perceived as a source of vulnerability. Recent empirical evidence suggests that debt levels above 30-50 percent of GDP may not be sustainable in emerging markets.<sup>3</sup> 5. Against this background, a few considerations are noteworthy:

- Fiscal stance has responded swiftly to changes in the macroeconomic environment. The consolidated primary surplus -- including the central and sub-national levels of government -- has been raised over time to keep the debt-to-GDP ratio on a sustainable path (Figure 1).<sup>4</sup> This has been the case even in periods of economic slowdown, making fiscal stance less counter-cyclical than desirable. Concern about the sustainability of public indebtedness calls for corrective action even in periods of below-potential growth, making fiscal consolidation, rather than short-term demand management, the overriding objective of fiscal policymaking in indebted countries.<sup>5</sup> In fact, the OECD experience shows that a pro-cyclical fiscal stance is not uncommon in industrial countries, particularly when retrenchment is implemented to restore fiscal sustainability against a backdrop of high, or rising, indebtedness.<sup>6</sup>

- 3 . The argument is that a typical emerging market may not be able to repay and re-finance its debt obligations due to its lower revenue ratio, its more volatile tax bases and its higher, more volatile spending on debt service. Budget financing is also affected by supply-side constraints in emerging markets, given their imperfect access to international capital markets and shallow domestic financial markets. Many emerging markets also face more “debt intolerance” than more mature economies in the sense that credit rating are often worse in some countries for the same level of indebtedness, reflecting individual countries’ record in external debt repayment and macroeconomic stability. Reinhart _et al._ (2003) show that external debt intolerance is a good predictor of domestic debt default.

- 4 . See de Mello (2006), for the estimation of a fiscal reaction function for Brazil. However, policy reactivity tends to be stronger in more mature economies. Recent research suggests that primary balances tend to have lower sensitivity to indebtedness in emerging markets than in industrial countries, controlling for other determinants of fiscal stance. This sensitivity is also affected by the level of indebtedness: it is estimated to be lower in emerging markets as the debt-to-GDP ratio rises (and not statistically significant when debt exceeds 50 percent of GDP) than in industrial countries (IMF, 2003).

- 5 . The example of Latin America is illustrative. According to ECLAC analysis, in 13 out of the 17 cases in which GDP growth was above trend, the change in the cyclically adjusted public-sector balance was negative, reflecting an expansionary fiscal policy. There are also episodes in which the budget balance adjusted for the cycle exhibited little variation despite significant changes in the output gap, such as in Chile (1992-98), Brazil (1990-94) and Mexico (1995-97). See Martner and Tromben (2004), for more information.

- 6 . The OECD experience suggests that public indebtedness is a key determinant of whether fiscal stance is pro-cyclical during downturns. But it is important to note that fiscal consolidation in a downturn need not be destabilizing so long as it restores confidence by putting the debt dynamics on a sustainable path. For example, Giavazzi _et al_ . (2000), as well as Alesina and Ardagna (1998), among others, show that fiscal contractions may be expansionary in indebted OECD countries and that the composition of adjustment, via tax increases and/or expenditure cuts, affects the expansionary potential of fiscal retrenchment. See also OECD (2003 _a_ ), Chapter IV, for more information.

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