Debt spikes, blind spots, and financial stress

• Published date: 01 October 2017
• Author: Laura Jaramillo,Joao Tovar Jalles,Carlos Mulas‐Granados
• DOI: http://doi.org/10.1002/ijfe.1598
• Date: 01 October 2017

RESEARCH ARTICLE

Debt spikes, blind spots, and financial stress*

Laura Jaramillo

1

| Carlos Mulas‐Granados

2

| Joao Tovar Jalles

3

1

Deputy Division Chief, Fiscal Affairs

Department, International Monetary Fund

2

Senior Economist, Fiscal Affairs

Department, International Monetary Fund

3

Economist, Fiscal Affairs Department,

International Monetary Fund

Correspondence

Carlos Mulas‐Granados, Senior

Economist, Fiscal Affairs Department,

International Monetary Fund, 700 19th

street NW, 20431 Washington DC.

Email: cmulasgranados@imf.org

JEL Codes: H60; H63

Abstract

Are blind spots of public debt spikes sizable? And how do they affect financial

stress indicators? This paper tackles these questions empirically, using informa-

tion from 179 episodes of public debt spikes between 1945 and 2014. We find that

large public debt spikes are neither driven by high primary deficits nor by output

declines but instead by stock‐flow adjustments. These blind spots in debt

dynamics are sizable in both advanced economies and emerging markets and

could amount to more than 20% of gross domestic product in the median epi-

sode. These public debt spikes increase financial stress indicators significantly,

in particular when a large share of public debt is held by domestic commercial

banks. Enhanced transparency and better debt forecasting tools could help

address financial market tensions resulting from blind spots in debt dynamics.

KEYWORDS

bind spots, debt spikes,financial markets, financial stress,public debt, stock‐flow adjustment

1|INTRODUCTION

Recent levels of public debt in advanced economies are

above those observed at the time of the Great Depression

and only slightly below the level registered in the after-

math of World War II. Emerging market economies also

suffered from increases in public debt since the beginning

of the Global Financial Crisis (Figure 1). This constant

growth in public debt stocks has been the result of numer-

ous episodes of debt spikes, after which countries have

been unable to bring back their debt levels to lower

grounds.

Using the historical debt database of the International

Monetary Fund (IMF; 1945–2014), we identify 179

episodes of public debt spikes in 90 countries, defined as

multiyear periods in which the debt‐to‐gross‐domestic‐

product (GDP) ratio increased by at least 10 percentage

points of GDP.

Surprisingly, increases in public debt were not driven

by large primary deficits. Figure 2 illustrates this point

for both advanced and developing (i.e., emerging and

low‐income) countries, by contrasting the increase in

debt‐to‐GDP and cumulative primary deficits during three

selected historical periods. During 1973–1987, debt

increased by about 30 percentage points, but cumulative

primary deficits amounted to less than 1½% of GDP.

During 1988–2007 public debt decreased by about 5% of

GDP, whereas cumulative primary surpluses reached

almost 34% of GDP. During 2008–2015, public debt again

increased almost 16 percentage points, although cumula-

tive primary deficits amounted to only 8½% of GDP.

The biggest driver of public debt spikes is not primary

deficits, nor output, nor interest payments. Instead, the

main driver is large stock‐flow adjustments (SFAs), the

residual term in a traditional debt decomposition exercise.

These SFAs can be consideredas blind spots in public debt

dynamics because they cannot be properly modelled or

accurately forecasted (Jaramillo, Kimani, & Mulas‐

*

We would like to thank Ben Clements, Julio Escolano, Vitor Gaspar,

Juergen Von Hagen, and participants in the Fiscal Affairs Department

Seminar at the IMF and the A Dynamic Economic and Monetary Union

conference on Fiscal Risks at the University of Bonn for their valuable

comments. Elijah Kimani provided excellent research assistance. All

remaining errors are ours. The views expressed in this paper are those

of the authors and do not necessarily reflect those of the IMF, its Execu-

tive Board, or IMF management.

Received: 11 November 2016 Revised: 5 August 2017 Accepted: 23 September 2017

DOI: 10.1002/ijfe.1598

Int J Fin Econ. 2017;22:421–437. Copyright © 2017 John Wiley & Sons, Ltd.wileyonlinelibrary.com/journal/ijfe 421

Granados, 2016). Moreover, they are typically associated

with a lack of transparencyin fiscal accounts (Weber, 2012).

Our first question is, therefore, “Are these blind spots

of public debt spikes sizable?”The answer is yes. For the

median episode among advanced economies, public debt

increased by 25% of GDP whereas SFA increased by 20%

of GDP. For the median episode among developing econ-

omies, debt increased 24% of GDP whereas SFA increased

by 30% of GDP.

In addition, we are concerned with the reaction of

financial markets to these types of public debt spikes,

because their effects are potentially disruptive. In princi-

ple, public debt stocks can affect financial stability

through several channels.

1

If debt is too high, the

sovereign's credibility becomes less ensured in the eyes

of international investors, which could result in higher

volatility caused by difficulties in refinancing government

debt, which in turn could trigger wider financial instabil-

ity. Also, a higher stock of public debt entails a higher

probability of affecting the prices of financial assets, corre-

spondingly influencing the soundness of the overall finan-

cial sector balance sheet, and leading financial markets to

react very negatively. A good example in this respect is the

2010 Euro area crisis, when financial markets reacted very

negatively to growing public debt levels in Greece and

other peripheral European countries. Our second

question is therefore “what has been the impact of these

episodes of public debt spikes on financial stress indica-

tors?”Our empirical results clearly show that public debt

spikes provoke financial markets'distress. As Figure 3

illustrates, financial stress increases when a public debt

spike episode occurs, especially in advanced economies.

The financial indicators that suffer more from public debt

spikes are stock returns and their volatility. The negative

impact of debt spikes on financial markets is particularly

significant when a large share of public debt is held by

domestic commercial banks.

The remainder of the paper is structured as follows:

Section 2 reviews the scarce literature in this field, and

Section 3 presents the data and the criteria to select debt

spike episodes. Section 4 performs debt decomposition of

the 179 episodes in our cross‐country sample. Section 5

looks into the reaction of financial markets using both

static and dynamic approaches. Section 6 summarizes

the main findings of the paper and concludes.

2|LITERATURE REVIEW

Many public finance scholars have explored the drivers of

debt increases, but the analysis of blind spots in debt

FIGURE 1 Public debt, 1880–2015 (percent of GDP). The chart above uses weighted averages. Source: Fiscal Affairs Department (FAD)

Historical Public Debt Database and IMF Fiscal Monitor [Colour figure can be viewed at wileyonlinelibrary.com]

FIGURE 2 Advanced and developing countries: Changes in

general government debt to GDP and cumulative primary deficits,

1973–2015 (percent of GDP). Each sub‐period shows the averages

across advanced and developing countries for which data is

available. Source: FAD Historical Public Debt Database, Mauro,

Romeu, Binder, and Asad (2013), IMF Fiscal Monitor, and authors'

estimates [Colour figure can be viewed at wileyonlinelibrary.com]

422 JARAMILLO ET AL.