We present an empirically grounded quantitative framework for modelling sovereign credit risk and evaluating the sustainability of sovereign debt. We study the impact of fiscal and public investment policies on the sovereign’s borrowing cost and credit risk in presence of stochastic output shocks and credit-sensitive funding from investors, with a focus on the dynamics of liquidity flows and the sustainability of sovereign debt. Our model successfully replicates a range of empirical observations on sovereign credit risk and sovereign defaults. In particular, it reproduces Argentina’s 2001 default and Greece’s 2011 debt restructuring events and leads to realistic dynamics for debt, spreads and credit ratings conditional on output.

The framework is useful for debt sustainability analysis and may be used to estimate the impact of fiscal policy on debt and output.