary Fund standards. We show that official lending regimes raise the stock of safe debt and facilitate consumption smoothing through debt reduction. However, to the extent that bailouts translates into higher future debt stocks and countercyclical deficits in persistent recessions, they also have countervailing effects on sustainability. As a result, the effect of official loans is nonlinear in their size. As the threshold for safe debt rises, the maximum debt level the country finds it optimal to sustain when markets price rollover risk falls. This result unveils a fundamental trade-off in the provision of official loans, in turn rooted in a basic form of moral hazard. Quantitatively, the model is able to replicate Portuguese debt and spread dynamics in the years of the bailout after 2011. We show that, depending on the composition of debt by maturity and official lending, sustainable debt levels can vary between 50% of GDP and 180% of GDP depending on the state of the economy and the conditions for market access. Longer maturities have a stronger effect on sustainability than lower spreads.

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Bibliographic Reference

Corsetti, G, Erce, A and Uy, T. 2018. 'Debt Sustainability and the Terms of Official Support'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=13292