Policy Space and Stabilization Policies in Emerging Markets

For advanced economies, fiscal space is usually measured by public debt. This paper argues that for emerging markets integrated into global portfolio markets the space that matters for stabilization policy sits on the external balance sheet: how much of the country’s liabilities can run to non-residents or fall due in foreign currency, relative to the liquid foreign-currency buffer that can meet them. A panel VAR estimated on 20 such emerging markets over 1990–2024 shows that the average fiscal response to capital outflows conceals a systematic divide. Countries with stronger external positions respond countercyclically, while those with weaker positions tighten policy and suffer larger output losses. The pattern survives year fixed effects, foreign-currency measures of exposure, controls for ratings and the exchange-rate regime, and a shock originating in US credit markets. Within emerging markets, it is predicted by three measures of external exposure—short-term debt to reserves, non-resident holdings of government debt, foreign-currency external debt—and not by domestic public debt; it reverses in advanced economies, where debt is what matters, and reappears in the 2009 and 2020 crises. Countries with weaker external positions also make less use of reserves after outflows, suggesting that one constraint limits both fiscal stabilization and foreign-exchange intervention. A simple model formalizes this mechanism: deficits and reserve sales draw on a common foreign-currency buffer, making the fiscal response depend on external exposure. The model also explains why pooled estimates conceal opposite responses across countries and why external backstops can expand stabilization capacity.