Fiscal procyclicality in emerging markets: The role of institutions and economic conditions

Abstract

AbstractProcyclicality of fiscal policy is a common feature in emerging markets, by contrast with high‐income economies, and leads to greater business‐cycle amplitudes. We investigate potential causes of fiscal procyclicality, including a host of economic and institutional variables of especial import in emerging markets. We employ dynamic panel methods in a large sample of countries to investigate what factors are associated with fiscal cyclicality. We find that fiscal procyclicality is mainly due to procyclical fluctuations in government investment expenditure. In addition, we find that procyclical fiscal policy is positively associated with government debt levels, terms‐of‐trade volatility, and costs of foreign borrowing, while negatively associated with better government efficiency. Only a weak association is found between International Monetary Fund program participation and fiscal procyclicality. Finally, we find that certain fiscal rules are associated with lower fiscal procyclicality and, in particular, balanced‐budget rules may help mitigate the adverse cyclicality effects of high terms‐of‐trade volatility and government debt burdens in emerging markets.