Debt sustainability in emerging market countries: Some policy guidelines from a fan-chart approach

- We simulate public debt trajectories for major emerging market countries (EMC).
- They differ in their fiscal responsiveness (FR) and foreign currency risk premiums.
- Higher FR would benefit EMC much more than a reduction in currency risk exposure.
- In recessions, countercyclical fiscal policy may be unsustainable under low FR.
- Future research could integrate the reverse effects of fiscal tightening on growth.

This paper uses a probabilistic approach to simulate the medium-term public debt trajectories of several major emerging market countries. We extend the standard debt sustainability analysis framework so as to more faithfully reproduce these countries' economic reality in two aspects. First, we allow them to differ in the cyclical stance of their fiscal policy and in their degree of fiscal responsiveness to debt. Second, we explicitly integrate the specific risk premium paid by each country when borrowing in foreign currency. It allows us to evaluate the impact of alternative policies that the government may consider to improve sustainability. The results lead to three policy recommendations: i) a country should consider decreasing its exposure to currency risk only in extreme cases (like Argentina); ii) on the contrary, greater fiscal responsiveness (i.e. stronger fiscal tightening whenever there is a debt increase) could enhance sustainability to a much greater extent; iii) countries with low responsiveness to debt or a poor fiscal consolidation track record should be cautious with countercyclical fiscal policies, as they may trigger an unsustainable debt trajectory in the trough of the economic cycle.