Structural change in the vision of sovereign debt:what is the correlation between the amount of debt and the perceived risk?

STRUCTURAL CHANGE IN THE VISION OF SOVEREIGN DEBT: WHAT IS THE CORRELATION BETWEEN THE AMOUNT OF DEBT AND THE PERCEIVED RISK?
Andrea Riccardo Feliciello1, Luca Fregolent2, Andrea Pietro Pizzo3

Abstract

In this paper we argue that there has been a structural change in the vision of sovereign debt after the recent financial crisis. The incredibly expansive fiscal policies that countriesadopted as stimulus for real economy brought them to accumulate a stock of debt just comparable to a post-war period and this fact is provoking fears about debt sustainability among financial markets. For the first time in economic history, developed countries’ sovereign debt is not considered riskfree anymore: Greece, Portugal, Spain and more recently Hungary are under the spotlights because oftheir high level of public debt on GDP ratio and markets are betting on their debt default. Is it really governments’ indebtedness the main problem for developed economies or are there other factors we should take under consideration? Is the panic in the financial markets justified? and finally, is the yield market requires to governments’ obligations in line with their financial situation? Ourtheory is that governments’ debt sustainability does not depend only on public debt but should rather be discussed on the aggregate indebtedness of a country, which include households and private corporations’ liabilities. Moreover, we believe that even if market concerns about countries’ sovereign debt can be explained by aggregate debt, governments characterized by high percentage of external debtare forced to pay a higher yield than countries with high percentage of debt held by domestic investors.

1 2

Politecnico di Milano, andrea.feliciello@mail.polimi.it Politecnico di Milano, luca.fregolent@mail.polimi.it 3 Politecnico di Milano, andrea.pizzo@mail.polimi.it

6/07/2010 -1-

CONTENTS
1. INTRODUCTION..................................................................................................................................... - 3 2. LITERATURE REVIEW .......................................................................................................................... - 4 a. i. b. i. ii. iii. iv. c. i. ii. Definition of sovereign debt .............................................................................................................. - 4 Structure........................................................................................................................................ - 5 The concept of sustainability ............................................................................................................. - 7 The standard model of budget deficit:........................................................................................... - 7 Ricardian approach ........................................................................................................................ - 8 Intergenerational equity view ........................................................................................................ - 8 Sustainability of government debt in EMU establishment.......................................................... - 10 Concept of Risk ............................................................................................................................... - 11 Inflation Risk ............................................................................................................................... - 11 Default Risk................................................................................................................................. - 12 -

3. PROPOSITION AND EMPIRICAL ANALYSIS .................................................................................. - 14 a. b. The impact of external debt on governments’ bond yields.............................................................. - 15 Implications of private debt on government debt sustainability...