Navigating Fiscal Uncertainty: Economic and Market Implications for Emerging Markets

The study explores the global economic impact of fiscal policy uncertainty, revealing its contractionary effects on industrial production and increased borrowing costs, especially in emerging markets. Using a novel database, it highlights how global fiscal stress events, like the US debt ceiling crises, lead to synchronized financial disruptions worldwide.

Research by researchers from the International Monetary Fund (IMF) Fiscal Affairs Department, investigates the significant economic effects of fiscal policy uncertainty (FPU) on both advanced and emerging markets. Authored by Gee Hee Hong, Shikun (Barry) Ke, and Anh D. M. Nguyen, this study creates a comprehensive, news-based database to examine the impact of global fiscal uncertainty across 189 countries from January 1995 onwards. The novel database tracks uncertainty in government spending, tax policy, and public debt, which can cause financial disruptions globally. Previous research on fiscal uncertainty has been largely limited to a few major economies like the United States, but this paper expands the analysis to assess the global consequences of fiscal policy uncertainty.

A Global Index of Fiscal Policy Uncertainty

The research uses over 47 million news articles archived in Dow Jones Factiva to construct fiscal policy uncertainty indexes. By employing a keyword-based search approach to identify fiscal stress events, the database captures not only country-specific uncertainties but also events that generate international concern, which the authors term as "global fiscal policy uncertainty." The study shows that such global fiscal uncertainty has severe contractionary effects on real economic activities, including industrial production. The contraction is most pronounced during events like the US debt ceiling crises, where ambiguity around debt and fiscal paths undermines market confidence. Interestingly, the research finds that global fiscal policy uncertainty causes more significant reductions in industrial production than country-specific fiscal uncertainties. In both advanced and emerging economies, fiscal uncertainty leads to a decline in industrial output, with a one-standard-deviation increase in global fiscal uncertainty causing a 0.5 percent drop in industrial production within four months. This impact is consistent across income groups and is comparable in scale to other well-known economic uncertainty measures.

The Ripple Effect on Sovereign Borrowing Costs

The paper goes beyond the real economy to show that fiscal uncertainty also has considerable financial consequences. For example, it raises sovereign borrowing costs, especially in emerging markets, making it harder for these countries to finance their public debt. The global nature of fiscal policy uncertainty means that shocks originating in major economies, like the US, can lead to synchronous movements in global financial conditions, even after accounting for other macroeconomic shocks such as changes in US monetary policy. In particular, the research highlights how a surprise increase in global fiscal policy uncertainty leads to a rise in bond spreads and tightening financial conditions. Sovereign borrowing costs increase as bond yields rise, with the effects being more pronounced for emerging markets. The authors suggest that these markets are particularly vulnerable to global fiscal uncertainty due to their weaker financial systems and reliance on external capital.

Measuring Fiscal Uncertainty with VAR Models

The methodology used in the study is a Bayesian vector autoregression (VAR) model, which allows the researchers to measure the impact of fiscal uncertainty shocks on both real economic activity and financial conditions. The model shows that fiscal policy uncertainty shocks are contractionary in nature, reducing industrial output and tightening financial markets. In fact, fiscal uncertainty exerts a contractionary effect across all income groups. The research finds that a global fiscal policy uncertainty shock leads to a synchronous decline in industrial production across different income groups, while the financial impacts of such shocks, such as increased bond spreads, are particularly severe for emerging markets. This finding suggests that countries with weaker financial systems are more susceptible to fiscal stress, which raises concerns about the broader implications of fiscal policy uncertainty for global economic stability.

Global Versus Country-Specific Uncertainty

Moreover, the study also explores potential spillover effects, investigating whether the impact of global fiscal policy uncertainty is greater than that of country-specific fiscal uncertainty. The results confirm that global fiscal policy uncertainty has a more significant impact on domestic economies than localized fiscal uncertainty. This is because global fiscal stress events, like the US debt ceiling crisis, often cause synchronized global financial movements, amplifying their adverse effects. For instance, when the US faces fiscal policy uncertainty, it triggers widespread financial market disruptions, increasing the risk premium for borrowing in other countries. The paper emphasizes the role of the US in global fiscal uncertainty and its potential to drive global financial conditions.

Implications for Policymakers

The research findings have crucial implications for policymakers. With global fiscal policy uncertainty posing risks not only to industrial production but also to financial stability, the need for clear and predictable fiscal policies becomes even more pressing. Policymakers must recognize that the impact of fiscal uncertainty is not confined to domestic markets but can ripple through the global economy, especially when the uncertainty originates from major economies. The authors conclude by noting that global fiscal uncertainty remains a significant challenge for both advanced and emerging markets, with the latter being particularly vulnerable to financial instability as a result. This research underscores the need for governments to manage their fiscal policies carefully to mitigate uncertainty and its wide-ranging economic and financial consequences.