A Framework to Evaluate the Sustainability of Debt

This framework can be used to evaluate the sustainability of a country's debt profile. The dynamics generated are based on the interaction and feedback between a government agent, a rating agency and the financial market in a stock-flow consistent manner.

This framework can be used to evaluate the sustainability of a country's debt profile. The dynamics generated are based on the interaction and feedback between a government agent, a rating agency and the financial market in a stock-flow consistent manner.
This framework can be used to evaluate the sustainability of a country's debt. For example, simulations can show that trade off between the cost and solvency of the debt profile over time. 
The government agent's critical challenge is how to finance its activities by effectively managing its stock of cash balances over time. 
Government cash balances are increased by the collection of tax and non-tax revenues. Tax revenues are assumed to be a proportion, Tax Net Factor (TNF), of the economy's Gross National Income (GNI). This TNF is assumed to grow over time as the effectiveness of tax administration improves. Further, as the government's cash balances decline the Government agent reacts by increasing the tax net factor i.e. imposes new taxes. Non-tax revenues, on the other hand, are assumed to be a fixed proportion of GNI.
Government's cash balances are reduced as they utilize funds to finance expenditure on both infrastructure programmes and social programmes. These expenditures are assumed to be a function of set proportions of government revenues and a growth factor. However, as its cash balances decline the government agent reacts by reducing these expenditures. 
Government also has an obligation to pay Public Sector workers which reduces government cash balances. The wage bill is simply to product of the number of workers employed and the average wage bill. Note that the stock of workers at any given point in time in given by the net hiring rate (new hires less the rate at which persons retire) and the quit rate.
If tax revenues are insufficient to meet all its expenditures then the government will seek to finance itself by borrowing. Borrowing consists of local currency debt instruments and foreign currency debt instruments. {More details to follow}.
Of course, as the Government issues debt instruments it is obligated to service its debt by repaying principal and interest as they come due. This debt servicing payments serve to reduce its cash balances. 
The Government fiscal balance will then be captured by  its Tax and Non-Tax Revenues less its expenditure on Social Programmes, Infrastructure Projects, Wage Bill and Interest on Outstanding Debt. 
The government agent determines how much to borrow in a given year by comparing its actual holdings of cash against its desired government cash balance. The government then adjusts its demand for financing over time as the gap between actual cash and desired cash closes. Of note, the desired debt financing determined by the historical demand for funds to pay wages and service outstanding debt. 
This links the debt raising and debt servicing activities of the government to the balance sheet of the government at any given point in time.  Specifically, debt raising activities which increase cash flows (A) from the issuance of debt simultaneously increases the stock of debt (L). Similarly, debt repayments which  reduces the stock of debt (L) have the effect of reducing its cash flows (A) in a stock-flow consistent manner.
The credit rating agent continuously monitors the performance of the government agent and derives a credit score based on the evolution of liquidity and solvency ratios of the government. 
This credit score, along with the financial markets assessment of the debt burden, impact the actual amount of debt raised domestically and internationally. More specifically, deteriorations in either the credit score or the debt level lead to lower funds accessed accessed from the capital market and a lower proportion of market-based debt denominated in foreign currency. 
This credit score, along with the financial markets assessment of the recent fiscal performance , also impact the maturity profile of the debt that government is able to secure over time.  Deterioration fiscal performance and rating downgrades cause the financial market to offer shorter maturities.
Finally, the financial market makes assessments of the appropriate credit risk and liquidity risk premium based on changes in the credit score and fiscal performance of the government agent to determine the interest rate on newly issued debt. 

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