Review Journal“The Determinants of the composition of public debt in developing and

emerging market countries”

By Kristine Forslund, Lycia Lima, Ugo Panizza

Review of Development Finance I (2011)207-222

Reviewed by Iman Sufrian NPM 1206313974

A. BACKGROUND/INTRODUCTORY

The use of domestic public debts have had a long history of being a financing

source in large sample of countries back in 19th century (Reinhart and Rogoff; 2008).

This particular field of study topic is important because Reinhart and Rogoff (2008)

also stated that the accumulation of a large domestic debt was often contributed to

external debt crisis and large inflationary periods that hindered the achievement of

welfare society in affected countries.

There have been numbers of research that attempt to study the determinants

of debt composition in developing and emerging countries. The authors of this paper

mentioned four studies related to this paper. Those four papers are Burger and

Warnock (2006), Claessens et. Al. (2007), Eichengreen and Luengnaruemitchai

(2004) and Borensztein et. al (2008). The findings of the previous four studies are as

follows:

a. Using a cross-sectional data of 49 countries which consists of 27 emerging

countries and 22 advanced countries, Burger and Warnock (2006) find that

policies and institutions play an important role in the development of the local

government bond market. In particular, they find that low inflation, rule of law, and

country size are positively correlated with the development of the domestic

government bond market and that the fiscal balance GDP growth are negatively

correlated with the size of the government bond market;

b. Claessens et al. (2007) use panel data of 36 countries (of which 12 are emerging

countries and 24 advanced countries) for the 1993-2000 period. They also find

that country size, size of the banking system (as measured by total deposit over

GDP), good institutions, low inflation, flexible exchange rates and fiscal burden

are positively correlated with the size of the domestic bond market. Moreover,

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they find that countries with flexible exchange rates tend to have large domestic

bond markets.

c. Eichengreen and Luengnaruemtchai (2004) also use panel data techniques of 41

countries over the period 1990-2000. They find that country size and institutional

quality are positively associated with the development of the domestic bond

market. However, contrary to Claessens et al. (2007), they find that lower

exchange rate volatility is positively correlated with the size of domestic bond

market and argue that this might be due to the fact that a fixed exchange rate

lowers currency risk and may encourage foreign participation. They also find that

countries without capital controls ten to have larger bond market.

d. Borensztein et.al (2008) expand theirs sample and distinguish between the

determinants of the development of markets in government, corporate and

financial sector bonds rather that considering the bond market as a single

aggregate. They find that country size is significantly correlated with the size of

bond market but that the relationship is non-linear. They also find that bond

market development is positively correlated with trade openness, total public

debt, institutional quality, lack of capital control, and the privatization of pension

system. Moreover, they also find that level of domestic interest rate is negatively

correlated with market capitalization even though there is no significant

correlation between banking spread and the size of government bond market.

However, when focus on emerging economies, they find that country size

become very much less correlated with the size of public debt.

This paper has similar objectives with the above mentioned papers. The

objectives of this paper are as follow:

a. To document recent trends in the composition of public debt across a large

sample of developing and emerging market countries;

b. To test whether there are empirical regularities that explain the choice between

domestic and external public debt

However, there are difference between this paper and the four papers discussed

above. Those differences are:

a. The definition of public debt. The previous papers focused on bond market

development while this paper focuses on total public debt.

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b. This paper covers up to 95 developing countries, of which 33 are low-income

countries. While the four previous papers examine a relatively small group of

emerging market countries. In addition, the analysis of the previous papers jointly

included developing and industrial countries (except the study conducted by

Borenztein at.al, 2008). The inclusion of industrial countries in dataset analyzed is

suspected as the cause of variance in bond market development between these

two groups of countries. Therefore this paper excludes the industrial countries

and focusing on developing countries.

c. The difference of methodology used in this paper compared to the previous four

papers. While previous studies either focused on cress-country differences

(Burger and Warnock, 2006) or jointly looked at cross-country and with countries

differences, this paper also used fixed effect estimation which allows for the

isolation of the determinants of changes within countries.

B. METHODOLOGY

Initially, the authors of this paper conducted a wide literature review other

researches about Public Debt.

Based on literature review, the author of this paper then constructed a model

that determined public debt composition. They also constructed controls variables

which classified into five different categories.

Subsequently, the model is empirically tested using the panel of developing

countries for the 1990-2007 period to capture both the domestic and external

component of public debt.

The authors of this paper used both random effect and fixed effect models.

They also tested for difference across groups of countries by splitting the sample

between low income developing countries and middle-income developing countries.

Based on the estimation of the model the authors then analyse the result and

draw conclusion about the determinants of domestic public debt in developing

countries.

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C. JOURNAL CONTENT

Determinant of debt composition

The authors of this paper conducted an estimation of public debt compositions

by regressing domestic public (measured as a share of total public debt) over a set

of country characteristics. Control variables were classified into five different

categories:

a. Macroeconomic imbalances. The proxies of this variable were inflation, current

account balance, government balance, total public debt and its square and

exchange rate misalignment;

b. Country size and level of development. The proxies of this variable were GDP,

GDP per capita, M2 over GDP and corruption;

c. Crises and external shocks. The proxies of this variables were a banking crisis

dummy, a sovereign default dummy, a dummy that captures sudden debt

explosion, a dummy that captures sudden debt reductions, the growth rate of the

real exchange and the term of trade index;

d. Openness’. The proxies of this variables were a measure of de facto trade

openness and a measure of de jure capital account openness;

e. Exchange rate regime. However, it was not clear about the indicator used to

proxy this variable.

In all regressions the authors controlled for global factors by including year fixed

effect. In the random effects regressions the authors also included a set of regional

dummies, where East Asia and Pacific was the excluded dummy.

The authors of this paper acknowledged two caveats in their analysis. Those

two caveats were:

a. Causality concerns. The authors realized that they could not claim causal

relationship from explanatory variables to debt composition.

b. The fact that supply and demand effects often could go in opposite directions.

Therefore, it was difficult to have a clear prediction on the relationship between

explanatory and dependent variables.

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Hypothesis

Based on the model above, which describe the determinants of domestic debt

share, the author of this paper then constructed hypothesis about relationship of

each indicators with domestic debt shares. The expected relationships are described

as follow:

a. The authors expected to have negative relationship between Log of inflation and

domestic debt share;

b. Current account balance was expected to have positive correlation with domestic

debt share;

c. However, the relationship between domestic debt share and the government

balance was expected to be uncertain;

d. The relationship between the level of debt and domestic debt share was positive

and nonlinear relationship;

e. Exchange rate misalignment was expected to have positive relationship with the

domestic debt share;

f. Exchange rate was expected to have positive relationship with the domestic

debts share;

g. The expected signs for the second set of explanatory variables and the domestic

debts share were positive;

h. The effect of banking crises on domestic debt share was positive;

i. The default dummy was expected to have positive relationship with domestic

debt share;

j. The author expected to have a positive correlation between debt contraction

dummy and domestic debt share.

k. Sudden debt explosion was expected to have a positive sign in the model;

l. The term of trade was expected to have a positive correlation with domestic debt

share;

m. However, the author of this paper did not have clear expectation for the

relationship between domestic debt share;

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Results

The authors of this paper presented the empirical result for both models:

random effect model and fixed effect model. Based on both empirical result model,

the authors of the paper then summarized the result as follow:

a. Control variables played a limited role in explaining cross-country differences in

the composition of public debt

b. Inflationary history had no statistically significant effect on the composition of

public debt. There was no evidence that countries with a history of high inflation

have lower shares of domestically issued debt

c. The composition of public debt was driven by the presence of capital control.

Countries with high level of capital controls there was no statistically significant

correlation between domestic debt share and inflationary history. In countries with

low and intermediate level of capital controls, inflationary history had a negative

and statistically significant impact on domestic debt share. This suggests that

capital control have a negative effect on the development of domestic debit

market in countries characterized by high policy credibility but might help

developing the bond market in countries characterized by low policy credibility.

D. SUMMARY

Based on above parts, it can be seen that the wide range of literatures studies

mentioned in this paper has provided some insights about the relationship between

each control variable and domestic debt share. However, since this study is lacked

of micro foundation, it is difficult to explain about how exactly each control variable

and explanatory variable interacts. The behaviour of the economic agents (such as

government and investors) that affect the variables in the model is not systematically

analysed. Moreover, some inconsistent result between this paper and the previous

papers about the relationship of certain control variables and the explanatory

variable will likely make the analysis of the result become even more difficult.

Further study that includes micro foundation of the relationship between

control variable and explanatory variable will improve the understanding of how

those variables interact.

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Policy Implication

Nevertheless, this study may have some important policy implication, in

particular with regard to the finding that inflationary history has no statistically

significant effect on the composition of public debt. This paper explores the

determinants of this finding and shows that the results are driven by the presence of

capital controls.

This paper shows that in countries with high level of capital controls there is

no statistically significant correlation between domestic debt share and inflationary

history. However, in countries with low and intermediate level of capital controls, the

authors found that inflationary history has a negative effect on the development of

the domestic debt market in countries characterized by high policy credibility but may

help developing the domestic bond market in countries characterized by low policy

credibility.

Although, the authors recognize that the positive effect is likely to vanish if

countries that impose capital control continue to adopt irresponsible policies.

However, in countries that are seriously to improve policy credibility, capital control

can be considered as an additional policy instrument in building a local debt market.

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REFERENCES

Kristine Forslund, Lycia Lima, Ugo Panizza ,The Determinants of the composition of

public debt in developing and emerging market countries, Review of

Development Finance I (2011)207-222

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