Past event
Brown Bag Seminar with Professor Stavros A. Zenios, Durham University Sovereign debt sustainability analysis under political risk
Stavros is a Professor of Operations Management and Finance at Durham University, and professor of Finance and Management Science at the University of Cyprus, and a Member of the National Academy of Cyprus. He is a Non-resident Fellow of Bruegel and a Senior Fellow at the Wharton School Financial Institutions Center. He consulted extensively with international institutions and commercial enterprises, including the European Stability Mechanism, the Bank for International Settlements, the Finnish Ministry of Finance, the Cyprus Auditor General, the Union Bank of Switzerland, and the World Bank.
Abstract: This talk synthesizes two lines of work over the last five years to develop theoretically rigorous and empirically relevant debt sustainability analysis models. I first discuss how to model financial, economic, and fiscal uncertainty with correlations and fat tails using scenario trees and set up the sovereign's debt financing optimization model. It addresses the problem of public debt management offices to finance government borrowing “at the lowest cost against acceptable risks” with debt sustainability conditions on debt stock and flow. We use the model to assess the impact of a large quantitative easing program of the ECB on debt dynamics. I will then discuss the integration of political risk in the analysis. We have recently identified a strong factor structure in country political ratings, uncovering systematic variations in global political risk (P-factor). The P-factor commands a significant risk premium of 4.44% per annum with a Sharpe ratio of 0.70. It is unspanned by the existing asset pricing factors, manifests in all asset classes, and is related to systematic variations in expected global growth and aggregate volatility. We will use these findings to document the effects of political risk on sovereign debt through the yields and growth channels and show that it shifts the quantiles of debt trajectories that assess sustainability. Calibrating the model on representative countries, we make several observations: sustainable debt dynamics can become unsustainable under political risk; debt sustainability can be restored through political reforms; reforms are as effective in improving debt sustainability as the quantitative easing episode, even when costly; reform delays reduce fiscal space.