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How do financial cycles affect public debt cycles?

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Abstract

We employ the duration framework to study determinants of public debt cycles in 57 advanced and emerging economies over the 1960–2014 period, with a particular focus on the impact of financial cycles. The results suggest that the association between financial and debt cycles is asymmetric. Debt expansions preceded by overheating in credit and financial markets tend to last longer than other expansions, but there is no significant association between financial cycles and debt contractions. There is strong evidence of duration dependence in both phases of the cycle, with the likelihood of expansions and contractions to end increasing with the length of their respective spells. Higher initial level of debt increases the spell of contractions (persistence of adjustment effort hypothesis) and reduces the spell of expansions (debt sustainability hypothesis). The results are robust to the inclusion of global factors, openness, political stability, and debt crisis indicators as additional controls.

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Notes

  1. There are two main differences between the VAR and duration methodologies: (i) the VAR assesses the impact of structural shocks to financial variables, while the duration framework assesses the impact of the cyclical turns in financial variables and (ii) the VAR assesses the impact on the magnitude of the debt ratio, while the duration framework assesses the impact on the length (duration) of debt expansions and contractions.

  2. The earlier version of the paper was published as an IMF working paper (Baldacci et al. 2010).

  3. This algorithm extends the so-called BB algorithm pioneered by Bry and Boschan (1971).

  4. There are several reasons why we choose to use the debt ratio in levels. First, we are using a ratio of two trending variables (debt and GDP). The division is expected to remove the common trend in both variables. Second, from the debt sustainability point of view, the debt ratio should be bounded from above. This further supports the choice of using cycles in levels. Third, detrended values may not be comparable across countries. For instance, positive cyclical component for a country with a low initial level of debt may not be comparable with a positive cyclical component for a country with a high initial level of debt. Finally, market participants and policymakers are closely watching the level of the debt ratio as a public sustainability indicator, rather than its detrended values.

  5. The results remain qualitatively unchanged when using Gompertz and exponential duration models.

  6. We also use contemporary changes in real GDP growth, inflation, nominal interest rate, and primary balance variables over the respective phase of the cycle, but results remain qualitatively unchanged.

  7. IMF (2015) provides a comprehensive discussion of transmission channels from banking crises to sovereign debt buildups.

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Authors and Affiliations

  1. International Monetary Fund, Washington, DC, USA

    Tigran Poghosyan

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  1. Tigran Poghosyan
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Correspondence to Tigran Poghosyan.

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I would like to thank Bernardin Akitoby, Tamim Bayoumi, Julio Escolano, Karina Garcia, Vitor Gaspar, Deniz Igan, Luis Jacome, Carlos Mulas-Granados, Martin Saldias, Damiano Sandri, Abdelhak Senhadji, Cesar Serra, Marzie Taheri Sanjani, and seminar participants at IMF’s Fiscal Affairs Department for useful comments and suggestions. Macarena Torres Girao provided excellent editorial assistance. The views expressed in this paper are those of the author and do not necessarily represent those of the IMF or IMF policy.

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Poghosyan, T. How do financial cycles affect public debt cycles?. Empir Econ 54, 425–460 (2018). https://doi.org/10.1007/s00181-016-1215-0

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