Fiscal Sustainability, Fiscal Debt and Economic Growth in the South Asian Region

Abstract

The issue of fiscal sustainability in South Asia is paramount since the tide of economic liberalization in the 1980s and given its ballooning public debt. Using annual data for 1960–2019, we perform a battery of tests to determine fiscal sustainability in Sri Lanka, India, and Pakistan. We adopt the Bohn (1998) model by estimating a fiscal reaction function (FRF). The model is derived from the theoretical foundation that shows a sufficient condition for satisfying the intertemporal government budget constraint whereby the primary balance reacts positively to the lagged debt-to-GDP ratio. A positive response to the primary balance suggests that the government is counteracting the increase in fiscal debt. The results show evidence of fiscal sustainability for the model in all three countries. We relax the assumption of a constant-parameter linear fiscal rule and allow nonlinearity in the FRF by (1) incorporating the Markov-switching fiscal rule into the FRF and (2) estimating a time-varying parameter model of the FRF. The Markov-switching model identifies two fiscal regimes described by periods of sustainable and unsustainable fiscal policies. The model also yields transition probabilities and the expected duration of the regimes, which we use to evaluate the No-Ponzi game condition. The results show that while this condition is satisfied, the long-term debt-stabilizing condition fails to hold. The time-varying parameter model of the FRF shows different episodes when the primary balance reacts positively or negatively to the lagged debt-to-GDP ratio, corroborating the results of the Markov-switching model. We then examine the impact of fiscal debt on growth in these regimes using a threshold regression model. For fiscal debt above some threshold, that is 78 percent of the GDP in Sri Lanka, 67 percent of GDP in India and 58 percent in Pakistan, economic growth in these countries tends to decline. Our results suggest that while fiscal stance in these economies is sustainable, the governments need to curtail the growing fiscal debt below the optimal threshold level to promote economic growth.