Institution, external debts, and fiscal policy: an empirical investigation in Asia Pacific countries

Institution, External Debts, and Fiscal Policy: An Empirical Investigation in Asia Pacific Countries NGUYEN TRUNG THONG University of Economics Ho Chi Minh City - thongnt@ueh.edu.vn NG

Institution, External Debts, and Fiscal Policy:

An Empirical Investigation in Asia Pacific Countries

NGUYEN TRUNG THONG

University of Economics Ho Chi Minh City - thongnt@ueh.edu.vn

NGUYEN PHUC CANH

University of Economics Ho Chi Minh City - canhnguyen@ueh.edu.vn

Abstract

Fiscal policy attracts attentions from public, in which the quality and the responses of fiscal policy are seen

as the determined factors of its efficiency This paper investigates the impacts of external debts and governance quality on fiscal policy through the taxation and government expenditures in Asia Pacific countries from 2002

to 2013 Through the panel data estimations, we find that both institution and long-term external debts have negative impacts while short-term debts have no effect on fiscal policy This paper has significant contribution

to the practice by the useful implications for international financial organization such as IMF, Worldbank in arranging their agreements with governments to implement the conservative fiscal policies in the long-run

Keywords: institution; external debt; fiscal policy; Asia Pacific

1 Introduction

In last decade, Asia Pacific area is the most dynamic economic region in the world, especially in

the the period of 2002 – 2007 (see figure 1) In along with the high economic growth, their ratios of

external debts have decreased slightly in the period of 2002 – 2007, then increased significantly in

the period of 2008 – 2013 (see figure 2)

Figure 3 Economic growth in Asia Pacific, US, and the world

Source: World Bank

Figure 4 External debt in some Asia Pacific countries

Source: ADB

Apparently, the recent debt crisis of European, especially in Greek case, caused a lot of harmful impacts and chaos in their economies (Arghyrou & Tsoukalas, 2011; Featherstone, 2011; Lane, 2012; Overbeek, 2012) This fact repoints the role of fiscal policy in the creating of external debts and then

China East Asia and Pacific countries India

External debts in some Asia Pacific countries

Australia China India Japan Korea Thailand Vietnam

external debts impact on the behaviors of governments in conducting fiscal policy In fact, the fiscal policy through government expenditures is the main cause of external debt (Barro, 1979; Buiatti et al., 2014), then the high level of external debt increases the burden of fiscal policy and the probability

of default that, in return, put more challenges on fiscal policy (Alt & Lassen, 2006; Elgin & Uras, 2013; Teles & Mussolini, 2014) A notable study of Afonso and Jalles (2013) with a wide range of sample from 155 countries to assess the links between growth, productivity and government debts, they find a negative effect of the debt ratio An exception for the countries in OECD, the higher the debt maturity the higher the economic growth and financial crisis is detrimental for growth; while, fiscal consolidation promotes growth and higher debt ratios are beneficial for total-factor productivity (TFP) growth

Therefore, understanding the impacts of external debt on government behaviors in conducting fiscal policy not only contributes to the literature of macroeconomic policies, especially fiscal policy

in particular, but also contributes to policy makers of international organizations such as IMF in implementing suitable agreements with local goverments for substainable development

Besides the fiscal policy, the institutional quality is recently got more attention from researchers

in explaining the difference in economic developments and other macroeconomic factors across countries (Chen et al., 2014; Helland & Sørensen, 2015) The institution is defined as the “rule of game” in the society to adjust the behaviors of agencies in the economies that includes the government, hence it is argued to have impacts on the government’s behaviors in general, and the fiscal policy in particular More precisely, since the institution has impacts on the government’s behavior thus it must have impacts on the effects of external debt on fiscal policy, but the impacts of institution and the association between institution with the external debts on the government’s behaviors in fiscal policy are scare

Therefore, this study provides arguments and empirical evidences shedding light on the question

of how the institution impacts on the government’s behaviors in implementing fiscal policy In particular, this study examines the effects of external debts and its associations with the institution

on the fiscal policy of governemts At least to our existing knowledge, this is the first study which examines the impacts of institution and its effects on the impacts of external debt on fiscal policy

In order to conduct this study, we use five governance quality indicators from World Bank Worldwide Governance Indicators dataset including the Government effectiveness, the Regulatory quality, the Rule of law, the Control of corruption, and the Political and voice in the period of 2002 –

2013 for 28 Asia Pacific countries We believe that these governance quality indicators are the best proxy for the institution in present, which are measured and provided by the Worlbank, a reliable source In addition, this study is significant contribution to previous works by using four indicators including total tax revenue, total expenditure, current expenditure, and capital expenditure of government to proxy for the fiscal policy

With this strategy, we believe that this study has significant contribution to both literature and

practice First, this study has contribution to the literature of the institution economics by defining

its impacts on the government’s behaviors in fiscal policy implementing The empirical evidence from the panel data estimator shows that both institution and long-term external debts have negative

impacts on fiscal policy Second, this study has significant contribution to the practice by the useful

implications for internation financial organization such as IMF, Worldbank in arranging their

agreements with governments to implement the safely fiscal policies in long-run Third, our paper

has a policy implication about countries that need more investments and debts from World Bank and IMF may improve their institutions and control the external debts more effectively

The paper is organized as following structure Section 2 reviews the literature related to the impacts of external debt on fiscal policy and our arguments on the effects of institution on the fiscal policy Section 3 presents the methodology and data Section 4 provides the results and discussions The final section remarks some main findings

2 Literarure review

In this section, we review the economic literature on the impacts of external debts on fiscal policy,

in which we discuss the impacts of institution and its association with the external debts on the fiscal policy

The accumulated external debt increases in both developed, developing countries, especially in low-income countries (Bua et a., 2014; Richter, 2015), which withdraws many works in both theories and empirical investigations from the Keynesian theory to Neo-classical theory (Alesina & Perotti, 1994; Leachman et al., 2007).In fact, government conducts fiscal policy in the line with monetary policy of central bank to smooth the economic cycles through the crisis or the hot growth However, government faces to a very difficult puzzle For instance, the overall economy is downturned in the period of crisis, it then decreases the government’s revenue where the the tax revenue is the main source While, the government must expand the fiscal policy to push the economy throughing the difficult period, which then creates a heavily fiscal deficit in fiscal budget, and therefore external debt (Teles & Mussolini, 2014) Even though, the fiscal deficit sometimes emerges when there are no reasons for intertemporal smoothing, and in the long run government debt tends to be excessively high (Velasco, 2000)

Then, the external debt leads to more challenges for the fiscal policy conducting since the higher debt services and also the higher borrowing rate if government wants to borrow more This situation

is also riskier in the country with with am incompleted tax bases in along with the uncontrolling fiscal policy, since it leads to a more frecency and a higher rate of fiscal deficit, then the external debt status, in turn, is higher and more severe in the impacts on the economy (Elgin & Uras, 2013; Mitze

& Matz, 2015) More severely, the higher external debt increases the probability of government’s

default, which then induces government into riskier and more difficulty in fiscal policy conducting (Alt & Lassen, 2006; Antelo & Peón, 2014)

In fact, tremendous studies have investigated roles of external debts on the macroecnomic factors, especially in the fiscal policy in both scholar and practice For example, Kameda (2014) finds that a percentage point increase in both the projected/current deficit-to-GDP ratio and projected/current primary-deficit-to-GDP ratios of Japan raises real 10-year interest rates by 26–34 basis points He also finds that the real budget deficit in 2008 causes an approximately 2–3% increase in the JGB yields, which depresses the real GDP of Japan by 0.39–0.63 percentage points in 2008 Richter (2015) finds that the growing government transfers of US cause more severe and more persistent stagflation

in their economy than in representative agent models, while a longer average duration of US government debt pushes the financing of government liabilities into the future and reduces the short-run impacts of explosive transfers Meanwhile, the study of Adam and Bevan (2005) examine the the relation between fiscal deficits and growth for a panel of 45 developing countries and find a threshold effect at a level of the deficit around 1.5% of GDP, where there appears to be a growth payoff to reducing deficits to this level, this effect disappears or reverses itself for further fiscal contraction, and the magnitude of this payoff necessarily depends on how changes in the deficit are financed through changes in borrowing or seigniorage and on how the change in the deficit is accommodated elsewhere in the budget They also find evidence of interaction effects between deficits and debt stocks, with high debt stocks exacerbating the adverse consequences of high deficits

Apparently, the fiscal deficit causes the external debts, but the external debts, in return, lead to a very difficulty challenges in fiscal policy implementing Doi, Hoshi, and Okimoto (2011), for instance, find that the government revenue to GDP ratio of Japan must rise permanently to 40–47% (from the current 33%) to stabilize their debt to GDP ratio, which pushs burden on the overall Japanese economy In which, the primary surplus to GDP ratio fails to respond positively to their debt, and as the most important finding the current fiscal situation for the Japanese government is not sustainable Similarly, Koczan (2015) finds that large capital inflows into emerging European economies during the mid-2000s resulted, in one hand, in rapid economic growth and convergence

to EU income levels, it also resulted, in other hand, in improved fiscal positions of most countries, on the back of strong revenue performance However, many countries have struggled to adjust to the new situation of lower external financing and lower growth due to the 2008 global economic crisis More precisely, Teles and Mussolini (2014) argue that level of the public debt-to-gross domestic product (GDP) ratio should negatively impact the effect of fiscal policy on growth, since government indebtedness extracts a portion of young people's savings to pay interest on the debts; therefore, the payment of debt interest requires an all ocation exchange system across generations that is similar

to a pay-as-you-go pension system, which results in changes in the savings rate of the economy In addition, Georgescu (2014) finds that a sharp deterioration of Romanian fiscal framework strength has been observed during post-crisis period, the public debt-to-GDP ratio currently reaching around 40%, thus doubling as compared to 2008, while the main drivers of excessive public indebtedness

and the increase in refinancing (rollover) risk on short term, which is supposed to overlap with the exchange rate and interest rate risks on medium and long term This study concludes that its situation requires appropriate policies focusing on economic growth recovery, fiscal consolidation ongoing, increasing capacity of generating budgetary revenues, public debt management improvement

Thus, the behaviors of government in conducting fiscal policy following the manner of their external debts decide the long-term substainibility of the economy The application of business thinking to the public sector has meant conceptualising the sovereign debt management function as

a corporate-style controller function as an innovation in public finance in recent years, where accruals-based appropriations and outcomes-focused strategy statements weaken a legislature’s power of control over the executive government and divert attention from the control of public finance, which increasingly appears to be delegated to the executive government and that facilitated

by increasing government participation in capital markets (Newberry, 2015)

Even though, Newberry (2015) finds that the financial control and accountability is not achieved

by relying on strategy statements, objectives and ex post review in New Zealand, which shows an extent of government participation in capital market activities involving large amounts of public money and leveraging of public assets Furthermore, de Mendonça and Pessanha (2014) denote that there was a reduction in the fiscal vulnerability, but the public debt management was not effective in increasing fiscal insurance in Brazil

In this context, the institution must have some crucial roles For example, González-Fernández and González-Velasco (2014) find that corruption also shows a direct and significant relationship with public debt in the Spanish autonomous communities, although its impact is lower than that of the shadow economy More precisely, Heinemann, Osterloh, and Kalb (2014) find that a country’s past stability performance, government characteristics and survey results related to general trust affect sovereign bond spreads and dampen the measurable impact of fiscal rules in European area, and the interaction of stability preferences and rules points to a particular potential of fiscal rules to restore market confidence in countries with a historical lack of stability culture

The institution of a country which is defined as the rules of the game in a society (North, 1990), includes three features: (i) “humanly devised” which contrasts with other economic fundamentals; (ii) “the rules of the game” to set “constraints” on human behavior; and (iii) their major effect will

be through incentives (see North, 1981; Acemoglu & Robinson 2008) Several works have studies the effects of institution, which is named as the new institutional economics, but the effects of institution

on fiscal policy are still ignored Therefore, we argue that if the institution of a country is higher, the government is stimulated to apply a more conservative fiscal policy, thus growth of expenditures is lower This paper measures the institutional quality by using the Worldwide Governance Indicators include Control of Corruption, Government Effectiveness, Political Stability, Regulatory Quality and Rule of Law

Thus this paper goes to investigate the impacts of external debt and governance quality on fiscal policy through the empirical study at Asia Pacific countries1 in 2002 – 2013 period Next section presents the methods and data which are used in this study

3 Methodology and data

3.1 Methodology

In order to investigate the impacts of governance quality and external debt on fiscal policy, we

denote agency variables as Y is output, T is total tax revenue, 𝚪 is average tax rate (0<𝚪<1), G is total government expenditure, D is accumulated external debt, i is debt borrowing rate, n is the term

of debt, g is output growth rate In the fiscal policy, we assume that taxes are the main source of

revenue, thus the total tax revenue depends on tax rate and output, we assume the tax rate is constant

in short period thus the total tax revenue in the beginning of fiscal budget is

where: T 1 is total tax revenue in year 1, Y1 is output in year 1 Similarly, we have the total tax revenue in year t:

Meanwhile, the total expenditure of government in year 1 is G 1 , in the case of (T 1 – G 1)>0, the

fiscal deficit causes the external debt in year 1 is D 1 = (T 1 – G 1 ) with borrowing rate is i and the term

is n In simplicity, we assume the total external debt in year 1 will be payback as annuity in n year,

thus the total principle and interest amount of D 1 to pay in year 2 is

𝑝1 = 𝐷1∗𝑖

Therefore, the budget balance in year 2 is

Where: T 2 = 𝚪Y 2 = [Y 1 *(1+g)], and p 1 is defined as equation (3) If the budget balance in year 2:

(T 2 – G 2 ) > 0 is enough to pay for external debt thus (T 2 – G 2 – p 1) > 0, it means that the increase in

tax revenue (𝚪Y 1 g) has to be bigger than the annual debt payment, this depends on the output growth

(g) or the increase in tax rate (𝚪) or the cut off in expenditure (G 2), or government can do both of them However, the budget balance in year 2 is not enough to pay for annual external debt payment,

or the budget balance is continued deficit, the new external debt in year 2 will be:

1 The countries in our sample include: Australia, Azerbaijan, Bangladesh, Bhutan, Cambodia, China, Fiji, Georgia, India, Indonesia, Japan, Kazakhstan, Korea, Kyrgyz, Malaysia, Mongolia, Nepal, New Zealand, Pakistan, Papua New Guinea, Philippines, Sri Lanka, Tajikistan, Thailand, Tonga, Uzbekistan, Vanuatu, Vietnam

D 2 = G 2 + p 1 - T 2 (5)

We assume the new external debt has same borrowing rate and term as the external debt in year

1, total accumulated external debt at the end of year 2 is:

Where pp1 is the principle payment in year 2 for exnternal debt D 1 Similarly, the new external debt will have same payment term as old debt (p2), therefore total external debt payments in year 3 including principle and interest are:

in which: debt is the accumulated external debt While the government expenditure has the

function as:

in which: govde is the government demand of expenditure However, some recent studies

investigate the effects of governance quality of government on economic growth and other aspects and find that this factor is important determinants of differences in cross countries (Chen et al., 2014; Helland & Sørensen, 2015) Therefore, the governance quality of government has strong impacts on fiscal policy conducting of government, thus we incorpeate the governance quality of government into function of tax and expenditure in equations (11) and (12) to define the responses of fiscal policy

to external debt and governance quality

With the empirical methodologies, we recruit the models in Koczan (2015) with variables including tax revenue growth rate, total expenditure growth rate, current expenditure growth rate and capital expenditure growth rate in equations:

where: Taxg it is total tax revenue growth rate of country i in year t; Expeng it , Currexpeng it , Caprxpeng it are total expenditure, current expenditure and capital expenditure growth rates of

country i in year t; Debt it-1 is vector of ratio of external debt (totaldebt), long-term external debt (longdebt) and short-term debt (shortdebt) on GNI of country i in year t-1, this variable is used to investigate the impacts of external debt on fiscal policy; GDPg it-1 is GDP growth rate of country i in

year t-1, this variable is used to present for the output growth rate; the vector of variables in Govqua t

are Corruption (which indicate the efficience of corruption controlling of country, higher value higher effective), govereffect (which indicate the efficience of government in economic management, higher value higher effective government), reguquality (which indicate the efficience of regulation, higher value higher effective), law (which indicate the efficience of law system, higher value higher effective), political (which indicate the political stability, higher value higher suitability), all these variables are calculated and provided by worldbank in World governance index; ɛ, v, u, z are

residuals

As an innovation in our papers, we use both current expenditure and capital expenditure to investigate the impacts of external debt and governance quality on fiscal policy due to the difference characteristics of these expenditures in total expenditure (Landau, 1983; Li & Lin, 2011; Nieh & Ho, 2006; Payne, 1998; Ramey, 2009; Şen & Kaya, 2014), thus the response of government in changing these expenditures In which, the current expenditures are more nessessary then the capital expenditures in social security and welfate therefore government is harder to cut off than capital expenditures Next section presents the data in this paper

3.2 Data

All data of variables including tax revenue, total expenditure, current expenditure, capital expenditure, GDP growth rate, external debt ratio are collected from Key indicators reports of Asia Development Bank, while the governance quality indicators are collected from the World Bank Worldwide Governance Indicators (Table 1)

Table 4

Variable definitions and sources

Taxg Tax revenue growth rate Calculated from reports of ADB

Expeng Total expenditure growth rate Calculated from reports of ADB

Currexpeng Current expenditure growth rate Calculated from reports of ADB

Capexpeng Capital expenditure growth rate Calculated from reports of ADB

Debt Ratio of external debt on GNI Calculated from reports of ADB

Longdebt Ratio of long external debt on GNI Calculated from reports of ADB

Shortdebt Ratio of short external debt on GNI Calculated from reports of ADB

Corruption Corruption controlling index World Bank

The data description in Table 2 shows that the everage ratios of total external debt in Asia Pacific countries is over 46%, meanwhile the long-term external debt is the main debt of these countries While the governance qualities are lower than the zero level that indicate the lower quality in these countries The average economic growth rates are relative high (over 5%) in the line with high growth rate in tax and expenditure of governments However, the standard deviations of capital expenditure growth rates are much higher than current expenditure growth rates that indicate the more volatile in capital expenditure of Asia Pacific countries It also means that Asia Pacific governments change their capital expenditure much more than the changes in current expenditures

Variables Obs Mean Std Min Max

The significant negative of correlations between tax revenue growth rates and current expenditures (Table 3) show that the external debts have negative relationship with tax revenue, meanwhile the significant negative of correlations between tax revenue growth rates with governance quality indicators define that the higher governance qualities the lower tax increase in Asia Pacific countries While both total and current expenditure growth rates have significant negative correlations with both short-term debt and governance quality indicators that indicate the negative effects of short-term debt and governance quality on current expenditure The correlations show that there are correlations between external debt and governance quality with fiscal policy in tax policy and current expenditure