Fiscal procyclicality in emerging markets: The role of institutions and economic conditions

• Date: 01 August 2020
• Author: Michael Hutchison,U. Michael Bergman
• DOI: http://doi.org/10.1111/infi.12375
• Published date: 01 August 2020

International Finance. 2020;23:196–214.wileyonlinelibrary.com/journal/infi196

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© 2020 John Wiley & Sons Ltd.

DOI: 10.1111/infi.12375

ORIGINAL ARTICLE

Fiscal procyclicality in emerging markets: The

role of institutions and economic conditions

U. Michael Bergman

1

|Michael Hutchison

2

1

Institute of Economics, University of

Copenhagen, Copenhagen, Denmark

2

Department of Economics, E2, University

of California, Santa Cruz, Santa Cruz,

California

Correspondence

Michael Hutchison, Department of

Economics, E2, University of California,

Santa Cruz, Santa Cruz, CA 95064.

Email: hutch@ucsc.edu

Abstract

Procyclicality of fiscal policy is a common feature in

emerging markets, by contrast with high‐income

economies, and leads to greater business‐cycle am-

plitudes. We investigate potential causes of fiscal

procyclicality, including a host of economic and in-

stitutional variables of especial import in emerging

markets. We employ dynamic panel methods in a

large sample of countries to investigate what factors

are associated with fiscal cyclicality. We find that

fiscal procyclicality is mainly due to procyclical

fluctuations in government investment expenditure.

In addition, we find that procyclical fiscal policy is

positively associated with government debt levels,

terms‐of‐trade volatility, and costs of foreign bor-

rowing, while negatively associated with better gov-

ernment efficiency. Only a weak association is found

between International Monetary Fund program

participation and fiscal procyclicality. Finally, we find

that certain fiscal rules are associated with lower

fiscal procyclicality and, in particular, balanced‐

budget rules may help mitigate the adverse cyclicality

effects of high terms‐of‐trade volatility and govern-

ment debt burdens in emerging markets.

KEYWORDS

fiscal cyclicality, fiscal rules

JEL CLASSIFICATION

E32; E62; H5

1|INTRODUCTION

Fiscal policy is generally more procyclical in emerging markets than in high‐income economies,

a stylized fact well‐documented over time by Gavin and Perotti (1997), Tornell and Lane (1999),

Lane (2003), Kaminsky, Reinhart, and Vegh (2005), Talvi and Vegh (2005), Mendoza and

Oviedo (2006), Alesina, Campante, and Tabellini (2008), Ilzetzki and Vegh (2008), Bergman and

Hutchison (2015), and others. Procyclical fiscal policy is problematic for a number of reasons,

including its contribution to greater business cycle volatility (Lane, 2003).

1

A number of

institutional and economic factors likely influence the cyclicality of fiscal policy (Calderón,

Duncan, & Schmidt‐Hebbel, 2012; Eyraud, Debrun, Hodge, Liedό, & Pattillo, 2018; Frankel,

Vegh, & Vuletin, 2013; IMF, 2009). In general, however, relatively little work has systemically

explored a broad range of economic and institutional characteristics that generate fiscal policy

cyclicality in emerging markets.

This paper investigates the causes of fiscal procyclicality in emerging markets, with parti-

cular focus on the common factors often facing this group of countries and suggested by the

literature—volatile commodity prices, increasing costs of sovereign borrowing during volatile

periods, market sensitive to foreign debt levels, participation in International Monetary

Fund (IMF) programs, natural‐resource dependence, frequently weak government bureau-

cracies, and so on. We also measure the types of government spending (consumption and

investment) mainly contributing to cyclicality. And we also consider the effects of two types of

fiscal rules—balance budget rules (BBR) and debt rules (DR)—on fiscal cyclicality, examining

whether they influence procyclicality directly or indirectly by mitigating other channels that

contribute to policy procyclicality. We address these issues using a dynamic panel fixed‐effects

framework for a large number of emerging markets and, for purposes of comparison, high‐

income economies.

Section 2briefly reviews the literature and discusses likely causes of fiscal cyclicality in emer-

ging markets. Section 3presents the empirical model and methodology. Section 4presents the data.

Section 5presents the empirical results and Section 6concludes. Overall, we find that high pro-

cyclicality in emerging markets is associated with a number of identifiable economic and institu-

tional characteristics. Well‐designed fiscal rules may also mitigate fiscal procyclicality.

2|MOTIVATION AND LITERATURE

A number of economic and institutional factors are likely contributors to fiscal cyclicality in

emerging markets. We address a number of leading candidates suggested in the extant literature

—three economic variables, three institutional factors and fiscal rules. The three economic

factors investigated are:

•Volatility in the terms‐of‐trade generally leads to volatility and transitory movements in real

income, government revenues, and hence fiscal procyclicality. Chile is a good example of an

1

Lane (2003) finds empirical evidence suggesting that emerging markets have experienced much more volatile output

and income fluctuations than high‐income economies, and that these fluctuations have been further exacerbated by

procyclical policies. He argues that institutional reforms in the conduct of monetary and fiscal policies can improve the

capacity to stabilize cyclical fluctuations; and while monetary institutional reforms, namely inflation targeting (IT), is

now widely accepted, relatively less progress has been made in designing and implementing new fiscal procedures.

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