FINANCIAL CONDITIONS AND FISCAL PERFORMANCE IN EMERGING MARKETS

I. INTRODUCTION The global financial integration of emerging markets has further accelerated over the past decade, as underlined by marked increases in the size of capital flows to many of these countries and the magnitude of their external asset and liability positions (International Monetary Fund [IMF], 2005a). A rapidly growing literature has concentrated particularly on three broad areas of implications these trends have for emerging market economies. One important strand has examined the effects of increased financial openness for economic growth (e.g., Edwards, 2001; Henry, 2003). Another key area of interest has been the impact of rising capital flows on the development of the financial sector (e.g., Chinn and Ito, 2006; Mishkin, 2006). Finally, the potential implications for macro-economic volatility and the exposure to financial crises have been subject to several studies (e.g., Feldstein, 2003; Prasad et al., 2003). Less recognized, however, are the important fiscal implications of the further financial integration of emerging markets. The latest push in financial globalization has gone in tandem with a marked improvement in market access for emerging market governments (IMF, 2004, 2005b). This has helped emerging markets as a group sustain a substantial increase in their nominal public external debt burden over the 1990s and particularly since 2000 and an increase in the share of bonds in the debt stock to levels higher than ever in the past three decades (World Bank, 2005). These trends are clearly visible in Figure 1, which shows public external debt relative to gross domestic product (GDP) and the nominal amounts outstanding of the three constituencies of this debt for four regional groups of emerging markets (see Section III for the country composition). While debt-to-GDP ratios have declined, the larger nominal debt burden, and particularly the rising share of bond debt, increases emerging markets' exposure to external financial conditions. [FIGURE 1 OMITTED] Larger external financing, particularly direct borrowing from the financial markets, implies a rising pass-through from global financial conditions to emerging markets' public finances--for better or worse. Recently, it was mostly for the better: during the first half of this decade, financial conditions were extraordinarily benign, with a weak U.S. dollar and record-low global interest rates. The rapid narrowing of yield spreads on emerging market debt during this period may have been partly due to improved fundamentals and structural changes in emerging market debt (IMF, 2005b). However, there is empirical evidence that market conditions, namely abundant liquidity and high-risk appetite, were at least as influential as improved fundamentals (IMF, 2004). In this sense, also these spreads can be regarded as largely exogenous for many emerging markets. Despite the likely importance of the impact of external financial conditions on fiscal performance in emerging markets, there is no systematic evidence. This may be partly due to the lack of a consistent framework for the analysis of the effects of financial conditions on budgetary positions. Moreover, there may be a perception that the readily available data on emerging market government debt positions does not allow such an analysis. This article argues that headline fiscal performance can be seriously influenced by the effects of financial conditions and that ignoring these effects can entail misleading conclusions about the soundness of the underlying budgetary positions. It makes a methodological contribution by providing a consistent framework for the analysis of the effects of financial conditions on fiscal performance--adding to the toolkit of analysts of fiscal policy provided by the literature on the measurement of the fiscal deficit, for example, Blejer and Cheasty (1993)--and by demonstrating that the readily available data allow at least broad estimates of these effects for a large number of emerging markets. …