Sustainability of public debt, debt stabilisation, fiscal rules and debt growth nexus in developing world

Abstract

Public debt of Sri Lanka has risen swiftly over the last few decades with a large and persistent budget deficit. Posing severe macroeconomic consequences, Sri Lanka appears embroiled in an increasing debt overhang raising concerns over the sustainability of public debt and fiscal policy. This thesis comprises of three standalone chapters seeking to determine the sustainability of public debt and fiscal policy, the transmission mechanism of debt stabilisation measures in the Sri Lankan economy, while quantifying the causality effect of public debt on economic growth within the sphere of developing Asia. Chapter 2 investigates the sustainability of Sri Lanka's fiscal imbalance and public debt. To test for sustainability of the fiscal imbalance, the study applies a symmetric Autoregressive Distributed Lag technique to estimate a government intertemporal budget constraint. To test for sustainability of public debt, it applies an asymmetric ARDL technique to estimate a fiscal reaction function, which allows for differential responses in the budget balance depending on whether shocks to regressors are positive or negative. The results indicate that Sri Lanka's fiscal management is inconsistent with strong form sustainability, which requires that expenditures not grow faster than revenues. The estimation of the fiscal reaction function finds robust evidence for fiscal policy asymmetries. Evidence emerges that Sri Lanka's fiscal policy stance is procyclical. Against upsurges in the debt-to-GDP ratio, authorities are found to pursue fiscal consolidation, thus suggesting weak form sustainability. Chapter 3 examines macroeconomic implications of debt stabilisation fiscal rules in Sri Lanka using a calibrated Dynamic Stochastic General Equilibrium model with heterogeneous agents and many market frictions. The transmission mechanism involves many debt stabilisation fiscal policy configurations vis-a-vis spending- and revenue- based consolidation measures. The findings reveal that the transmission of debt stabilisation policy shocks on heterogeneous agents and macro variables are polarised, but convincing in the Sri Lankan economic context. Evidence emerges that the revenue-based debt stabilisation is more contractionary than the spending-based debt stabilisation and results in more episodes of economic recession. The chapter finds that the dynamic responses of macro variables are more sensitive to consumer tax shocks than labour and capital tax shocks and consumer tax is conducive to stabilising public debt; but spending cuts seem less costly in terms of welfare losses of heterogeneous agents. The results indicate that existing tax policies require revision as there is a leeway for Sri Lankan fiscal authorities to raise taxes, as the prevailing rates are below the tax rates that generate maximum tax revenue. Chapter 4 examines the causal effect of public debt on economic growth within the sphere of developing Asia over the last two decades using an Instrumental Variable (IV) approach. The debt-to-GDP ratio is instrumented with a class of IVs to address the potential endogeneity bias in symmetric and asymmetric statistical modelling of the debt-growth nexus. The class of IVs includes a shock index, which captures the impact of variability of exchange rate on debt-to-GDP ratio and a binary variable that determines the partial cancellation of countries' debt levels via debt forgiveness or reduction. The class of IVs holds merits of no direct causation on growth apart from the indirect route via debt. The estimations show that the IVs have strong first-stage identification strength. The consistent estimations of the IV approach provide robust evidence for detrimental impact of debt on growth. The kinked constrained IV General Method of Moment (IV-GMM) estimator finds a statistically significant debt threshold that ranges in between 30-60 percent of GDP, beyond which the economic growth falls swiftly.