We model sovereign debt sustainability with optimal financing decisions under macroeconomic, financial, and fiscal uncertainty, with endogenous risk and term premia. Using a coherent risk measure we trade-off debt stock and flow risks subject to sustainability constraints. We optimize static and dynamic financing strategies and demonstrate economically significant savings from optimal financing compared with simple rules and consols, and find that optimizing the trade-offs can be critical for sustainability. The model quantifies minimum refinancing risk and maximum rate of debt reduction that a sovereign can achieve given its economic fundamentals, and an extension identifies optimal timing of flow adjustments that allow the sovereign to go beyond these limits. We put the model to the data on a eurozone crisis country, a low-debt country (Netherlands), and a high-debt country (Italy) and document the significance of the stock-flow trade-off for debt sustainability, identify potential improvements of Dutch Treasury practices, and identify unsustainability risks in the 2019 Italian budget. The model informs diverse policy decisions on sustainable public finance and is an essential building block of the European Stability Mechanism methodological framework to assess debt sustainability and repayment capacity of member states, especially in the context of financial assistance.
|Number of pages||19|
|Publication status||Published - 2021|