The Global Dimension to Fiscal Sustainability

Since 2002, there has been a surge in global liquidity which has led to an
unprecedented compression in emerging market spreads. Amongst others, Hauner and
Kumar (2006) link recent improvements in fiscal sustainability in emerging markets
to this surge in global liquidity, allowing reduced debt financing. The nonstationarity
of this factor implies that the recent rise in global interest rates shows that higher
interest rates may soon again lead to a deterioration of fiscal sustainability in these
countries. A common factor driving global liquidity would also be in line with the
Sudden Stop literature (Reinhart and Calvo, 1999), which was motivated by the fact
that after the Russian Crisis, most emerging market economies faced a sharp and
general decline in capital flows. In the next section we empirically examine the role
that global liquidity plays in determining fiscal sustainability.

The size of the coefficient ρ in the fiscal reaction function (6) suggests that
there is an equivalent response of the primary surplus to an increase in debt in both
industrial countries and emerging market economies. However, as pointed out by
Bohn (2007) the size of ρ, which determines by how much the primary surplus
increases in response to an increase in debt, may be of different consequence for
different countries. Despite a positive fiscal response, countries where the fiscal
response exceeds debt service are more sustainable than countries with a fiscal
response short of debt service. As such, countries where a larger proportion of
government spending is debt service payments may need to respond more
substantively to the level of debt, as solvency concerns from private agents may arise
more readily. In our sample, in 2005 the debt service of emerging market economies
was on average about 65% higher than those of industrial countries, but average debt
was about the same (60% in terms of GDP), as such, a similar fiscal response
indicates that emerging market economies are less sustainable.

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