Risk Management for Sovereign Financing within a Debt Sustainability Framework

45 Pages Posted: 17 Sep 2018 Last revised: 17 Oct 2018

See all articles by Marialena Athanasopoulou

Marialena Athanasopoulou

European Stability Mechanism

Andrea Consiglio

University of Palermo - d/SEAS

Aitor Erce

European Stability Mechanism; Banco de España - Associate Directorate General International Affairs

Angel Gavilan Gonzalez

European Stability Mechanism

Edmund Moshammer

European Stability Mechanism

Stavros A. Zenios

University of Cyprus; Bruegel; University of Pennsylvania - Wharton Financial Institutions Center

Date Written: September 11, 2018

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.

Keywords: sovereign debt, sustainability, debt financing, optimization, stochastic programming, scenario analysis, conditional Value-at-Risk, risk measures

JEL Classification: C61, C63, D61,E3, E47, E62, F34, G38, H63

Suggested Citation

Athanasopoulou, Marialena and Consiglio, Andrea and Erce, Aitor and Gavilan Gonzalez, Angel and Moshammer, Edmund and Zenios, Stavros A., Risk Management for Sovereign Financing within a Debt Sustainability Framework (September 11, 2018). European Stability Mechanism Working Paper No. 31. Available at SSRN: https://ssrn.com/abstract=3250806 or http://dx.doi.org/10.2139/ssrn.3250806

Marialena Athanasopoulou (Contact Author)

European Stability Mechanism ( email )

6a Circuit de la Foire Internationale
L-1347
Luxembourg

Andrea Consiglio

University of Palermo - d/SEAS ( email )

Viale delle Scienze, edificio 13
Palermo, 90124
Italy

HOME PAGE: http://portale.unipa.it/persone/docenti/c/andrea.consiglio

Aitor Erce

European Stability Mechanism ( email )

6a Circuit de la Foire Internationale
Luxembourg, 1347
Luxembourg

Banco de España - Associate Directorate General International Affairs

Alcala 50
Madrid 28014
Spain

Angel Gavilan Gonzalez

European Stability Mechanism ( email )

6a Circuit de la Foire Internationale
L-1347
Luxembourg

Edmund Moshammer

European Stability Mechanism ( email )

6a Circuit de la Foire Internationale
L-1347
Luxembourg

Stavros A. Zenios

University of Cyprus ( email )

75 Kallipoleos Street
P.O. Box 20537
Nicosia CY-1678
Cyprus
+357 2 893605 (Phone)

HOME PAGE: http://https://www.researchgate.net/profile/Stavros_Zenios

Bruegel ( email )

Rue de la Charité 33
B-1210 Brussels Belgium
Belgium

University of Pennsylvania - Wharton Financial Institutions Center ( email )

3733 Spruce Street
Philadelphia, PA 19104-6374
United States

HOME PAGE: http://zenios.wordpress.com

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