Analyzing the Sustainability of Fiscal Deficits in Developing Countries

Abstract

Two approaches to analyzing the sustainability of fiscal deficits in developing countries. Cuddington surveys the recent literature on the sustainability of fiscal deficits, most of which focuses on the United States and other industrial countries, to see how useful it might be in developing countries.

The accounting approach to analysis focuses on steady states and assumes that a fiscal deficit (or surplus) that leads to unchanging debt/GDP ratios over time is sustainable. The data required to apply this approach are relatively modest.

The present-value constraint (PVC) approach assumes that the sustainability of fiscal policy depends ultimately on what level of fiscal deficit is financeable, which depends in turn of the behavior of lenders. Recent empirical implementations of this approach concentrate on methods for testing whether maintaining current fiscal policy (as captured by historical time series on government spending, revenue, and debt) violates the present-value-constraint or, equivalently, the no-Ponzi-game (NPG) condition. The econometric methods used in this literature (such as tests for the presence of unit roots and cointegration) require long-time series over a constant fiscal regime, requirements that may be unrealistic in many countries.

Typically, analyzing the sustainability of deficits in developing countries involves issues that are not particularly important in industrial countries. Developing countries rely far more on seignorage to finance deficits, although the degree of that reliance varies greatly among countries; the simultaneous presence of both domestic and foreign-currency borrowing is central in a growing number of developing countries; and concessional lending and grants may also be an important part of fiscal finance.

Cuddington generalizes the PVC approach to economies that use money-financing of deficits, economies for which concessional financing is available, and economies that incur both domestic and foreign debt.

He proposes a possible compromise in approaches: Rather than use time series techniques to describe constant fiscal regimes, one can specify fiscal rules into the foreseeable future based on country-specific information about fiscal targets (perhaps as stated in IMF stabilization programs). Then one can calculate the implied time path for domestic and foreign debt, given current debt levels as initial conditions. Using this hypothesized time path for debt, one can ask whether it satisfies the no-Ponzi-game condition. If it does, fiscal policy is - by this definition - sustainable. If the NPG condition is violated, fiscal policy is unsustainable. This paper - a product of the International Finance Division, International Economics Department - is part of a larger effort in the department to analyze the impact of public debt on the sustainability of developing countries' macroeconomic policies.