Political uncertainty and sovereign debt dynamics
This Bruegel working paper by Samantha Ajovalasit, Andrea Consiglio, Giovanni Pagliardi, and Stavros Zenios examines how political risk affects sovereign debt sustainability through a comprehensive empirical and modeling approach. The authors conduct panel regressions using data from 46 countries (developed and emerging markets) over 1999-2021. They employ the International Country Risk Guide (ICRG) composite political ratings as a continuous proxy for political risk, which captures twelve factors including government stability, corruption, law and order, and democratic accountability. Ajovalasit et al. develop a novel stochastic debt sustainability model that incorporates political risk through two key channels:
- Yields channel: Political risk affects sovereign bond spreads and borrowing costs
- Growth channel: Political risk impacts economic growth rates
The model uses scenario trees to represent uncertain financial, economic, fiscal, and political variables, optimizing debt maturity choices to minimize expected financing costs while maintaining sustainability constraints.
Findings
- Significant political effects: A deterioration of political ratings by 10 units leads to:
– Bond yield increases of 106 basis points (171 bp for 2008-2021 period)
– GDP growth reduction of 2 percentage points (3.05 pp for recent period) - Debt sustainability impact: Political risk can expose seemingly sustainable debt as unsustainable, particularly for high-debt countries during high interest rate periods. The effects are substantial – for high-debt, high-risk countries, political risk can increase debt trajectories by up to 50 percentage points.
- Reform effectiveness: Structural reforms that improve political ratings can be as effective as major quantitative easing programs. For a high-debt, high-risk country, reforms could stabilize debt requiring fiscal effort equivalent to 1.75% of GDP per annum.
- Universal relevance: Contrary to conventional wisdom, political risk significantly affects debt sustainability in developed countries, not just emerging markets. The study shows that even mean-reverting political risk (with zero expected value) impacts debt dynamics through uncertainty effects.
Are bad governments a threat to sovereign defaults? The effects of political risk on debt sustainability
Authors: Samantha Ajovalasit, Andrea Consiglio, Giovanni Pagliardi, Stavros Zenios
From: Bruegel
Quantifying sovereign debt tail risks
This IMF working paper by Davide Furceri, Domenico Giannone, Faizaan Kisat, Waikei R Lam, and Hongchi Li introduces a novel framework called “Debt-at-Risk” to analyze risks surrounding public debt outlooks. The debt-at-risk methodology builds on the “growth-at-risk” approach and employs a location-scale quantile panel regression model to assess how current macrofinancial and political conditions impact the entire spectrum of possible future debt outcomes. The framework examines debt risks beyond traditional “proximate” drivers (interest-growth differentials, primary balances) by investigating underlying factors such as financial stress and policy uncertainty. Debt-at-risk is defined as the predicted 95th percentile of a country’s projected debt-to-GDP ratio, representing a severely adverse scenario.
Key technical components
- Location-scale model: The empirical approach uses a location-scale model where:
– The location parameter captures shifts in the entire distribution of future debt as regressors move
– The scale parameter captures whether this shift differs across quantiles, identifying asymmetric effects on upper or lower tails of the predicted debt distribution - Sample and variables: The analysis covers 90 economies accounting for over 90% of global sovereign debt, spanning 1980-2024. Key variables include:
– Financial factors: Financial Conditions Index, Financial Stress Index, sovereign spreads
– Political variables: World Uncertainty Index, Reported Social Unrest Index
– Economic variables: initial debt, GDP growth, primary balance, inflation
Findings
- Current risk assessment: Global debt-at-risk for 2027 is estimated at 117% of GDP, approximately 20 percentage points higher than current IMF projections. This represents significant upside risk, with debt risks remaining as right-skewed as during the Global Financial Crisis.
- Risk drivers: The main factors contributing to upside debt risks globally are primary deficits and financial conditions. A one-standard deviation increase in the Financial Conditions Index correlates with a 3 percentage point GDP increase in three-year debt-at-risk. Financial stress episodes create asymmetric upside risks through multiple channels: increasing growth-at-risk, deficit-at-risk, and interest rate-at-risk.
- Economic variables: Higher initial debt levels and lower growth rates have long-lasting effects on debt distribution, with impacts persisting up to five years. These economic factors amplify risks more significantly in the upper tail of the distribution. A one-standard deviation change in GDP growth associates with more than 5 percentage point GDP increase in three-year debt-at-risk.
- Advanced economies: Three-year debt-at-risk estimated at 131% of GDP, driven primarily by primary deficits and financial conditions.
- Emerging market economies: Debt-at-risk at 96% of GDP, driven more by uncertainty and primary deficits.
- Risk evolution: Debt-at-risk has increased over time, with notable spikes during global shocks (2009 GFC, 2020 COVID-19). Advanced economies have seen some retreat from pandemic peaks, while emerging market risks have increased.
Debt-at-Risk
Authors: Davide Furceri, Domenico Giannone, Faizaan Kisat, Waikei R Lam, Hongchi Li
From: IMF
