There is growing concern about the debt sustainability of Caribbean countries, particularly in the wake of the pandemic, which led to sharply increased deficits. Recent research, as summarized in the latest edition of the IDB’s Caribbean Economics Quarterly (Rosenblatt, Clayton, & Mooney December 2023), suggests that although debt levels in the Caribbean may be weakly sustainably (Cevik and Nanda 2020; Hernández and González 2023), debt levels in several states may have surpassed “safe” levels (Powell and Valencia 2022). Nevertheless, fiscal sustainability is a fairly complex concept that overlaps both quantitative and qualitative considerations.
The “fiscal fatigue” theory, notably adopted by Ghosh et al. (2013), suggests that the primary balance initially improves as debt increases up to a certain level (“debt ceiling”). However, when debt surpasses this critical threshold, it begins to negatively impact the primary balance, leading to a vicious cycle of deteriorating primary balance and increasing debt. This theory suggests that debt cannot increase indefinitely and there is a point when public budgets are not able to sustain debt obligations—i.e. they become “fiscally fatigued”.
Note: dt refers to the lagged debt-to-GDP at time t. d* refers to the long-run equilibrium for debt and is the first intersection of the interest payment schedule with the fiscal reaction function. d** refers to the debt limit, after which fiscal fatigue occurs.
Previous research on debt sustainability, including fiscal fatigue, has primarily focused on analyzing developing countries broadly. Although there has been research on the Caribbean (Cevik and Nanda 2020; Hernández and González 2023), small island developing states (SIDS) have not been analyzed on the whole, and this presents an opportunity. SIDS, like those in the Caribbean region, have unique characteristics such as small scale, dispersed geography, and vulnerability to weather events. These characteristics shape their debt sustainability trajectories. In an upcoming policy note by Clayton and Rosenblatt (2024), it is estimated that debt levels of SIDS are “weakly” sustainable and primary balances are shaped by several factors.
The following are the key findings:
- Even during the pandemic, fiscal responses by SIDS have been weakly sustainable.
Based on Figure 2, it is observed that the primary balance improved in the last decade and was broadly responsive to debt. From 2012 onwards, we see that debt was “weakly” sustainable and this relationship was statistically significant. This relationship was maintained even with a worsening debt ratio and challenging macroeconomic conditions during the pandemic (2020-2022).
Notes: Points show coefficients using unbalanced sample from 1983 until the year indicated on the x-axis.
2. Fiscal policy is pro-cyclical during economic booms (and is counter-cyclical during downturns). SIDS countries tend to adopt pro-cyclical fiscal policies, meaning that during economic upswings, government spending rises which produces smaller primary balances. This trend can result in a gradual accumulation of debt over time, which can be burdensome for governments during economic downturns.
3. Meteorological natural disasters have a negative and contemporaneous impact on primary balances. When disasters strike, governments must ramp up spending on cleanup, social assistance, and reconstruction efforts, while dealing with lower-than-expected revenues from reduced economic activity. This strains their fiscal position, leading to higher debt-to-GDP ratios, and further weakens fiscal sustainability.
Considering these findings, recommendations for policymakers in SIDS include:
- Ensuring that fiscal rules include provisions to facilitate fiscal saving and consolidation during economic upswings. Institutional mechanisms such as fiscal rules are vital for containing primary deficits. By monitoring government spending and enforcing fiscal discipline, especially during economic booms, countries can maintain a healthier fiscal position.
- Prioritizing climate-resilient infrastructure, which can limit public expenditures and sustaining economic activity during and after storms. The IDB’s recently launched “ONE Caribbean” initiative can play a key role in supporting the development of climate-resilient infrastructure in the Caribbean.
- SIDS countries should make financial preparations for natural disasters. These preparations can include maintaining emergency funds and ensuring access to affordable borrowing options. These measures are essential for mitigating the economic fallout from disasters and ensuring fiscal resilience.
In conclusion, addressing pro-cyclical fiscal policies, implementing robust fiscal rules, and preparing adequately for natural disasters are critical steps toward enhancing the debt sustainability of SIDS, particularly those found in the Caribbean. SIDS face unique challenges due to their small size, dispersed geography, and susceptibility to external shocks, necessitating targeted policy interventions for long-term fiscal stability.
This blog is based on original research found here
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