Dynamic heterogeneous panel analysis of financial market disciplinary effects on fiscal balance

This study examines the financial market discipline hypothesis, focusing on whether and how governments adjust their fiscal balances in response to changes in borrowing costs across the member countries of the Organization for Economic Co-operation and Development (OECD). Unlike previous studies, we employ autoregressive distributed lag (ARDL) and cross-sectional (CS) ARDL estimations to control for heterogeneity across countries and cross-country dependence. The estimation results denote that financial markets pressure, measured as long-term interest rates, interest payments, or effective borrowing costs, exerts significant disciplinary effects in the long run on the cyclically adjusted primary balance. However, in the short run, government responses to financial markets pressure are heterogeneous among the sample countries. In some countries, a contemporaneous rise in borrowing costs may negatively affect the primary balance. This study also provides strong evidence of governments’ asymmetric responses to changes in borrowing costs. In the long run, governments tend to pursue policies that reduce the primary deficit in response to an increase in borrowing costs. In contrast, a decrease in borrowing costs appears to exert limited disciplinary effects.