**_4.3.3 Fiscal response._** The fiscal responses in EMDEs differ between U.S. real, inflation, and reaction shocks, as shown in figure 6.<sup>12</sup> Inflation and especially reaction shocks to U.S. interest rates are followed by an improvement in the primary balance (smaller deficit or larger surplus; figure 6A). This comes despite some weakening of real GDP, in the case of reaction shocks, and comes about almost exclusively as a result of declines in government expenditure. Most likely, the tightening of the cost and availability of credit triggered by inflation and reaction shocks lead governments to cut spending. Real shocks are also associated with a significant increase in the primary balance, but this reflects a rise in government revenues in addition to a decrease in government expenditure. Finally, the tightening of fiscal policy in response to all three shocks leads to declines in government debt to GDP, although these are only statistically significant in the case of real shocks (figure 6B).

**_4.3.4 Composition of government debt._** As with the other variables examined in this paper, the composition of EMDE government debt responds differently to different U.S. interest rate shocks (figures 6C-6E). In the face of inflation and reaction shocks, the composition of government debt shifts in ways that suggest a tightening of credit markets. Inflation and reaction shocks are associated with a statistically significant decrease in debt held by external creditors, as well as an eventual rise in short-term debt. Inflation shocks lead to little change in foreign-currency debt, but this type of debt rises considerably following reaction shocks. This latter development likely reflects the depreciation in the exchange rate, which boosts the local-currency value of foreigncurrency debt.

Conversely, in response to a real shock, government debt held by external creditors as a share of total government debt rises significantly, consistent with a loosening of global credit markets. The share of foreign currency debt does not materially change for most of the estimation period, but the share of short-term government debt (with a maturity of one year or less) declines significantly. This may reflect active maturity extension by fiscal authorities to minimize rollover risk, and again suggests improved access to credit markets; it may also indicate the maturation, and nonreplacement, of this debt.

**4.4 Impacts on investment- and noninvestment-grade EMDEs.** In principle, one might expect more vulnerable economies to exhibit a more adverse response to higher U.S. interest rates than economies with stronger fundamentals. That should be especially true in the case of those shocks which tighten global financing conditions—i.e., reaction shocks. To assess this hypothesis, the analysis compares the response of investment-grade and noninvestment-grade EMDEs to U.S. reaction shocks. Economies were categorized according to the average foreign-currency long-term sovereign debt rating of Fitch Ratings, Moody’s, and Standard and Poor’s.

By and large, there was little evidence of important differences in the estimated effects of U.S. interest rate shocks on financial, economic and fiscal variables between investment- and noninvestment-grade EMDEs (figure 7). To be sure, noninvestment-grade EMDEs showed greater increases in EMBI+ spreads, 3-month yields, and 10-year yields than did investment-grade EMDEs, as one would expect, and in the latter case the difference was even statistically significant.

> 12 Unlike in the previous figures, we show responses over 8 quarters as it may take time for fiscal policies to adjust.

12