Measuring fiscal policy sustainability in developing Asia: what does the Markov Switching Augmented Dickey-Fuller Test tell us?

Abstract

This paper measures fiscal sustainability in 22 developing Asian countries for the period 1999–2017. Previous literature generates conflicting results: one paper applies the usual stationarity and cointegration tests and finds that fiscal policy is sustainable but in weak form. Another paper employs a fiscal reaction function and finds that fiscal policy is unsustainable. This paper uses an expanded version of the Markov Switching Augmented Dickey-Fuller test (MS-ADF), which remedies the shortcomings of conventional stationarity tests to provide more statistical power in the presence of nonlinearities and structural breaks. The MS-ADF has never been applied to this set of countries. Results show that the majority of the countries have “uncertain” debt trajectories, not definitively sustainable or unsustainable but somewhere in-between. This is a more nuanced picture of the debt trajectories in the region relative to what is obtained using the established methods. A more nuanced assessment could lead to more suitable policy corrections.