The feedback effects of sovereign debt in a country’s economic system: a model and application

Many of the existing theoretical and empirical studies ignore the two-way relationship between a sovereign’s credit risk and economy. To address this gap, we develop a theoretical model that incorporates the feedback effects of sovereign-debt credit risk on a country’s economy and then provide empirical implications. The model links the risks of sovereign debt and economic fundamentals through a two-way transmission mechanism. In doing so, it demonstrates how economic-fundamentals-driven sovereign-debt credit risk can have a significant impact on economic fundamentals through a feedback effect that has the potential to significantly raise the sensitivity of a country’s economic performance to shocks from both the credit risk associated with sovereign debt and economic fundamentals. The outcomes of the theoretical model are then verified by empirically testing the feedback effects using a structural equation model (SEM) framework on data covering sovereign debt defaults worldwide. We demonstrate how disregarding feedback effects may result in information that is insufficient and less helpful to public-debt-management policymakers.