5. Economic Interpretation of Common Factors
In this section we seek to establish if the common factor of the fiscal reaction
functions can be linked to global liquidity. As an example, such contention would be
for example consistent with the Original Sin argument from Eichengreen and
Hausmann (1999) suggesting fiscal policy in emerging market economies is related to
developments in world capital markets: Emerging economies have difficulty issuing
debt in domestic currency, at fixed interest rates and in long maturities. Therefore
changes in world interest rates are expected to impact on their ability to conduct fiscal
policy.
Given that the common-factor is nonstationary we use the Johansen (1988,
2002) approach to test for cointegration.15 As a measure of global liquidity we use US
interest rate on 10 year US Treasury bonds. As global liquidity would impact debt
sustainability through debt service, we additionally study the relationship between the
factor and country level debt service data.
In Table 7 we obtain strong evidence of Johansen cointegration between the
fiscal reaction function factor and US interest rates, which suggests that changes in
world interest rates have an impact on their ability to conduct fiscal policy. We
believe this is a powerful result since we have identified that fiscal policy in emerging
market economies is conditional upon a common factor and this common factor can
be related to US interest rates. We furthermore find that US interest rates are
cointegrated with debt service in both industrialised and emerging market economies.
Evidence for emerging market economies is slightly stronger (see Appendices A1 and
A2). Figure A1 in the appendix further illustrate a close relationship between average
15 Gengenbach et al. (2006) also emphasizes a Johansen (1988) cointegrating approach when
examining global factors.
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