Can fiscal rules improve financial market access for developing countries?

A number of countries have introduced fiscal rules to deter fiscal profligacy, enhance the credibility of fiscal policy, and reduce borrowing costs. In this paper, we examine the outcome of fiscal rules in terms of improving financial market access for developing countries. We use entropy balancing and various propensity score matching. We find that the adoption of fiscal rules reduces sovereign bond spreads and increases sovereign debt ratings for a sample of 36 developing countries, which are part of the JP Morgan Emerging Markets Bond Index Global (EMBIG), for the period 1993-2014. We explain this finding by the effect of fiscal rules on the credibility of a country's fiscal policy: more credible governments are rewarded in the international financial markets by low sovereign bond spreads and high sovereign debt ratings. These results are robust to a wide set of alternative specifications. We also show that this favorable effect is sensitive to several country structural characteristics. Our findings confirm that the adoption and sound implementation of fiscal rules is an instrument for policy makers to improve developing countries’ financial market access.     

How much to share: Welfare effects of fiscal transfers

Recent sovereign debt crisis has challenged policy makers to explore the possibility of establishing a fiscal transfer system that could alleviate the negative impact of asymmetric shocks across countries. Using a simple labour production economy, we first derive an analytically tractable solution for optimal degree of fiscal transfers. In this economy, fiscal transfers can improve welfare by moving the competitive equilibrium with fiscal transfers closer to the social planner's solution. We then extend the model to a DSGE setting with capital, international bond and linear taxes, and we analyze how implementation of a simple revenue sharing rule affects welfare and macroeconomic variables over time. Simulation results show that risk sharing through fiscal transfers always improves welfare in the long run. However, under certain model specifications, short‐run transitional welfare loss can outweigh the long‐run benefits. These results suggest that, in designing fiscal transfers across countries, government should take into consideration the intertemporal nature of welfare gains.     

Fiscal limits and monetary policy: default vs. inflation

This paper studies the monetary policy trade-off between low inflation and low sovereign risk in the environment where fiscal authorities fail to fully ensure the sustainability of government debt. Building on the Fiscal Theory of Price Level (FTPL) and the Fiscal Theory of Sovereign Risk (FTSR), this paper differs in its baseline assumption about the monetary policy objective, which is neither to rule out defaults regardless of inflation costs (as in FTPL), nor to follow inflation targeting regardless of associated sovereign risk (as in FTSR). Instead, we study the case in which the central bank controls the risky interest rate to minimize the probability of default while ruling out large inflation hikes. We show that this policy regime can mitigate default risks only when the central bank is expected to allow sufficient increases in inflation. When agents believe that the central bank's tolerance toward inflation hikes has increased, equilibrium risk premium goes down, suggesting that information concerning changes in the central bank's preferences over inflation directly impacts default risks.     

A longer-run perspective on fiscal sustainability

We investigate the sustainability of fiscal policy in a set of 19 countries by taking a longer-run secular perspective over the period 1880–2009. Via a systematic analysis of the stationarity of the first-differenced level of government debt, and disentangling the components of the debt series using structural time series models, we conclude that since in most cases non-stationarity can be rejected, longer-run fiscal sustainability is not rejected (Japan and Spain can be exceptions). The same is true for a panel analysis when allowing for multiple structural breaks, and for cross-country dependence. In addition, endogenously identified breaks can be related to episodes of sovereign default.     

Regime changes and fiscal sustainability in Kenya

Kenya's fiscal policy landscape is characterized by primary deficit spending forcing the government to rely on debt to meet its objectives. The justification often being that as a developing economy, annual growth rates and future prospects may in the short run justify the uptake of debt to finance infrastructural development. However, given potential fiscal limits, fiscal cycles usually alternates between sustainable and unsustainable regimes and this has a bearing on long run sustainability. This study therefore sought to investigate the nature of fiscal policy regime in Kenya and the extent to which fiscal policy is sustainable in the long run taking into account periodic regime shifts. Markov switching models were used to endogenously determine fiscal policy regimes. Regime switching tests were used to test whether No-Ponzi game condition and debt stabilizing condition were met. The results established that regime switching model was suitable in explaining regime sustainable and unsustainable cycles. An investigation of fiscal policy regimes established that both sustainable and unsustainable regimes were dominant, and each lasted for an average of four years. There was evidence to imply the existence of procyclical fiscal policy in Kenya. Regime switching tests for long run sustainability suggested that the No-Ponzi game condition weakly holds in the Kenyan economy. Regime-based sensitivity analysis indicated that persistence of unsustainability regime for more than 4 years could threaten long-run fiscal sustainability.     

Effects of asset purchases and financial stability measures on term premia in the euro area

We study the effects of the announcements of ECB asset purchases and of financial stability measures in the euro area in the wake of the global financial crisis and the euro area sovereign debt crisis on 10-year government bond term premia in 11 euro area countries. We find that the term premia of euro area countries with higher sovereign risk, as measured by sovereign CDS spreads, decreased more in response to the announcements of asset purchases and financial stability measures. Term premia of countries with lowest sovereign risk either increased as in Germany, or were not significantly affected or fell slightly, as in the Netherlands and Finland.     

Cross-country fiscal policy spillovers and capital-skill complementarity in integrated capital markets

The 2010 European sovereign debt crisis has renewed discussions on fiscal policy coordination. One rationale for coordination is fiscal policy cross-country spillovers. A common finding in the literature is that spillovers tend to be small in normal circumstances but can be large if monetary policy is at the zero lower bound. Orthogonal to the existing literature, we document a novel channel that generates cross-country spillovers over the medium run. We assume perfect capital markets integration and find that capital-skill complementarity can lead to large spillovers without the zero lower bound nor a large import share in government expenditures. As capital markets have become increasingly integrated in the Eurozone, the current degree of fiscal policy coordination between its members, low, may be insufficient. We also find that the smoothing benefits from a temporary rise in public debt spill over to other countries.     

Fiscal limits in developing countries: A DSGE Approach

This paper studies fiscal limits in developing countries using a dynamic stochastic general equilibrium (DSGE) approach. Distributions of fiscal limits, which measure a government’s capacity to service its debt, are simulated based on macroeconomic uncertainty and fiscal policy. The analysis shows that expected future revenue plays an important role in explaining the low fiscal limits of developing countries, relative to those of developed countries. Large devaluation of real exchange rates can significantly reduce a government’s capacity to service its debt and lower the fiscal limits. Temporary disturbances, therefore, can shift the distribution of fiscal limits and suddenly change perceptions about fiscal sustainability.     

Sovereign credit ratings in the European Union: A model-based fiscal analysis

We present a model-based measure of sovereign credit ratings derived solely from the fiscal position of a country: a forecast of its future debt liabilities, and its potential to use fiscal policy to repay these. We use this measure to calculate credit ratings for 14 European countries over the period 1995–2012. This measure identifies a European sovereign debt crisis almost two years before the official ratings of the credit rating agencies.     

Mispricing of Risk in Sovereign Bond Markets with Asymmetric Information

The likelihood that a government will repay its sovereign debt depends both on the amount of debt it issues and on the government's future ability to repay. Whilst the former is publicly observable, the government may have more information about the latter than investors. This paper shows that this asymmetric information problem impairs the market's ability to differentiate economies according to their fiscal sustainability, and can lead to a disconnect between bond prices and default risk. The model can help rationalise the behaviour of Eurozone bond prices prior to the recent European sovereign debt crisis.     

Sovereign Risk,Public Investment and the Fiscal Policy Stance

Of the different types of government outlays, since the 2000s public investment has been the main variable of adjustment during recessions in advanced and emerging economies. These contractions (expansions) have been associated with relatively medium-high (low) sovereign spreads, especially in advanced economies. To rationalize these issues, we develop a model of fiscal policy and sovereign default, with corporate default risk. Policymakers must decide between the provision of an unproductive public good and public investment, weighting their respective net benefits in terms of short-term stabilization and debt sustainability. In our model, investment follows a countercyclical stance only in the case of low levels of debt and moderate negative shocks, and otherwise contracts during recessions. The policy stance, along with the mix between different outlays, is determined by how sovereign risk responds to adverse economic shocks.     

Debt sustainability in emerging market countries: Some policy guidelines from a fan-chart approach

This paper uses a probabilistic approach to simulate the medium-term public debt trajectories of several major emerging market countries. We extend the standard debt sustainability analysis framework so as to more faithfully reproduce these countries’ economic reality in two aspects. First, we allow them to differ in the cyclical stance of their fiscal policy and in their degree of fiscal responsiveness to debt. Second, we explicitly integrate the specific risk premium paid by each country when borrowing in foreign currency. It allows us to evaluate the impact of alternative policies that the government may consider to improve sustainability. The results lead to three policy recommendations: i) a country should consider decreasing its exposure to currency risk only in extreme cases (like Argentina); ii) on the contrary, greater fiscal responsiveness (i.e. stronger fiscal tightening whenever there is a debt increase) could enhance sustainability to a much greater extent; iii) countries with low responsiveness to debt or a poor fiscal consolidation track record should be cautious with countercyclical fiscal policies, as they may trigger an unsustainable debt trajectory in the trough of the economic cycle.     

Sovereign default and the sustainability risk premium effect

We analyze the joint determination of interest rate risk and debt sustainability for governments with fiscal imbalances. Because higher interest rates imply increased debt services, they worsen the government's financial situation and increase the probability of sovereign default. Thus, higher interest rates eventually lead to a decrease in the real demand for government bonds, which imposes an additional constraint on government debt sustainability.     

The impact of fiscal policy announcements by the Italian government on the sovereign spread: A comparative analysis

This paper attempts to evaluate the impact of fiscal policy announcements by the Italian government on the long-term sovereign bond spread of Italy relative to Germany. After collecting data on relevant fiscal policy announcements, we perform an econometric comparative analysis between the three administrations that followed one another during the period 2009–2013. The results indicate that only fiscal policy announcements made by members of Monti's cabinet had a significant impact on the Italian spread. We argue that these findings may be partly explained by a credibility gap between Monti's technocratic administration and Berlusconi's and Letta's governments.     

Limits to government debt sustainability in OECD countries

The recent euro area sovereign debt crisis has shown the importance of market reactions for the sustainability of debt in advanced economies. This paper calculates endogenous government debt limits given the markets assessment of the probability to default. The estimated primary balance reaction function to growing debt has the “fiscal fatigue” property (a loosening fiscal effort makes the primary balance insufficient to support rising debt) at high debt levels. The combination of this feature of the primary balance reaction function with the market interest rate reaction to growing debt determines the government debt limit beyond which debt cannot be rolled over. An application to OECD countries over the period 1985 – 2013 with a model-based risk-premium shows that current debt limits are high for most of the OECD thanks to particularly low risk-free interest rates. It also shows for some countries that current debt levels are not sustainable without a change in government behaviour. Most importantly, the framework illustrates the state contingent nature of debt limits and therefore the vulnerability of governments to a change in macroeconomic conditions and to market reactions. Last, computations with an estimated interest rate reaction to public debt illustrate that debt limits are lower in the euro area than in other countries because of a sharper market interest rate reaction to rising debt.     

Monetary policy and fiscal limits with no-default

This paper discusses monetary and fiscal policy interactions that stabilize government debt. Two distortions prevail in the model economy: income taxes and liquidity constraints. Possible obstructions to fiscal policy include a ceiling on the equilibrium debt-to-GDP ratio, zero or negative elasticity of tax revenues, and a political intolerance of raising tax rates. At the fiscal limit two mechanisms restore solvency: fiscal inflation, which reduces the real value of nominal debt, and open market operations, which diminish the size of government debt held by the private sector. Three regimes achieve this goal. In all regimes monetary policy is passive. In all regimes a muted tax response to government debt is consistent with equilibrium. The propensity of a fiscal authority to smooth output is found to determine what is an acceptable response (in the form of tax rate changes) to the level of government debt, while monetary policy determines the timing and magnitude of fiscal inflation. Impulse responses show that the inflation and tax hikes needed to offset a permanent shock to transfers are lowest under nominal interest rate pegs. In this regime, most of the reduction in the real value of government debt comes from open market purchases.     

The fiscal theory of the price level and initial government debt

It is widely believed that the Fiscal Theory of the Price Level (FTPL) does not work in an environment in which initial government debt is zero. This paper demonstrates that this view is incorrect when the government issues a set of financial assets restricted to standard nominal debt contracts and money. In particular, it is possible to define a non-Ricardian fiscal policy for which the set of equilibrium price sequences under non-Ricardian fiscal policy is a proper subset of the set of equilibrium price sequences under Ricardian fiscal policy.     

Credit market discipline: Theory and evidence

Popular in the academic literature and financial press, the credit market discipline hypothesis holds that credit markets, through risk premia increasing in debt level, constrain governments from borrowing and thus, impose fiscal discipline on sovereign borrowers. While several papers document rising risk premia, none have investigated the consumption response. This paper fills this gap by using data on U.S. states' risk premia from 1973–98. An optimizing model is formulated, whereby states intertemporally smooth consumption in the face of interest rates which increase with debt. Deviations from optimality are considered by allowing for governments which consume out of contemporaneous resources. In both cases, credit market discipline is rejected. Rejection is robust to sample splits based on ideology and the stringency of balanced budget requirments.     

Fiscal capacity and the risk of sovereign debt after the Glorious Revolution: A reinterpretation of the North–Weingast hypothesis

Several explanations have been given to account for the fact that, in contrast to the claim made by North and Weingast (1989), the decline in interest rates on British sovereign debt did not occur until several years after the Glorious Revolution in 1688. This paper puts forward the hypothesis that the decline in the risk premium on Britain's sovereign debt was due to the significant increase in excise duties in the early part of the eighteenth century. This increase was possible for two reasons. On the one hand, with the Glorious Revolution, parliament no longer had reason to fear that the King would strengthen his political power due to the availability of more fiscal revenue. On the other hand, the new excise taxes were borne mostly by the poor, that is a social class not represented in parliament. The delay in reducing the interest rate on British sovereign debt, following the Glorious Revolution, was, therefore, due to the length of time needed to increase and improve the fiscal bureaucracy responsible for the collection of excise duties.     

Inflation and the fiscal limit

We use a rational expectations framework to assess the implications of rising debt in an environment with a “fiscal limit”. The fiscal limit is defined as the point where the government no longer has the ability to finance higher debt levels by increasing taxes, so either an adjustment to fiscal spending or monetary policy must occur to stabilize debt. We give households a joint probability distribution over the various policy adjustments that may occur, as well as over the timing of when the fiscal limit is hit. One policy option that stabilizes debt is a passive monetary policy, which generates a burst of inflation that devalues the existing nominal debt stock. The probability of this outcome places upward pressure on inflation expectations and poses a substantial challenge to a central bank pursuing an inflation target. The distribution of outcomes for the path of future inflation has a fat right tail, revealing that only a small set of outcomes imply dire inflationary scenarios. Avoiding these scenarios, however, requires the fiscal authority to renege on some share of future promised transfers.