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The authors are grateful to Adolfo Barajas, Mercedes Da Costa, Andrew Feltenstein, Ana Maria Jul, Mohsin S. Khan, Kalpana Kochhar, George Kopits, Timothy Lane, Miguel Messmacher, Saleh M. Nsouli, and Krislet Samphantharak (who was a INS summer intern during 2002), for their suggestions, discussions, and comments. Juan Carlos Flores provided excellent research assistance. Remaining errors are the responsibility of the authors.
Even in the case of a country running large fiscal deficits and expected to continue to do so for many years, solvency can be formally reinstated by assuming that very large budgetary corrections will take place some time in the distant future, without specifying the technical and political economy considerations that would make those adjustments feasible.
The classical reference is Hamilton and Flavin (1986), who tested whether the U.S. data supported the hypothesis that the transversality condition was met during the postwar years.
The difference between the fiscal sustainability indicator proposed in this paper and Blanchard’s will be discussed in detail in Appendix V.
The constant discount factor can be thought of as the weighted average of future real interest rates adjusted for growth. As will be shown in Section II.B, when βt+ivaries over time the expression for the intertemporal budget constraint becomes somewhat more complex than in equation (4). The formal derivation of the latter equation, with full account given to the domestic and external component of debt, is presented in Appendix III.
Obviously, the only way to fully address the issue of endogeneity is to specify sustainability within the framework of a general equilibrium model.
The IFS indicator aims at gauging sustainability without explicit reference to the time frame set by the authorities to achieve convergence to the target debt ratio. In Appendix IV, we present an alternative, but closely related indicator which takes explicitly into account the time dimention of fiscal sustainability. Also, for the sake of simplicity, we do not show explicitly the stochastic shocks associated with each of the variables affecting IFS. Indeed, the observed values of interest and growth rates, primary fiscal balance, and the debt ratio in the previous period can be thought of as comprising both a bechmark value and a shock specific to each variable. Thus, both the debt ratio resulting from equation (7) and the IFS indicator defined in equation (8) fluctuate over time due to changes in policy as well as shocks. IFS fluctuations due to small and temporary shocks do not matter from the sustainability viewpoint; it only matters the region (above or below 1) where IFS fluctuates.
In the same paper, Barro demonstrated that a competitive equilibrium would have to be in the efficient region where r>g(β*> 1) in a steady state.
A number of studies—Talvi and Vegh (2000), among others—propose algorithms based on structural rather than observed primary surplus ratios. But this procedure is difficult to apply because of the erratic nature of economic cycles in developing countries which makes it more difficult to predict them and to obtain reliable estimates of potential GDP. But aside from this technical difficulty, most would agree that a persistent deterioration of the primary surplus would lead to fiscal unsustainability, regardless of the sources behind the deterioration.
Detragiache and Spilimbergo (2001) found that the likelihood of a debt crisis or a debt correction rises when the debt ratio is above 40 percent. Pattillo, Poirson, and Ricci (2002) have found that, on average, debt ratios above 35-40 have a negative impact on growth. Our choices of d* for the countries in our sample are, in most cases, below the “danger” threshold level.
The results do not seem to be very sensitive to changes in the values of the parameter β*. In the case of the United States, for instance, if the value of β* were to increase from 1.006 to 1.01, the average value of IFS would increase from 0.962 to 0.970. Similarly, in the cases of Indonesia and Thailand, increases of β* from 1.03 to 1.04 would increase the average values of IFS from 1.612 to 1.625 and from 1.022 to 1.033, respectively.
Calvo, Izquierdo, and Talvi (2002) make the connection between fiscal sustainability and swings in the RER: .. unexpected stops in capital flows of a permanent nature can generate substantial swings in the RER, which may in turn lead to fiscal sustainability problems, particularly in relatively closed, highly indebted and dollarized emerging markets.” And, as the authors point out, the fact that often public sector debt is largely denominated in terms of tradables and government revenues comes mainly from nontradable activities leads to a larger increase in the observed debt ratio following a RER depreciation.
Most often, currency crises are preceded by a period of RER appreciation. In these circumstances, the IFS algorithm falls, signaling an apparent improvement in the country’s sustainability position. However, when the RER correction takes place, the algorithm will increase abruptly reflecting fiscal unsustainability. This seems to have been the pattern for a number of countries in our sample (Indonesia and Korea in 1998, Mexico in 1994, and Thailand in 1997) as shown in Figure 2, Appendix II.
In the case of the United States, the Granger causality runs both ways: from λ to β and vice versa.
The hierarchical method groups countries into clusters and smaller clusters into larger clusters, thus forming a “tree” (or dendrogram). This is obtained by a mathematical algorithm that minimizes a distance (or dissimilarity) function, given by: d(a, b) = [Na Nb/(Na + (Xg -Xb) ‘(Xa -Xb)i where Xa is the mean for cluster a with Na objects and Xt is the mean for cluster b with Nt objects (objects are countries or clusters). As the tree shows the combination of clusters (among all possible combinations) that have minimum distance (more homogeneous), it is a good guide to decide the level of clustering that one would like to choose (see Karson, 1982).
We also computed the IFS algorithm and its components for Argentina using the official quarterly data for the primary fiscal balance for the period 1994:4–2000:4. This series was kindly provided by the Argentine authorities (see Appendix II).
Although those shocks were clearly beyond the government’s control, fiscal policy continued to be expansionary in this period. As Mussa (2002), states “… the deficit never came in well below the target; generally it was just below or even slightly above the permitted limit. Indeed, during the five-year period from 1995 through 1998, the deficit of the Argentine government was within the quarterly limits prescribed at the beginning of each year under the IMF-supported program less than half of the time.”
This adjusted primary fiscal balance series was taken from Teijeiro (2001), who states that the official measure of the fiscal deficit during the 1990s was rigged to give an appearance of fiscal responsibility and inspire investors confidence. Some of the problems of the official data include: (a) failure to record expenditures paid with government bonds; (b) failure to register interest on the public debt that were capitalized; (c) recording income from privatizations as recurring revenues; and (d) treating many expenditures financed by the World Bank and the Inter-American Development Bank as off-budgetary items.
In the case of Korea, we should acknowledge that there was consensus among analysts on the fact that fiscal unsustainability was not an issue after 1997 despite the jump in the public debt ratio. The idea is that given the low initial level of Korea’s debt ratio, this ratio was still “outside the danger zone” even after the jump. However, in our opinion, since the “danger zone” would be known only imprecisely, it might not be a good practice to ignore debt growth until it reaches such a danger zone.