Government Debt and Risk Premia
Speaker: Dr. Yang Liu (The University of Hong Kong)
|I document that government debt is related to risk premia in various asset markets. Higher debt-to-GDP ratio: (i) predicts higher excess stock returns with 30% five-year out-of-sample R-squared; (ii) correlates with higher credit risk premia in corporate bond excess returns and yield spreads; (iii) is associated with lower real risk-free rates and expected returns on government debt; and (iv) comoves with higher fiscal policy uncertainty. I rationalize these facts in a model featuring distortionary taxation and time-varying fiscal uncertainty. The tax risk premium is sizable and varies with fiscal uncertainty, which is endogenously linked to the debt-to-GDP ratio. Fiscal uncertainty increases debt valuation, and conversely debt raises uncertainty in fiscal consolidations.