Non-technical summary of ESM Working Paper 70: Concessional credit lines for sovereigns in financial distress
The euro area has faced multiple crises since 2010, starting with the sovereign debt crisis, followed by the Covid-19 pandemic and the war in Ukraine. In a world with high public debt and frequent external shocks, crisis prevention is less costly than crisis resolution, highlighting the importance of sovereign access to credit lines from international financial institutions during financial distress. This paper quantitatively analyses concessional credit lines for financially distressed governments with sound economic fundamentals.
We develop a sovereign default model where the government can access non-contingent long-term debt and concessional credit lines only during financial distress episodes. These credit lines are long-term, non-defaultable, have grace periods, and are available to countries with sound economic fundamentals. We calibrate our model to Portugal, a representative small open economy in the euro area with strong economic and financial fundamentals but potentially susceptible to external shocks.
Our framework addresses five questions: (i) how does the access to credit lines affect sovereign borrowing costs during distress, (ii) to what extent do these facilities contribute to macroeconomic stabilisation, (iii) what are the benefits and costs of attaching grace periods to these credit lines, (iv) how does the existence of such facilities affect sovereign borrowing in the long run, and (v) what is the politically perceived cost of using credit lines by countries, the so-called stigma premium, that could explain the lack of use of these facilities?
Our findings indicate that credit lines capped at 10% of annual GDP with a grace period of 10 years reduce sovereign spreads by 120 basis points and halve the default risk upon introduction. Smaller credit lines (4% of GDP) with a 3-year grace period lower spreads by 60 basis points. While grace periods provide temporary relief during an unexpected decline in output, they can worsen the debt dilution problem,1 raising borrowing costs. Credit lines available only during risk-on episodes, without grace periods and with short-term maturities, lower spreads over the long run without worsening debt dilution. Our results also suggest that the stigma premium for a credit line capped at 4% of annual GDP with a grace period of 3 years is around 9%. In other words, the politically perceived cost of using these credit lines by countries would have to reach 9% to explain their lack of use. Without grace periods, we find that the stigma premium can reach up to 5%.
1 Debt dilution occurs when a borrower, such as a government, issues new debt without considering how it reduces the value of its existing debt. This happens because the new debt increases the risk of default, making all outstanding debt less attractive to investors. As a result, lenders demand higher interest rates to compensate for this risk, raising borrowing costs for the borrower.