Assessing the mean reversion behaviour of fiscal policy: the perspective of Asian countries

Abstract

This article investigates fiscal policy sustainability in 10 Asian countries by adopting a battery of unit root tests. Univariate unit root tests reveal that the fiscal stance in these countries follows a nonstationary process while the opposite conclusion was drawn for the same dataset using the commonly employed panel unit root techniques. By utilizing the series-specific panel unit-root test recently developed by Breuer et al. [2002, SURADF (Seemingly Unrelated Regression Augmented Dickey-Fuller)] that allows testing for the presence of nonstationarity within individual cross sections of the panel, we found that only cross sections four out of 10 countries in the panel are stationary. This means that fiscal deficits in most Asian countries are in violation of their intertemporal budget constraint and that the deficits are too large.

Acknowledgements

The authors are grateful to Prof. Myles S. Wallace who kindly provided the RATS programme code. This project is funded by MOSTE (Project no.: 05-020-EA001). An earlier version of this article was presented at International Conference in Economics and Finance, 2005 (ICEF) in Labuan, Sabah, Malaysia. The authors are grateful to the participants of the conference for their comments and suggestions. The authors would also like to thank the editor of this journal and an anonymous referee for constructive comments, which have improved the quality of present version. The usual disclaimer applies.

Notes

¹ The general view is that budget deficit is sustainable if the intertemporal government budget constraint holds in present value terms. A violation of government intertemporal budget constraint would indicate that the deficit is not sustainable.

² The Asian financial crisis is a case in point. In the aftermath of the crisis, most of the countries severely affected by the turmoil employed fiscal stimulus to put the economy back on track. Indeed, countries like Malaysia were able to recover much faster because they did not have a fiscal debt problem.

³ Chiang Mai Initiative was hailed as an important first step towards creating a manifestation of the broader desire for economic, monetary and financial cooperation in Asia. For the latest literature on economic cooperation and integration in Asia, see Kwack (2004) and Aminian (2005).

⁴ According to the Maastricht Treaty protocol, the government budget deficit should in fact not exceed 3% and the public debt should be lower than 60%, both measured in terms of real Gross Domestic Product (GDP). Interestingly, the newly formed Euro area pursued one step further to evaluate the effectiveness of the fiscal policies for their member countries following the fiscal regulatory set up by European Central Bank (ECB) (Martin, 2002; Buiter, 2003).

⁵ The methodology has also been used to investigate the sustainability in the current account. Literature includes Husted (1992) and Wu et al. (1996).

⁶ The interest on this issue arises from two important developments in these countries: (1) the large fiscal imbalances witnessed in many countries of Western Europe and the United States over the past two decades and (2) the fiscal discipline demanded from the EU member countries for European Monetary Union (EMU) membership by the end of 1999.

⁷ In the literature, specific assumptions have been made in relation to the process generating the variable r _t . Studies like those of Hamilton and Flavin (1986), Trehan and Walsh (1988) and Kremers (1989) postulated a strictly exogenous d _t and a constant r _t while Makrydakis et al. (1999) and Uctum and Wickens (2000) tested in terms of stochastic r _t . In this article, the r _t is assumed to be stochastic rather than fixed to reflect the more recent empirical regularities and over time there exists interest rate variability, a more realistic assumption.

⁸ The difference between (R − G) is the government budget position. If G > R, the government is experiencing budget deficit while analogously if R > G, the country is experiencing budget surplus.

⁹ The transversality condition requires a zero limit of future government debt discounted at a rate that depends on the probability distribution of future debt and not at the government bond rate. The requirement of the budget process to be sustainable implies effectively that Ponzi games are ruled out as a viable option of government finance where further new borrowing cannot be used indefinitely as a method of financing interest payments on existing debt.

¹⁰ Theoretically, the performance of a unit-root test may be improved by increasing the sample size. This can be achieved by longer data span, though a relatively long time series is likely to go through some structural change, potentially causing new problems. Alternatively, extra information can be gained by using panel data.

¹¹ MacDonald et al. (2002) demonstrates the problem of pooling I(1) and I(0) variables into a panel. Specifically, they argued that aggregation into panel makes no sense and the results are of little value.

¹² This test is a general form of the Abuaf and Jorion (1990) and Taylor and Sarno (1998, MADF) panel unit root tests.

¹³ The panel SURADF test is a recent innovation. Interested readers may refer to other application of this methodology, such as the study of hysteresis hypothesis in unemployment (Chang et al., 2005) and the article by Holmes (2001) on PPP.

¹⁴ The 5% value of the asymptotic normal distribution, 1.96, is used to assess the significance of the last lag.