Debt Intolerance: Threshold Level and Composition
Fiscal vulnerabilities depend on both the level and composition of government debt. This study investigates this threshold level of debt and its composition to understand the non-linear behavior of the long-term interest rate by developing a novel approach: a panel smooth transition regression with a general logistic model (i.e., a generalized panel smooth transition regression). Our main findings are threefold: (i) the impact of the expected public debt on the interest rate would increase exponentially and significantly as the foreign private holdings ratio exceeds approximately 20 percent; otherwise, strong home bias would mitigate the upward pressure of an increase in public debt on the interest rate; (ii) if the expected public debt-to-GDP ratio exceeds a certain level that depends on the funding source, an increase in foreign private holdings of government debt would cause a rise in long-term interest rates, offsetting the downward effect on long-term interest rates by expanding market liquidity; and (iii) out-of-sample forecast of our novel non-linear model is more accurate than those of previous methods. As such, the composition of government debt plays an important role in the highly non-linear behavior of the long-term interest rate.
As argued by Reinhart et al. (2003), fiscal vulnerabilities depend on both the level and composition (foreign vs. domestic) of government debt. They describe the “debt intolerance” phenomenon, in which interest rates in developing economies can spike above the “tolerance ceiling,” even though the debt levels could be considered manageable by advanced country standards. Long-term interest rates in advanced economies have been lower than those in emerging markets although debt levels in advanced economies such as Japan, the United Kingdom and the United State are much higher than in emerging markets (Figures 1 and 2). While significant research has been devoted to estimating the marginal impact of public debt on long-term interest rates, there are different estimated impacts, even though they control for fundamental variables such as inflation expectations and growth rates.