Government spending shocks and default risk in emerging markets

Ming Jiang and Jingchao Li

PLOS ONE, 2023, vol. 18, issue 7, 1-16

Abstract: The coronavirus pandemic has revived interest in the effects of fiscal policy. This paper studies the effects of government spending on default risk in emerging economies. We first build a general equilibrium small open economy model where government spending shocks influence external debt and sovereign bond spreads. We show that external debt piles up and sovereign bond spreads increase following a government spending shock. We then develop VAR evidence based on a panel of 18 countries. We find that in response to a 10% government spending increase, (1) the real effective exchange rate appreciates by 1.0% and the current account to GDP ratio deteriorates by 0.0025 on impact; (2) external debt increases by an average of 3.5% in the year following the shock; and (3) the EMBI Global spread rises by an average of 25 basis points within two years and peaks at 132 basis points 14 quarters after the shock, suggesting a higher sovereign default risk. The empirical results confirm the theoretical predictions from the general equilibrium model.

Date: 2023
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Persistent link: https://EconPapers.repec.org/RePEc:plo:pone00:0288802

DOI: 10.1371/journal.pone.0288802

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