Sovereign Risk and Procyclical Fiscal Policy in Emerging Market Economies

Yui Suzuki
2011 Social Science Research Network  
This paper develops a dynamic stochastic general equilibrium model that accounts for the differences in the cyclical features of the fiscal policy between developed and emerging market countries, and in particular procyclical government consumption and transfer payments in emerging market countries. I develop a small open economy model with a sovereign government that has access to international credit markets with the default option. The government maximizes public utility by adjusting (i) its
more » ... y adjusting (i) its asset position in the international capital market, (ii) government consumption, and (iii) transfer payments to households. Government consumption is defined as the sum of a public goods component that is directly beneficial to households, and a hidden transfer payment component. These hidden transfers appear in national accounts as government consumption, however, I argue they behave more as transfers. The government finds this hidden transfer payment component useful as it is more flexible over the cycle than the standard institutionalized transfer programs like social security. The option to default implies that creditors require a higher risk premium when the sovereign government experiences a sequence of negative shocks and accumulates debt, thereby deterring risk sharing and intertemporal consumption smoothing. The model is solved numerically and calibrated to two cases: the Mexican and the US economies. It replicates the differences in the fiscal policy over the business cycle in emerging market and developed countries. The default option is shown to be the key driver for the asymmetries observed in the data, suggesting that sovereign default has significant effects on risk sharing and the behavior of fiscal policy. JEL classifications: F41, F34, E62. House for their guidance and encouragement. I also thank participants in the international macro lunch and international economics seminar at the University of Michigan for many useful suggestions. All errors are my own. 1 and developing countries have access to only one-period, risk-free bonds. While Riascos and Végh (2004) were the first to study the procyclical fiscal policy in developing countries by applying a dynamic stochastic general equilibrium model, their model fails to predict the greater procyclicality that private consumption undergoes as compared to government consumption in both developed and developing countries. This will be introduced in the next section. This paper addresses puzzling cyclical features of the fiscal policy in emerging market countries and their sharp contrast with those in developed countries. A dynamic stochastic general equilibrium model is developed to study the interaction among transfer payment, government consumption, and sovereign borrowing with the default option by a rational and benevolent government. This model is an extension of Arellano's (2006) ; it explicitly describes a government's stance in determining government consumption and transfer payment over the business cycle. Government consumption is defined as the sum of a public goods component that is directly beneficial to households and a hidden transfer payment component. These hidden transfers, inspired by a public project that was recently implemented in Argentina, appear in national accounts as government consumption, but I argue that they behave more as transfers. The government finds this hidden transfer payment component useful for smoothing private consumption as it is more flexible over the cycle than standard institutionalized transfer programs like social security. A benevolent government has access to the international capital market where it can trade one-period bonds with the default option. Since sovereign debts are not enforceable due to sovereign immunity and the lack of an international proxy for the domestic bankruptcy court, the sovereign government's option to default on its debts plays a critical role in their pricing. The government, understanding the advantages and disadvantages of exercising this default option, decides to exercise it in optimal situations. As the utility of households is over private consumption and the public goods component of government consumption, equating these marginal utilities leads to both of them to being procyclical at equilibrium due to imperfect insurance under an incomplete capital market; this is analogous to the result of procyclical private consumption in a standard small open economy model (e.g., Mendoza (1991) ). On the other hand, were it not for the default option, transfer payments and the hidden transfer payment component of government consumption should have been countercyclical, since a
doi:10.2139/ssrn.965036 fatcat:jcjiimunpnegffg4yofmymmohq