Risk profiles for re-profiling the sovereign debt of crisis countries
Article publication date: 19 January 2015
This paper aims to use a risk management approach for re-profiling of sovereign debt. It develops profiles that trade off expected cost of financing alternative debt structures against their risk. The risk profiles are particularly informative for countries facing sovereign debt crisis, as they allow us to identify, with high probability, debt unsustainability. Risk profiles for two eurozone countries with excessive debt, Cyprus and Italy, were developed. In addition, risk profiles were developed for a proposal to impose debt sanctions in the Ukrainian crisis and it was shown that the financial impact could be substantial.
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 off expected cost of debt financing against the Conditional Debt-at-Risk. The model is applied to three diverse settings from current crises.
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 gross domestic product growth and small deviations can push debt into unsustainable territory. For Italy, our analysis provides evidence of debt unsustainability. Common assumption of debt by eurozone member states could restore sustainability for Italy. Finally, it is shown how a proposal to impose debt sanctions against Russia for the Ukrainian crisis could have significant financial impact for Ukraine.
Additional work is needed to calibrate the simulation models for each country separately. Nevertheless, the direction of the results is such that more careful calibration will most likely not alter the conclusions but make them stronger instead.
The results provide significant insights for the management of sovereign debt for Cyprus and Italy. They also show the significant positive impact on Ukrainian public finances from debt sanctions. However, the most important practical implication is to show how the proposed methodology provided a decision support tool for restructuring and rescheduling sovereign debt for crisis countries.
There is widespread acceptance that debt restructuring has been too little and too late in recent crises failing to re-establish market access in a durable way. How to develop risk profiles for alternative debt structures has been illustrated. Debt profiles that are unsustainable can be identified, with high probability, and alternative structures proposed that restore sustainability. The methodology proposed in this paper is providing a useful tool of analysis. The topic of debt relief is currently debated widely at policy circles by the IMF and the United Nations, and the analysis of this paper provides some insightful input to the debate.
The use of scenario analysis for sovereign debt modeling and the use of an optimization model developed by the authors in previous research provide empirical analysis for three current problems in sovereign debt management. Useful insights are obtained for three important real-world cases for Cyprus, Italy and Ukraine.
The authors thank Anna Gelpern and two anonymous referees for providing insightful comments on legal and behavioral aspects of sovereign debt management and bringing to their attention relevant references. The paper benefited from comments received from participants at the 2014 Rome International Summer School on Risk Management, the 3rd Greek Public Policy Forum and research seminars at University of Copenhagen and Universidad de San Andres, Buenos Aires.
Disclamer. The author is a non-executive director of the Central Bank of Cyprus. The opinions expressed herein have not been shared with or endorsed by the Bank.
Consiglio, A. and Zenios, S. (2015), "Risk profiles for re-profiling the sovereign debt of crisis countries", Journal of Risk Finance, Vol. 16 No. 1, pp. 2-26. https://doi.org/10.1108/JRF-09-2014-0129
Emerald Group Publishing Limited
Copyright © 2015, Emerald Group Publishing Limited