Managing Default Risk

Revised version, March 2019

High sovereign debt in advanced economies has recently revived the debate about the role of coordination problems and self-fulfilling beliefs as drivers of sovereign default risk. I show how default risk can be decomposed in a solvency-risk component and a coordination-risk component. I then study how fiscal policy can be effective in managing the risk of coordination and I characterise how the shape of the optimal policy is affected by the presence of this risk: making the deficit contingent on interest rate movements is more effective in managing default risk than using non-contingent fiscal targets.

JEL classification: D82, D84, E62

Keywords: Default risk, fiscal policy, coordination, global games

The views expressed in this publication are those of the authors and do not necessarily reflect the views of the BIS or its member central banks.