Macroeconomic Determinants of Sovereign Risk: A Debt Sustainability Analysis

This paper analyses the effect of the debt sustainability indicator on sovereign risk. This stochastic indicator uses simulations of real interest and growth rates to capture uncertainty and combines this with the expected fiscal response of changes in debt levels. A two-variable VAR model is used for the Monte Carlo simulations of real interest and growth rates. The expected fiscal response is determined using long time series of eighteen countries. The results suggest that the indicator has a significant and positive relationship with sovereign CDS spreads. A one percentage point increase of relative deviation of upper-bound debt levels with respect to the median paths leads to an increase of 26.68 bps on average of 5-year sovereign CDS spreads over the subsequent five years. Lastly, inflation, trade-to-GDP and Export-to-Import have a significant effect on sovereign CDS spreads as well.