Fiscal fatigue, fiscal limits, and sovereign credit spreads

term structure
credit risk
public debt
working paper
Working Paper

Jean-Paul Renne, Kevin Pallara


November 1, 2023

We develop a dynamic sovereign credit risk model using the concept of fiscal fatigue, according to which stabilizing high debt levels requires unsustainable large surpluses, leading ultimately to credit risk. We define the fiscal limit as the debt level associated with a specific default probability at a given time. Exploiting the information encoded in sovereign credit spreads, we estimate time-varying fiscal limits and fiscal spaces (the gap between these limits and actual debts) for eight countries from 2007 to 2022. Fiscal spaces correlate negatively with economic policy uncertainty and bond market volatility, but positively with central bank balance sheet size.

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