16 December 2024

Bruegel: Incorporating political risk into analysis of sovereign debt sustainability

Political risk is not taken into account when assessing whether countries can manage their debts, but it could be and should be. Authors: Ajovalasit, Consiglio, Pagliardi, Zenios

Debt sustainability analysis (DSA) is a tool used by institutions such as the International Monetary Fund and the European Commission to assess whether countries can continue with their fiscal policies without running into debt that is too large to service without major corrections. Under European Union fiscal rules updated in April 2024 ¹ , the European Commission uses DSA to assess whether countries are likely to breach debt and deficit limits of 60 percent and 3 percent of GDP, and if countries that already exceed those levels are likely to be able to rein in their debts within a reasonable timeframe. 

Such DSA-based analysis is expected to be a reliable watchdog of public finances. It is based on economic data, integrating macro, budgetary and financial variables into a transparent risk-based assessment of debt. However, a significant element is missing from DSA as applied by the Commission and other institutions: political risk. This remains absent even though institutions are aware of this risk, which has been receiving increasing attention in their reports.

Political events such as snap elections, collapsing government coalitions and regional conflicts put pressure on public finance, as do issues that must be managed at political level, such as inequality (Alesina and Perotti, 1996). Climate change could also lead to increased political instability and therefore fiscal unpredictability (Dell et al, 2014). Political risk is already a factor in sovereign ratings, but is it also relevant for DSA?

In this analysis, we discuss how political risk can influence sovereign debt. We look first at how political risk can be measured and second at how it might alter debt sustainability projections ² .

Measuring political risk

Political risk is the probability of disruptions caused by political decisions or events that can impact economic and business processes (Sottilotta, 2016). Disruption can stem from government instability or changes in government policies, and these two are not necessarily correlated (Gala et al, 2023). Political risk has often been equated with government instability. The World Bank proxies this risk for emerging markets by the numbers of political assassinations, coups or revolutions ³ . For developed markets, political risk is considered to be heightened around elections and is proxied by political cycles (Alesina et al, 1997). But coups and revolutions are extreme events, and elections come about only every few years. More granular and regularly updated indicators would therefore be more useful. 

A comprehensive proxy of political risk is provided by International Country Risk Guide (ICRG) ratings ⁴ . These weigh several political factors that can disrupt the economy and business, including government instability, internal and external conflict, corruption, the presence of the military in politics, religious and ethnic tensions, undermining of law and order, lack of democratic accountability and weak bureaucracy. The factors are aggregated into a score of 0 to 100, with a higher value indicating lower political risk. Political risk is a well-documented determinant of economic growth, investments and asset prices ⁵ .

Significantly, political risk is not only an emerging markets problem. It also matters for developed markets, as seen in the volatile political risk ratings for Italy and France (Figure 1). The volatility is quite significant for both countries. Italy’s rating improved notably from 2014 to 2018 reflecting reforms enacted by prime ministers Matteo Renzi and Paolo Gentiloni. France’s rating dropped steeply in summer 2024 as a consequence of the snap parliamentary elections....

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