Modelling the sustainability of public sector debt and net foreign asset positions

The European Sovereign Debt crisis in 2010 not only brings the sustainability of public finance to the forefront, but also the sustainability of external balances. Chapter 2 of this thesis proposes an approach to measuring fiscal sustainability of a country; Chapter 3 investigates the divergent external imbalances in Europe, and Chapter 4 proposes the measures of external sustainability for a country. Chapter 2 proposes a measure of public sector debt sustainability based on probabilistic statements of various future events relating to debt sustainability. It illustrates the approach using data for 10 developed countries over the period 1958-2010. The approach accommodates various alternative definitions of sustainability, which is new in the literature. The approach employs a Global cointegrated Vector Auto Regression model, modelling both long-run relations and cross-country interactions. Applying our approach on an empirical sample including eight EU countries, shows that our measures offer a multi-dimensional description of fiscal sustainability. Chapter 3 characterises the long-run time series properties of net foreign assets in twelve EU countries over the period 1970-2011. Using a multi-country restricted VAR model, we establish that shocks to net foreign asset persist over time. We then measure the size and the source of the permanent effects of the shocks. We find, the current account drives the net foreign assets in the long-run. Unanticipated changes in cross-border finance flows have a significant permanent effect on net foreign assets across the EU economies, more than output shocks and dollar exchange rate shocks. Chapter 4 measures the likelihood of sustainability of the net foreign assets and the current accounts. In response to the sovereign debt crisis, the European Commission includes both the stock and flow external balances under its surveillance. We illustrate our measure by implementing the introduced policy. Our sustainability likelihoods are based on a formal model incorporating behavioural feedbacks and cross-country movements. Illustrating on the EU empirical sample adopted in Chapter 3, our measures not only describe countries' sustainability of external balances but also serve as early warning indicators