Political risk significantly affects sovereign debt's sustainability by influencing bond yields and GDP growth. When political risk is high, investor uncertainty increases, leading to higher risk premiums and borrowing costs. This situation also negatively impacts economic performance by reducing private investment, slowing productivity growth, and creating financial instability. As a result, political risk is crucial for assessing sovereign debt sustainability, especially in countries with high debt levels. A decline in governance quality leads to increased borrowing costs, reduced fiscal space, and worsened challenges to debt sustainability. Conversely, strong and stable governance can mitigate these risks by promoting economic stability and relieving refinancing pressures.

The empirical findings from Ajovalasit et al. (2024) reveal a strong link between political risk and both yields and growth. Countries with greater political instability tend to see higher bond yields as investors seek compensation for the increased uncertainty. For instance, a deterioration of the ICRG ratings by ten units leads to a full-sample average annual increase in bond yields by 106 bp, compounding fiscal pressures on high-debt countries. Moreover, the analysis highlights that ten units' deterioration of the political rating leads to an economically large and statistically significant reduction in GDP growth by two percentage points, further straining fiscal space. Evidence from the broader literature supports these findings. For instance, Eichler (2014) demonstrates that political risk increases sovereign borrowing costs. Additionally, studies such as those by Bekaert et al. (2014) confirm the adverse effects of political risk on asset pricing and sovereign bond yields, highlighting its impact across both emerging and developed markets.

Ajovalasit et al. (2024) extend this evidence by showing that political risk has a more pronounced effect in high-debt countries, particularly during elevated global interest rates. This amplifies the debt-to-GDP ratio, creating a feedback loop where fiscal vulnerabilities heighten political risk, which, in turn, worsens budgetary outcomes. The empirical analysis also illustrates the asymmetric effects of political risk: while stable governance substantially narrows yield spreads, political shocks create outsized spikes in borrowing costs. These dynamics are particularly evident in Ajovalasit et al.'s case studies on Italy and France, where improvements in political ratings reduced yields and stabilised debt, whereas political shocks significantly widened spreads.  

Italy 2014–2019 Reforms: Italy implemented structural reforms to improve governance and economic stability during this period. Political ratings improved, and this reduced perceived political risk, which led to stabilising debt trajectories. As shown in Figure 1, Panel (a), the coral fan charts with political DSA projections indicate a much narrower debt-to-GDP range compared to the counterfactual scenario, where political ratings remained static. The reforms allowed Italy to achieve lower realised debt ratios than initially anticipated, highlighting the fiscal benefits of governance improvements.  

France 2024 Snap Elections: In contrast, the snap elections in France during the summer of 2024 created a sudden drop in political ratings, increasing perceived risk among investors. Figure 1, Panel (b), illustrates how this shock significantly widened the debt-to-GDP trajectory compared to a counterfactual scenario in which France maintained political stability. The coral fan charts display a higher and more volatile debt range, emphasising the destabilising impact of political shocks on fiscal outcomes. Projections from the 2024 World Economic Outlook reinforce this assessment, showing raised debt ratios due to heightened political uncertainty. Informed by the Italian and French experiences, policymakers must act firmly to manage political risk and its fiscal implications. Even small improvements in governance quality can yield significant budgetary benefits. Policymakers can stabilise debt trajectories and foster economic resilience by prioritising political stability and incorporating political risk into debt management strategies. This is particularly urgent in a global environment characterised by rising interest rates and increasing geopolitical tensions, exacerbating high-debt economies' vulnerabilities.