From Risk to Resilience: How Fiscal Rules Drive Growth in Emerging Market Economies

In a bold reassessment of conventional economic wisdom, "Expansionary Fiscal Consolidation Under Sovereign Risk" by Carlos Esquivel (Rutgers University) and Agustin Samano (World Bank, Development Research Group) introduces a fresh perspective on fiscal consolidation. The paper, released as part of the World Bank’s Policy Research Working Paper series, presents a sovereign debt model that integrates long-term government borrowing, private capital accumulation, and fiscal rules. The study’s central argument is striking: in economies plagued by sovereign risk, adopting fiscal rules, particularly debt ceilings linked to GDP, can reduce default risk and promote long-run economic growth, even if they temporarily depress consumption and investment. Far from being purely contractionary, fiscal consolidation under the right conditions can be expansionary.

Fixing Market Failures: Debt Dilution and Underinvestment

The authors root their analysis in two key distortions that frequently arise in high-risk emerging markets. The first is debt dilution, when governments issue new long-term debt without considering its impact on the value of existing obligations. This behavior leads to rising risk premiums demanded by creditors, as they anticipate future borrowing will undercut their returns. The second is underinvestment by households and firms, stemming from the heightened default risk. When the prospect of sovereign default depresses expected returns on capital, rational investors scale back, deepening the economic malaise.

These two distortions are mutually reinforcing. As governments borrow more and raise default risk, private investors further reduce their capital commitments, which in turn makes it harder for governments to meet their obligations. The authors argue that fiscal rules, specifically a ceiling on the debt-to-GDP ratio, can break this vicious cycle. By enforcing discipline and making future debt issuance more predictable, such rules reduce sovereign spreads and stabilize expectations. This leads to an environment where both government borrowing and private investment become more sustainable.

Argentina as a Test Case: Measuring the Pain and Gain

To bring theory into practice, the authors calibrate their model to Argentina, a nation synonymous with fiscal instability and recurrent debt crises. Their simulation imposes a debt limit of 44.2% of GDP, deemed optimal in terms of maximizing welfare. Initially, the implementation of this fiscal rule results in a steep but brief contraction. Consumption falls by 5% and investment by 7%, as resources are reallocated to reduce debt levels. However, the short-term pain gives way to long-term gains. Within a year, consumption recovers, and over time it rises 1.35% above the pre-rule level. Investment also rebounds, contributing to a 1.2% increase in GDP. Sovereign spreads plunge from an average of 7% to just 2%, significantly lowering borrowing costs.

These dynamics underscore the central thesis: though fiscal consolidation entails sacrifice, its structural effects on sovereign credibility and capital formation more than compensate for the initial economic losses. Welfare gains, measured in consumption equivalent terms, reach 0.5%, a modest figure that belies the deeper macroeconomic transformation taking place.

Discipline Without Shackles: When Commitment Isn’t Necessary

Recognizing that political institutions in many emerging markets may struggle to enforce hard fiscal commitments, the authors test their model under a more relaxed scenario. Here, governments are allowed to deviate from fiscal rules at any time, but such deviations result in permanent loss of market credibility. Once a government breaks the rule, either by overspending or defaulting, it cannot credibly implement another rule in the future.

Even in this no-commitment environment, the model shows improved outcomes. Sovereign spreads fall further, default risk diminishes, and capital accumulation rises. Welfare gains increase to 1.2%, more than double those seen under strict commitment. The authors interpret this as evidence that the value of the rule itself, the benefits it confers in terms of credibility, lower spreads, and investment, is enough to sustain it. Governments, even without institutional constraints, are incentivized to follow the rule because deviating from it becomes too costly. This finding carries profound implications for countries with weaker fiscal institutions: credible rules don’t require rigid enforcement mechanisms to succeed, they just need to be valued and preserved.

Backed by Data: Investment Rises Where Rules Exist

To validate their theoretical claims, Esquivel and Samano analyze empirical data from 63 emerging economies spanning 2000 to 2019. Using panel fixed-effect regressions, they find that countries with debt rules experience significantly higher private investment, around 1.4 percentage points of GDP more, than those without such rules. Controlling for sovereign spreads, public debt, and GDP cycles, the positive impact of debt rules remains statistically significant.

Further, using local projections to assess the short-run effects of adopting a fiscal rule, they find that investment typically declines in the first two years post-adoption, but then rises sharply, mirroring the transition dynamics predicted by the model. By the fifth year, private investment increases by approximately 1.5% of GDP, reinforcing the notion that fiscal discipline, once established, can unleash productive investment.