Sovereign Debt and Risk of Default

The areas of interest of this researcher is issuing of sovereign debt and the risk associated with it. It is the central government’s debt. According to International Monitory Fund (2021), sovereign debt is an important way for governments to finance investments in growth and development because governments use this fund for the development and production sector. However, Kum & Oktem (2018) opposed the view and claim that the relationship between government debt and growth has negative. That means a negative long-term correlation between Government Debt (GD) and Growth Domestic Product (GDP) is mainly because of the negative impact of economic growth on the GD. Therefore, Kum & Oktem (2018) opines that GD is not the reason for growth, but growth is the cause of GD.

The constancy of the issuing of sovereign debt is depending on the country’s sovereign credit rating so that it helps investors assess risk with the debt investment. Arteta & Hele (2008) opine that sovereign debt crisis can lead to reduced foreign credit to private domestic firms via a decline in supply, as lenders' perceptions of country risk worsen. Therefore, the risk of sovereign debt has a lot of negative effects not only for the private sector but also for the relevant government sector as well. As per Crosignani (2021), sovereign debt can be either internal or external debt. The internal debt is the debt owed to a lender who is living within the same country, while external debt is debt owed to lenders in foreign countries. Therefore, while it is a government bond and bill, the country that has lower creditworthiness borrows the loan from a multinational organization such as The World Bank or International Monitory Fund (IMF), but which has decent creditworthiness would borrow the loan internally. 

Crosignani (2021) has discussed in his paper that banks invest a large proportion of their assets in domestic government bonds which is a government guarantee. As stated above, the credit risk depends on the creditworthiness of the particular country, and there is a positive relationship between countries' creditworthiness and banks’ balance sheet. That means, the lower creditworthiness the more impairs on the balance sheet. 

While this happens, banks rely on a government bailout. Corsignani developed the model which claims that sovereign debt capacity depends on the capitalization of the domestic bank. As he explained that if the risk is excessively high, low-capital banks lend less in the productive sector and increase the domestic government bond. He uses a two-country model with two different dates to examine how productive, financial and government sector is interrelated. The product sector borrows the loan from the financial sector, and invest in the productive area, while financial sectors invest in them as well as invest in government bonds. At that moment, the government wants to decide the initial level of bank debt, offering a one-period bond, and repays at a certain period of time with an exogenous tax rate to the payoff of the productive sector. Consequently, high payoff imposes productive sector to pay more taxes and government would have more revenue, but it would also lead to default of the productive sector and so the government to default. The picture below shows the model of how the productive sector, financial sector, and government are linked in the sovereign debt and how it is repaid. 

Picture 1

 Crosignani’s model of Bank capital, government bond holdings, and sovereign debt capacity.


This research is excessively important for further dissertation because it discusses how and why banks are interested in investing in sovereign debt during a time of crisis. Even though most of the example was taken from the global financial recession of 2007/2008, it is extremely important to examine the recession due to the coronavirus. 


Arteta, C. & Hele, G. (2008). Sovereign debt crises and credit to the private sector. Journal of International Economics, 74(1), pp. 53-69.

Crosignani, M. (2021). Bank capital, government bond holdings, and sovereign debt capacity. Journal of Financial Economics, 141, pp. 693-704

International Monitory Fund. (2021, July). The IMF and sovereign debt

Kum, H., & Oktem, O. (2018). Government debts and economic growth: The case for selected EU countries. International Journal of Economics and Financial Issues8(6), pp. 192-196.



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