Debt and Fiscal Commitment

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Debt and Fiscal Commitment

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Bibliographic details

• Authors: Francisco Roch
• Published: June 28, 2022

Overview

• Publication: F&D Magazine, Analytical Series.
• Author: FRANCISCO ROCH, economist in the IMF’s Research Department.
• Published on June 28, 2022.
• Central thesis: Credible commitment to fiscal policy materially improves the feasibility and welfare outcomes of deleveraging plans in economies facing sovereign-default risk.

Context and motivation

• COVID-19 triggered large fiscal stimulus programs in advanced and emerging market economies, pushing public debt to historically high levels and increasing default risks, tighter borrowing constraints, and a wave of debt downgrades—especially in emerging market economies.
• Deleveraging plans typically center on fiscal rules that constrain public spending; credibility of commitment is highlighted as critical to improve market access conditions (IMF Fiscal Monitor, October 2021).

Default risk (modeling framework and implications)

• The analysis builds on the Eaton and Gersovitz (1981) endogenous sovereign default model and extensions (Aguiar and Gopinath 2006) widely used for countries with default risk.
• Key mechanisms:
  • Debt dilution: issuance of new debt reduces the value of existing debt, creating incentives to overborrow.
  • Deficit bias: governments that cannot commit to future fiscal policies tend to allow deficits and public debt to increase.
  • Rational lenders demand higher spreads when anticipating higher future deficits and default risk, reducing governments’ current borrowing capacity.
• Model calibration targets the historical relationships among aggregate income, sovereign debt, and spreads: average sovereign debt and spread levels; countercyclicality of spreads; implied procyclicality of fiscal policy in emerging market economies.

Value of commitment (quantitative findings)

• Definition: A government with commitment carries out its announced fiscal plans; a government without commitment deviates and overborrows.
• Simulated comparative outcomes:
  • Transitioning from without to with commitment eliminates more than 80 percent of both the average level and the volatility of the spread.
  • Mean debt level is lower for the government with commitment, while the mean market value of debt claims is higher—indicating the committed government does not simply borrow less on average but borrows more cheaply.
• Deleveraging performance:
  • Implementing the optimal plan with commitment cuts in half the probability of default within 10 years of the consolidation episode’s start.
  • No simulated instance where a high-commitment government chooses to default or a low-commitment government chooses to repay.
  • High-commitment governments smooth the initial adjustment: choose slower deleveraging in the first year and faster debt reduction from the second year onward.
  • During the first six years of deleveraging:
  • Low-commitment government: starts with a median saving ratio of 5 percent that is eventually reduced to 3 percent.
  • High-commitment government: starts with a median saving ratio of about 3 percent that is reduced only slightly over time.
  • A constrained government (a noncommitted government subject to a prescribed path of debt ceilings, e.g., in an IMF-supported program) imposes excessive austerity relative to the optimal high-commitment plan and deleverages much faster.
  • The high-commitment government achieves a greater reduction in spreads than the constrained government.
  • Optimal deleveraging with debt limits achieves 60 percent of the welfare gains achieved by the optimal plan with high commitment.

Policy implications and recommendations

• Enhancing long-term fiscal discipline and credibility is quantitatively important to reduce sovereign risk and to increase the likelihood and welfare gains of successful deleveraging.
• Mechanisms to build and signal credibility include:
  • Clear communication and aligning private forecasts with official announcements.
  • Strong fiscal institutions, such as fiscal rules and fiscal councils.
  • A good track record on past fiscal performance.
  • Political will to adhere to announced fiscal plans.
• Practical lesson: Fixed debt-target paths (debt limits) can lead to excessive, poorly timed austerity and lower welfare gains compared with flexible, credible commitment to optimal borrowing paths that internalize debt dilution and sovereign-spread responses.

Evidence links to existing literature

• Empirical and theoretical consistency with prior findings:
  • David, Guajardo, and Yepez (2022): Successful fiscal consolidation episodes accompanied by IMF-supported programs and sovereign-spread improvements.
  • End and Hong (2022): Yields react more to fiscal consolidation announcements in countries with more credible fiscal reputations.
  • Aguiar and Gopinath (2006); Eaton and Gersovitz (1981): foundational models of defaultable debt and endogenous default risk.
• New contribution: Quantitative computation of optimal borrowing paths under default risk and the measurable value of credible commitment for deleveraging design (Hatchondo, Martinez, and Roch 2022).

Source: IMF F&D Magazine — "Debt and Fiscal Commitment" by Francisco Roch, published June 28, 2022.