2019 Joint Research Program
XXIV Meeting of the Central Bank Researchers Network

Fiscal Policy: Fiscal Sustainability and Proposals for Institutional Change

Santiago Bazdresch
Santiago García-Verdú


The Center for Latin American Monetary Studies’ (CEMLA) Board of Governors created the Joint Research Program with the dual aim of promoting the exchange of knowledge among researchers from Latin American and Caribbean central banks and of providing insights on topics that are of common interest to the region. Annually, the Central Bank Researchers Network chooses a subject to study among its members. The collection of papers in the Joint Research Program contains research by researchers from CEMLA’s associates and collaborating members. It is published as a working paper series to encourage debate among the central bank and academic community. The views expressed in the Joint Research Program are those of the author(s) and do not necessarily represent the views of their central banks, CEMLA’s Board of Governors, or CEMLA’s Staff. Previous volumes are available at https://www.cemla.org/jointresearch.html.

This electronic volume compiles 10 articles written on the topic of public debt sustainability as part of CEMLA’s 2019 Joint Research Program. The papers confront the fiscal sustainability issue using different methodologies in order to answer a number of specific questions and describe the recent history of debt and public finance for many of the member economies up until 2019. The compilation of statistics, the application of different methodologies, and the description of different institutional setups and their process of reform over time, paint a detailed and useful picture of the pre-Covid-19 evolution of debt and primary budget levels in Latin American economies. It serves as a starting point for academics and policymakers to think about these issues in the post-pandemic period. In this introduction, we describe the importance of this topic, the main methodologies used in this literature, and how they have been applied in the articles included. We also reflect on the analysis and policy challenges that remain and speculate on how to address them. In the face of the Covid-19 pandemic and the resulting public deficit increases and GDP declines during 2020, beyond serving the general purpose of furthering the analysis of public finance and debt sustainability, this project and book turn out to be highly prescient given the circumstances.

Santiago Bazdresch and Santiago García-Verdú

Debt limit and fiscal space for some Latin American Economies
Ignacio Lozano-Espitia and J. Manuel Julio-Román
Published version in the Latin American Journal of Central Banking 1, Volume 1, Issues 1–4, 2020, 100006


This paper provides evidence on the debt limits and fiscal space for some Latin American emerging economies under the fiscal fatigue approach (Ghosh et al., 2013). We propose the spline technique to estimate each government's reaction function and the sovereign risk premium endogenous to the country's indebtedness. Estimates were made with an unbalanced panel of 13 economies—six from Latin America—for the period 1980–2018. The results vary importantly across the countries. They suggest, for instance, that the Colombian public debt limit would be close to 68% of GDP and that the fiscal space—the gap between the current debt level and the estimated debt limit—would reach 16 percentage points. Among the other Latin American economies, Peru and Chile have the largest fiscal space (50% and 39%, respectively), while Ecuador has the lowest (13%). The findings for Mexico look like those of Colombia.

Assessing public debt sustainability for Costa Rica using the fiscal reaction function
Valerie Lankester-Campos, Kerry Loaiza-Marín, and Carlos Monge-Badilla
Published version in the Latin American Journal of Central Banking 1, Volume 1, Issues 1–4, 2020, 100014


This paper assesses Costa Rica's public debt sustainability empirically using three complementary approaches: the calculation of the debt-stabilizing primary fiscal balance obtained from the government's intertemporal budget constraint, the estimation of the parameters of a fiscal policy reaction function (FRF) following the methodology originally proposed by proposed by Bohn (2007); and the estimation of fan charts for the primary fiscal balance and public debt expressed as shares of GDP following the approach proposed by Celasun et al. (2006). With annual data from the period 1974–2018, we find that debt has been unsustainable for specific long- and short-term episodes. For the most recent observations, the conclusion is that debt trajectory is unsustainable. Given that a major fiscal reform was approved at the end of 2018, an uncertainty evaluation of its impact on the primary balance's adjustment path until 2023 and 2030 is included using the official estimated reform projections. The results indicate that the maximum level of the debt ratio will be 68% in 2026, after which this upward trend reverses.

Fiscal Sustainability in Uruguay: A Balance Sheet Dynamics Approach
Alejandro Aquino, Verónica España, Rosanna Fernández, and Leonardo Vicente


In this paper we evaluate fiscal sustainability beyond the Debt Sustainability Analysis methodology, analyzing the balance sheet dynamics of the consolidated public sector (not just gross debt) and using a more comprehensive data set in institutional coverage (not just central government), debt structure (not only debt level matters) and higher frequency (quarterly) data. We first perform an historical analysis for Uruguay, highlighting important events of debt dynamics and finding the mains strengths and weaknesses of public finances over the last 30 years. Then, we conduct a prospective analysis, where fiscal variables are determined within a macroeconometric model, including an empirical fiscal reaction function. In this context, we simulate different debt paths as a result of macroeconomic scenarios, as well as public finances policy decisions, in a medium-term outlook. We find that the main debt dynamic drivers come from the fiscal-financing perspective (i.e., interest payments, primary deficit, and monetary base) and the macroeconomic framework (i.e., inflation, currency depreciation, and real GDP growth).

Debt Sustainability and Monetary Policy Attainment in EMEs
Manuel Ramos-Francia, Santiago García-Verdú, and Manuel Sánchez-Martínez


We explore the link between debt sustainability and monetary policy attainment in a set of EMEs. To that end, we consider how the primary balance responds to changes in debt. We first estimate a set of panel data regressions using different controls, in which we group the economies depending if their average inflations are above or below a threshold. We divide the EMEs depending if they have had a currency, banking, external or internal debt crisis. In general, we find that EMEs with a shoddier inflation record or those that have had one or more of the mentioned crisis episodes, have primary balance that reacts more markedly to changes in the debt level. In addition, their primary balances depend negatively on the inflationary component, and depend positively on their current accounts, reflecting the twin-deficit phenomena. As a corollary, those groups that have had a better macroeconomic record could have higher sustainable levels of debt in the long-term. Nonetheless, this does not mean that those EMEs with a better record will opt for having higher debt levels.

Fiscal Sustainability: The Case for Jamaica
Prudence Serju-Thomas
Published version in the Latin American Journal of Central Banking 1, Volume 1, Issues 1–4, 2020, 100018


The paper assesses the sustainability of fiscal policy in Jamaica alongside a large public debt stock, albeit falling, in the context of an economic reform program. In addition, the paper examines the risks associated with the large public debt stock. Fiscal reaction functions are used to assess fiscal sustainability via an OLS, VAR, GMM and VECM models while the vulnerability of the public debt stock is evaluated using the IMF debt sustainability analysis (DSA) framework through shocks to real GDP, primary balance, interest rate, real exchange rate, and a combined shock. After the implementation of the country's economic reform program, the results show that fiscal policy in Jamaica is on a path to attain sustainability. However, after adjusting the sample to exclude the economic reform period, the findings show that fiscal policy in Jamaica is unsustainability. Further, the results indicate that in the long run a primary surplus of 4.8 per cent of GDP would be required to achieve a public debt-to-GDP ratio of 60 percent. The risk assessment of the public debt reveals that Jamaica's debt is most vulnerable to sharp exchange rate depreciations and that the overall risk to the public debt stock is high. Of note, the DSA results should be interpreted in the context within which the framework is created in that it does not account for all dynamics within the economy and therefore may overstate the extend of the impact. In light of the results and given that foreign currency debt accounts for approximately 60 percent of the public debt stock, it is critical to rebalance the debt portfolio in favour of domestic debt.

Debt Sustainability in Guatemala: Institutional Arrangement and Quantitative Analysis
Juan Catalán-Herrera


This paper assesses debt sustainability for Guatemala. Debt stability has been achieved at very low expenditure levels, at the expense of adequate provisioning of public goods and services and a widening gap in social development and infrastructure. Since fiscal outcomes are not independent from fiscal policy arrangements and procedures, the paper also sets forth a hypothesis of possible institutional arrangements that have allowed for the containment of fiscal deficits for over 20 years. This paper argues that embedded in the legal framework and institutional arrangement, there is an “implicit” fiscal rule that favors stability. The paper explores characteristics of how fiscal policy is conducted, showing that government expenditures are pro-cyclical, providing room for improvement in its business cycle management. Fiscal policy has been mainly concerned with stability rather than other possible goals like improving long-run growth, attenuating business cycles, improving human development indicators, and dealing with redistribution issues, among other goals that fiscal policy could pursue.

Natural Limit of the Public Debt of El Salvador and Its Relationship with Fiscal Sustainability
César Alvarado and Gabriela Viera


The increase in public debt and the limited availability of monetary policy instruments in El Salvador raise uncertainty about its fiscal sustainability. In response, since 2016, the Fiscal Responsibility Law (FRL) defined a set of fiscal rules that must be complied with in the medium term. However, Salvadoran public finances’ structural characteristics and the economy’s exposure to internal and external shocks endanger their compliance, analyzing the vulnerability to default on the sovereign debt necessary. This document calculates the natural limit of the public debt (NDL) of El Salvador by applying the methodology developed by Mendoza and Oviedo (2004, 2006), using information from the period 2001-2018. Our results show that, in a fiscal crisis scenario consisting of a reduction of tax revenues by three points of the Gross Domestic Product (GDP) and a reduction of public spending by half, the Government would pay a maximum public debt of 71.0 % GDP. Likewise, in the absence of a fiscal crisis, there is a probability of 0.64 that the public debt exceeds the NDL in the medium term, presenting challenges for public finances to comply with the FRL provisions. We recommend tackling tax evasion and the creation of progressive taxes, such as wealth and property taxes. If applied to taxpayers of higher income and wealth, it would not significantly harm the economy’s growth as a whole.

Fiscal Rules as Alternatives for the Design of Fiscal Policy: The Case for Central America and the Dominican Republic
Raul Ovalle, Francisco Ramírez, and Henry Rosario


The presence of deficit bias of fiscal policy has generated a debate about the feasibility of adopting fiscal rules in order to mitigate it. Economies of Central America and the Dominican Republic (hereafter CARD economies) do not escape from this reality: since the last decade they are running fiscal deficits on the base of discretionary policies, jeopardizing fiscal sustainability and macroeconomic fundamentals. In this paper, we explore how fiscal rules can contribute to macroeconomic stability, and reduce volatility in macroeconomic variables when compared with discretionary behavior followed by the authorities. Using a small open economy RBC model calibrated for the above-mentioned economies, we ranked discretionary fiscal policy and fiscal rules using a welfare measure. Results point out that debt-goal rules based on adjustment of taxes, as well spending goals relative to output reduce macroeconomic volatility relative the discretionary case. This suggests that there is room for the improvement of the current framework of fiscal policy toward one that leads to less macroeconomic volatility. However, it is important to remark that the benefits from adopting a fiscal rule are conditional to a credible commitment from the authorities, with dynamic consistency of the fiscal regime.

Fiscal Sustainability Assessment for Suriname 1978-2017. A Fiscal Reaction Function Approach
Albert Mungroo and Peggy Tjon Kie Sim-Balker


High and unsustainable public debt is an economic problem at the center of many emerging and developing economies. This paper investigates, for the 1978- 2017 period, how Surinamese Governments reacted to changes in public debt and assesses if fiscal policy was sustainable. Therefore, we estimate a fiscal reaction function by using the following econometric techniques OLS, VAR, TAR, GMM, and VECM. The results show a positive and statistically significant, but weak, relationship between the primary balance and total debt, indicating that governments do react to debt-increases by improving the primary balance. The exercise shows that fiscal policy is sustainable. However, we find that this was not a result of appropriate fiscal policy. While factors outside of the Government’s control worsened the primary balance through declining revenues, the fiscal policy did not react swiftly by adjusting expenditures, which led to an increase in inflation.

Effects of Fiscal Policy Shocks in Nicaragua: Evidence from a SVAR Analysis
Mario Alberto Araúz Torres and Néstor Adolfo Torres Betanco


In the past few years, the economic performance of Nicaragua demonstrated dynamism. Nonetheless, the Nicaraguan Institute of Social Security (INSS) went into a deficit position. The government implemented major fiscal reforms, which in turn triggered widespread protests, social instability, and an economic downturn. Consequently, tax revenues fell dramatically, revealing the recessive process in which the country’s public finances underwent. To surmount this situation, the government has taken major policy measures, including public spending adjustments, tax policy changes, and new amendments to social security. Employing principles drawn from fiscal policy insights, this research aims at providing evidence, in the case of Nicaragua, on the effects fiscal policy shocks have on output. It uses a structural vector autoregressive (SVAR) model, with quarterly data for 2006Q1-2020Q1. Results are analyzed and quantified through impulse-response functions, suggesting that under the current context, the implementation of fiscal policy changes is subject to internal and external factors that may hinder accomplishment of policy goals.