Capital Punishment? Financial Openness, Private Borrowers, and Fiscal Discipline in Developing Countries Mark S. Copelovitch University of Wisconsin David Andrew Singer MIT IPE Society Nov. 15, 2008

Explaining Fiscal Discipline Puzzle: some LDC governments balance their budgets; others run large deficits – “Common pool resource” problem State of the literature: – Exclusive focus on institutions (e.g., Hallerberg and Marier; Persson and Tabellini; von Hagen; etc.) – Mostly OECD – How does financial openness matter? (“straitjacket” or “bonanza”?) – Interests?

Financial openness and domestic interests Argument: impact of financial openness on fiscal behavior is conditional upon domestic interests Domestic “fiscal disciplinarians”: private external borrowers – Banks; some private firms – Varies across countries, time

Private External Borrowers Why are they “fiscal disciplinarians”? – Private cost of capital depends (in part) on sovereign borrowing costs “Sovereign ceiling” – Sovereign borrowing costs increase with default risk – Private external borrowers want the government to have good credit

Composition of Foreign Borrowing, All Developing Countries, $ billion

Private External Borrowing, Select Countries Private non-guaranteed debt, % of GDP

Financial openness has a conditional impact on budget deficits When private external borrowing is extensive: – Financial openness leads to fiscal discipline, because private borrowers want to minimize borrowing costs When private external borrowing is minimal: – Financial openness is indeterminate Facilitates government borrowing (larger capital pool) International investors punish governments for deficits (Mosley 2003)

Empirical Analysis Data: 49 countries, (601 obs) DV: overall budget balance/GDP Explanatory variable: interaction of financial openness (“ KAOPEN ”) and private external borrowing/GDP Other variables: – Inflation, growth, (log) GDP, (log) GDP/c, total external debt/GDP, ER regime, liquid liabilities/GDP, political institutions (checks, PR, federalism, fractionalization) Model: OLS with LDV, country and year fixed effects

Coefficient on Financial Openness at Different Levels of Private External Borrowing

First Differences

Caveats and Conclusions Tentative conclusion: financial openness triggers fiscal discipline from domestic groups that favor affordable foreign capital Bring interests back in to the study of government budgeting Robustness; alternative model specifications Case study evidence