Alert regimes for Brazilian fiscal policy: evidences from Markov switching unit root tests

Abstract

Applied works on sustainability of the Brazilian public debt are usually limited to long-run analysis. This work, instead, aims to identify short-term Movements of the deficit-to-GDP time-series, here called alert regimes, which would be a leading indicator of severe fiscal problems. The criterion is based on the fact that a strong growth of the public deficit-to-GDP trajectory, even if transitory, might raise debt-to-GDP ratio and default risk to such a high level that the government could face credit restrictions. The econometrical approach was based on unit root tests with Markovian switching. The results showed the relevance of allowing for time-varying transition probabilities, different volatilities between regimes and explanatory economic variables, thus leading to such a large parameter space that required estimation by the Markov Chain Monte Carlo method. We also proposed a criterion to set the cutoff point for the transition probabilities. The main conclusion of the work was that, as of 2014, Brazilian fiscal policy was very often on alert regime, even though showing a slight trend toward a sustainable perspective regime at the end of the sample (May 2019), given the parameters then in force.