economies in a panel context. In particular, we avoid difficulties in our panel, with
nonstationary common factors leading to a spurious regression problem, by adopting a
principal components approach (see Bai, Kao and Ng, 2007). However, if these
principal components are nonstationary they break the link, emphasized by Bohn
(2007), between primary surplus and debt and hence suggest fiscal policy may have
other preoccupations.
The main focus of our work is on fiscal sustainability issues in emerging
market countries and for this purpose we exploit a panel data set for 27 emerging
markets over the period 1990 and 2005. We also analyze debt sustainability for 15
industrial countries for a longer sample spanning the period of 1978 and 2005 (the
longer data period is not available for the emerging market countries). We see the
industrial country panels as providing a ‘control’ set of results by which the emerging
market results may be compared and which are not susceptible to small T. Our results
may be summarised as follows. For our emerging market economies, we find that a
global factor is the key to explaining fiscal sustainability, and we find that this factor
is nonstationary and can be identified as a global liquidity effect: while a surge in
capital inflows eases public sector financing constraints, a sudden stop increases the
cost of external financing and debt service. The nonstationarity of this factor would
seem to be bad news for policy makers in emerging markets: while fiscal positions
have greatly improved with the recent surge in global liquidity, and new global credit
crunch could bring a rapid deterioration of public finances. We also uncover this
global factor in the fiscal response of industrial countries, however there is are marked
difference: while a global liquidity shock affects the fiscal response of industrialized
countries, it neither dominates nor takes away industrialised countries’ ability to