This paper examines the role of primary fiscal balances as a signaling device in a
world in which investors are uncertain about the nature of the sovereign debt issuer.
Based on the Drudi-Prati model that rationalizes debt accumulation and delayed
stabilization, we verify the existence of a rating (sovereign spreads) function that
depends negatively (positively) on the debt ratio and negatively (positively) on the
primary balance. This relationship, however, is non-monotonic and is conditioned on
a threshold debt level. At low debt levels, the primary balance has an ambiguous
relationship with sovereign spreads, but as debt increases, the primary balance?s
effect on spreads is magnified. At low debt levels, both dependable and weak
governments may generate a deficit. But at high debt levels, when default risk
becomes relevant, the dependable government will generate higher primary balance
surpluses to signal to investors its true type. Using individual country data for
Argentina, Brazil, and Turkey, we show that the model describes well the Brazilian
and Turkish experiences during their most recent volatility periods, characterizing
those governments as dependable (in Drudi-Prati?s terminology). Argentina followed
a different adjustment pattern. Pooling the country data and allows verification of
the relationship. The explanatory power of the model improves by allowing
heteroskedasticity in the shocks to each country and heterogeneity in the values of
the estimated coefficients. Hence though spreads react to debt levels and primary
balances in the dependable government cases, they do so with different intensity.
These results imply that, given current debt levels, relaxing the fiscal stance would be
costly for any of these countries, and if they wish to achieve sovereign spreads
compatible with investment grade ratings, further fiscal tightening may be required.
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