Public Debt Sustainability and Fiscal Reaction Functions in Latin America and the Caribbean

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Jan 2023
The governments response to the COVID-19 pandemic left Latin America and the Caribbean economies with increased levels of sovereign debt as a percentage of output, bringing up the question of debt sustainability in the region. The literature has identified two testable conditions on the fiscal reaction function for debt sustainability: i) a positive response of primary balances to debt (Bohn, 1995) and ii) the response of primary balances to debt should be higher than the growth adjusted interest rate (Ghosh et al., 2013). This paper revisits these conditions, both from the theoretical and empirical perspective. It introduces a new “implicit growth” measure which is the relevant one for the debt-to-GDP ratio dynamics. It also tests empirically both conditions for economies in the region. The results suggest that debt is likely sustainable in the region, although it cannot be assured at a 95 percent confidence level. A deep look at the causes of this results pointed towards fiscal fatigue, the fact that primary balances become less responsive to debt levels the higher the latter are. At post-pandemic debt levels sustainability is far from certain. The results here indicate decisive action is required to ensure debt will fall back to prudent levels.