Fiscal Policy, Default and Emerging Market Business Cycles

Developing country fiscal policy outcomes documented in data point to stark differences compared with developed ones. Most prominent difference is the excessive volatility of government consumption and transfer payments and their positive correlation relative to output. This seemingly non-optimal behavior is puzzling since it is in contrast with standard theory prescriptions and likely to contribute to aggregate volatility. To study the possible roots of this I build a model by incorporating a detailed explicit fiscal sector to what is otherwise a standard sovereign default setup. The environment I define is one of incomplete markets that resembles small open developing economies with respect to existence of short-maturity non-state contingent defaultable debt as the only tradable asset for the sovereign government and financial frictions on private sector. I use this model to identify the contribution of market incompleteness due to the commitment problem of the sovereign. The findings point that the endogenous state-contingent borrowing constraints that sovereigns face as a result of commitment problem in debt repayment is a major factor in accounting for the pro-cyclicality of transfer payments and excessive relative volatility of transfers and government consumption in these countries. The effect of financial frictions of the type defined as working capital constraint on an imported input combined with debt sensitive private borrowing cost is increased volatility of fiscal policy due to debt loosing its buffer-stock property in smoothing out shocks to fiscal revenues.