Unless emerging market governments reduce their dependence on foreign capital
inflows by borrowing in domestic currency or reducing borrowing altogether through
fiscal reform, fiscal sustainability remains subject to global liquidity shocks.
As debt problems have been at the centre of many recent crises in emerging
markets, debt sustainability analysis has become standard practice when assessing
macro economic policy. The Present Value Constraint (PVC), or Intertemporal
Budget Constraint (IBC) approach, is often used to assess fiscal sustainability in
empirical studies. Fiscal policy is deemed sustainable, when the continuation of past
policies would keep future debt accumulation under control. Since Hamilton and
Flavin (1986) the PVC, equivalent to the Non-Ponzi game, or transversality, condition
has been tested using time series econometrics in numerous studies (e.g. Hamilton and
Flavin, 1986, Hakkio and Rush, 1991, Trehan and Walsh, 1991, MacDonald, 1992,
Ahmed and Rogers, 1995, Quintos, 1995, Mendoza and Ostry, 2006 and Arghyrou
and Luintel, 2007). In particular, Trehan and Walsh (1991) is of interest in what
follows since they emphasize the relationship between primary surplus and debt.
However, Bohn (2007) provides a substantial challenge to the time series
literature on fiscal policy. Specifically, Bohn suggested that rejections of stationarity-
based sustainability tests are invalid because in an infinite sample, any order of
integration of debt is consistent with the transversality condition which implies that
intertemporal budget constraint is always satisfied. Instead, Bohn (2007) emphasizes
whether a country’s primary surplus responds positively to debt as an indicator of
sustainability. As in Bohn (1998) this depends upon the assumption that the series are
stationary. For them to be related in a statistical sense when they are nonstationary,
they must be of the same order of integration and primary surplus and debt must be
cointegrated. We seek to shed light on this issue for industrial and emerging market
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