Risk profiles for re-profiling sovereign debt

Purpose – This paper aims to use a risk management approach for re-profiling of sovereign debt. Itdevelops profiles that trade off expected cost of financing alternative debt structures against their risk. Therisk profiles are particularly informative for countries facing sovereign debt crisis, as they allow us toidentify, with high probability, debt unsustainability. Risk profiles for two eurozone countries with excessivedebt, Cyprus and Italy, were developed. In addition, risk profiles were developed for a proposal to imposedebt sanctions in the Ukrainian crisis and it was shown that the financial impact could be substantial.Design/methodology/approach – Using scenario analysis, a risk measure of the sovereign’s debt –Conditional Debt-at-Risk – was developed, and an optimization model was then used to trade offexpected cost of debt financing against the Conditional Debt-at-Risk. The model is applied to threediverse settings from current crises.Findings – The methodology traces informative risk profiles to identify sustainable debt structures.Interesting, although tentative, conclusions are drawn for the countries where the methodology was applied.Cyprus’s debt sustainability hinges on current International Monetary Fund (IMF) projections about grossdomestic product growth and small deviations can push debt into unsustainable territory. For Italy, ouranalysis provides evidence of debt unsustainability. Common assumption of debt by eurozone memberstates could restore sustainability for Italy. Finally, it is shown how a proposal to impose debt sanctionsagainst Russia for the Ukrainian crisis could have significant financial impact for Ukraine.Research limitations/implications – Additional work is needed to calibrate the simulation modelsfor each country separately. Nevertheless, the direction of the results is such that more carefulcalibration will most likely not alter the conclusions but make them stronger instead.Practical implications – The results provide significant insights for the management of sovereigndebt for Cyprus and Italy. They also show the significant positive impact on Ukrainian public financesfrom debt sanctions. However, the most important practical implication is to show how the proposedmethodology provided a decision support tool for restructuring and rescheduling sovereign debt forcrisis countries.