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Teaser, summary, work performed and final results

Periodic Reporting for period 2 - DebtRisks (Public Debt: Risk Management and Restructuring Optimization)


The over-arching challenges revealed by the eurozone crisis were imprudent public debt management, weak macroeconomic management, anddebt overhang. This project develops the capacity for risk management of public debt, pursuing three board objectives:1. Develop an...


The over-arching challenges revealed by the eurozone crisis were imprudent public debt management, weak macroeconomic management, and
debt overhang. This project develops the capacity for risk management of public debt, pursuing three board objectives:
1. Develop an asset-and-liability management framework for risk management of public debt
2. Operationalize the framework using multi-period stochastic programming integrated with multi-factor simulation
3. Extend the optimization model to incorporate debt sustainability analysis and study debt restructuring

In the aftermath of the 2008 global financial crisis sovereign debt increased sharply in most advanced economies. Average public debt increased by one third from trough to peak, with almost all countries experiencing a significant increase. In the euro area, public debt rose too about 84% in 2010, which decisively contributed to a sovereign debt crisis in the region, with five countries (Greece, Ireland, Portugal, Spain, Cyprus) requiring external financial assistance. The fact that public debt levels have barely declined since then, have prompted a renewed interest in debt sustainability analysis and have led to intense policy discussions. Our project addresses important questions relating to the debt sustainability of sovereigns. It incorporates optimal debt-financing decisions for an economy facing uncertain economic growth, interest rates, and fiscal balance to address some important questions: How do issuance strategies trade-off interest costs and refinancing risks? Through which channels do they influence debt flow and stock dynamics? How do these interactions depend on the stock of legacy debt, risk tolerance, or the sensitivity of interest rates to debt? What additional efforts and when, could render sustainable a given debt stock level? The answers have significant implications for the public.

The project also considers the use of contingent debt for sovereign debt risk management, either as stand-alone instruments that facilitate risk sharing with the markets, or in the context of an asset-liability management framework

Work performed

The ALM framework has been completed and a paper on this appeared in the special issue of the Springer journal Optimization and Engineering on Financial Engineering (Consiglio and Zenios, 2017). The development and testing of a prototype stochastic programming model was completed and a paper on this was very well received and published in the Journal Globalization and Development edited by Nobel laureate and leading authority on the sovereign debt crisis Joseph Stiglitz. We also completed several tasks on sovereign contingent debt. In particular Consiglio and Zenios (2018) suggested sovereign contingent debt and developing the appropriate risk management models and a pricing model for these instruments was published in Consiglio, Tumminello and Zenios (2018). We also published a paper on pricing GDP-linked bonds in incomplete markets

The progress during my stay in the USA led to the development of collaborations with the Bruegel think tank in Brussels and the European Stability Mechanism in Luxembourg. As envisioned in the amendment of the original grant I did my secondment with these institutions from September to December 2017. As part of my secondment with the Bruegel foundation, we co-authored with the Deputy-director a Policy Contribution on sovereign contingent debt (Demertzis and Zenios). A young research assistant (David Pichler) was also involved in this task and received training on developing a simple simulation model for sovereign debt. The collaboration with the economists, mathematicians and econometricians of the European Stability Mechanism led to a deeper understanding of the problem and extensions that were not envisioned in the original proposal, namely the modeling of debt stock and flow and of the endogeneity of interest rates. A complete model as implemented and tested extensively, and we have co-authored paper with ESM staff which is currently under review. We are also preparing a post for a more general audience on the portal.

I also developed contacts with the Cyprus Public Debt Management Office (PDMO) and the Cyprus Fiscal Council (FC). We conducted a workshop and signed an agreement of collaboration with the Cyprus Fiscal Council to test the model on Cyprus data.

The knowledge acquired on this project was used in training a PhD student who is currently enrolled at University of Cyprus Finance Department. Two papers co-authored with the student has been published (Lotfi and Zenios, 2018, Consiglio et al., 2016).

I also gave invited talks to several institutions (Federal Reserve Bank of Philadelphia, Princeton University, Stevens Institute of Technology, European Stability Mechanism, Wharton School, RPI, University of Bergamo) and to scientific conferences (DebtCon2 (Geneve), EURO (Valencia), and as the plenary speaker to the Symposium on Quantitative Finance and Risk Analysis (Mykonos).

During my stay in the US I benefited immensely from the environment of the Wharton School and took several courses: Banking (MSc, Richard Herring), Central Banking (MSc, Zvi Eckstein). Macroeconomics (MSc, Andrew Abbel), Mathematical Finance (PhD, Jessica Wechter), Microeconomics (PhD, Itay Goldstein), Fintech (distant learning, various instructors at MIT), Globalization (distant learning, Richard Baldwin). I also attended routinely research seminars at the departments of Finance, Business Economics and Public Policy and Operations, Information and Decisions. The training aspects of the project exceeded my expectations and were immensley beneficial for my work and will undoubtedly help with my future work.

Final results

We developed a model that addresses the optimization of sovereign debt financing, advancing significantly the state-of-the-art: integrates debt financing decisions in a debt sustainability framework, consider the tension between debt stocks and debt flows, models the endogenous response of interest rates to debt, and introduces a risk measure to assess risks. The model identifies unsustainable debt with high probability and identifies strategies for restoring sustainability. This model could be useful in dealing wth crisis countries and can inform both policy and operational decisions. In particular, it can identify hot spots of troubled countries and suggest policy steps to alleviate the problems.

In addition, we made several contributions on designing and pricing sovereign contingent debt instruments, a topic that has attracted the attention of the G20 leaders since 2016.

A most important advance during the return phase was to work with the Cyprus Fiscal Council to inform their policy recommendations for the case of Cyprus. We have signed an agreement of collaboration and we are exploring similar collaborations with the Italian Fiscal Council. We expect to continue the collaboration with the European Stability Mechanism to see our model adopted as part of their broader and mandated debt sustainability analysis they perform for program countries. Our contacts with alll the above institutions have been very productive and highly encouraging.

Depending on progress with the Cyprus Fiscal Council, we will try to make the technology more broadly accessible to other european Independent Fiscal Institutions. We are already engaged in discussions with scholars from University of Amsterdam that are advising the Dutch Treasury.

Website & more info

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