Sovereign Debt Sustainability and Central Bank Credibility

IMF Working Papers, January 28, 2022

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Surveys literature on sovereign debt sustainability from the mid-1980s to the present, focusing on four debates.
Argues that liquidity services provided by sovereign debt can lead to a “free lunch”, albeit of limited size.
The value of liquidity services depends on the credibility of the central bank, which can be accumulated via prudent policies and subsequently drawn on to allow for looser fiscal policy.

Shift from an “accounting based” view of debt sustainability, evaluated using government borrowing rates, to a “model based” view which uses stochastic discount rates.
Empirical tests focusing on the relationship between primary balances to debt.
Debt sustainability in the presence of rollover risk.
Whether government borrowing costs below rates of growth (“r < g”) generate a “free lunch” in the sense that debt sustainability does not require future primary surpluses.

Liquidity services of sovereign debt can relax fiscal constraints but the effect is limited in magnitude.
Central bank credibility is a critical determinant of the market value of sovereign debt’s liquidity services.
Credibility can be built through prudent monetary policies and then used to support looser fiscal stances when needed.
Interactions among fiscal policy, rollover risk, and stochastic discounting are central to modern debt sustainability analysis.

Subjects: Debt financing, Debt sustainability, Debt sustainability analysis, External debt, Fiscal policy, Fiscal stance, Public debt
Keywords: central bank credibility, credibility function, credibility of the central bank, debt crises, Debt financing, debt sustainability, Debt sustainability analysis, fiscal policy, Fiscal stance, fiscal-monetary interactions, marginal utility, market value, Ponzi scheme, sovereign debt