This paper examines factors likely to give rise to proyclicality of fiscal policy in emerging markets. It elaborates a rigorous conceptual framework within which it explores optimal policies assuming a Ramsey government. One key conclusions is that the high degree of uncertainty in these economies affects the decisions of policy makers. Another finding is that the characteristics of fiscal policy differ according to whether government borrows in domestic or foreign markets.

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Fiscal policy is shown to be procyclical in LA. Policy reaction to debt sustainability concerns can be the reason for this. The empirical analysis strongly backs this hypothesis. The primary balance which would render the debt sustainable is our fiscal sustainability index. The data show that the fiscal stance tightens when the index worsens. This effect is stronger the less sustainable debt is. In the nineties, this hypothesis totally explains the procyclicality of the fiscal policy.

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We analyze the sustainability of government debt for a sample of Latin American countries, employing unit root tests that incorporate nonlinear alternative hypotheses. These tests capture the potential thresholds or corridor behaviour that international agreements or markets impose on emerging economies’ public finances. We show that support for sustainability substantially improves when the possibility of nonlinear mean-reversion is taken into account.

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We examine the role of economic, political, and institutional variables in determining fiscal effort. We find that while primary surplus increases, as expected, with lagged debt, this effect tapers off beyond a threshold. We also find that an inverse U-shaped relationship exists between primary balance and revenue, fiscal effort rises with positive shocks to oil prices (for oil-exporters), when the economy grows above potential, and in the presence of an IMF program.

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If permanent output is uncertain, tax smoothing can be perilous: both debt levels and tax rates are difficult to stabilize and may drift upwards. Our alternative policy links the primary surplus not only to the debt ratio (like tax smoothing) but also to its volatility, thus preempting further adjustments while gradually reducing the debt.

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The objective of this paper is to build a model of partial equilibrium which is then exposed to simulated external shocks. The conclusions of are the following: 1) it is all on us, given that external shocks alone cannot render the Peruvian economy unviable, 2) the most detrimental external shock are is that to the interest rate and 3) the lack of external funding sources impairs sustainability indicators both in mean and in variance.

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There are different arguments in favor and against nominal and indexed debt which broadly include the incentive to default through inflation versus hedging against unforeseen shocks. We model these arguments and calibrate the model to assess the quantitative importance of each. In the model, the benefits of defaulting through inflation are tempered by higher future interest rates.

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