WP/20/52

r-g<0: Can We Sleep More Soundly?

by Paolo Mauro and Jing Zhou

© 2020 International Monetary Fund WP/20/52

IMF Working Paper

Fiscal Affairs Department

r-g<0: Can We Sleep More Soundly*

Prepared by Paolo Mauro and Jing Zhou

March 2020

IMF Working Papers describe research in progress by the author(s) and are published to elicit
comments and to encourage debate. The views expressed in IMF Working Papers are those of the
author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF
management.

Abstract

Contrary to the traditional assumption of interest rates on government debt exceeding economic
growth, negative interest-growth differentials have become prevalent since the global financial
crisis. As these differentials are a key determinant of public debt dynamics, can we sleep more
soundly, despite high government debts? Our paper undertakes an empirical analysis of interest-
growth differentials, using the largest historical database on average effective government
borrowing costs for 55 countries over up to 200 years. We document that negative differentials
have occurred more often than not, in both advanced and emerging economies, and have often
persisted for long historical stretches. Moreover, differentials are no higher prior to sovereign
defaults than in normal times. Marginal (rather than average) government borrowing costs often
rise abruptly and sharply, but just prior to default. Based on these results, our answer is: not
really.

JEL Classification Numbers: E43, E62, H63

Keywords: interest-growth differentials, public debt
Author’s E-Mail Address: pmauro@imf.org, jzhou@imf.org

*
We gratefully acknowledge helpful suggestions by Philip Barrett, Olivier Blanchard, Julio Escolano, Jean-Marc
Fournier, Vitor Gaspar, Ethan Ilzetzki, Catherine Pattillo, Andrea Presbitero, Kenneth Rogoff, and participants in
the IMF's 2019 Annual Research Conference. We thank S. Ali Abbas and Kunxiang Diao for sharing the external
public debt data.
Contents

1 Introduction 3

2 The Data 5

3 Interest-Growth Differentials: Empirical Regularities 6

3.1 The Prevalence of Negative Interest-Growth Differentials in History . . . . . . . . . 6

3.2 The Divergence between Advanced and Emerging Economies (1975–95) . . . . . . . 8

3.3 The Role of Financial Repression and Inflation in Interest-Growth Differentials . . . 9

4 Interest-Growth Differentials, Fiscal Variables, and Sovereign Defaults 12

4.1 Interest-Growth Differentials and the Fiscal Stance . . . . . . . . . . . . . . . . . . . 12

4.2 Interest-Growth Differentials in the Run-up to Default Episodes . . . . . . . . . . . . 14

4.3 Marginal Rates in the Run-up to Default Episodes . . . . . . . . . . . . . . . . . . . 16

5 Conclusion 17

A Data Appendix 27

A.1 Fiscal Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

A.2 GDP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

A.3 Other Financial Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

B Identify Financial Repression Years 29

2
1 Introduction

Standard economic models assume that the interest rate is higher than the growth rate of the
economy. In applications to countries’ public finances, if economic growth exceeds the cost of
government borrowing, the government can just roll over its debt, and the debt-to-GDP ratio will
decline without the need to increase taxes. Economists have recently started rethinking whether the
assumption of a positive interest-growth differential is sufficiently grounded in empirical experience,
and what the implications of relaxing such assumptions would be. In his 2019 American Economic
Association presidential address, Olivier Blanchard reminded us that the interest-growth differential
for government debt has often been negative in the United States. Moreover, differentials have been
negative, on average, in a majority of advanced economies since the Global Financial Crisis (GFC)
that began in 2008, and they have remained negative even in advanced economies whose economic
growth has returned to a healthy pace. Policymakers need to weigh such negative differentials
against the background of higher public debts than prior to the global financial crisis.1 In this
paper, we provide evidence on the prevalence of negative differentials over the past two centuries in
55 advanced and emerging economies. We also show that differentials in country-years preceding
defaults on public debts are no higher than usual, suggesting that interest-growth differentials have
no predictive power for government defaults—at least not until it is too late for policies to take
corrective actions.

The prevalence of high debt levels and low interest-growth differentials suggests several interrelated
questions. First, are the recent low interest-growth differentials unique from a historical perspective?
Second, are there any prominent drivers of changes in such differentials? Third, what is the empirical
association between interest-growth differentials and sovereign defaults? Can low interest-growth
differentials be viewed as strengthening debt sustainability?

In this paper, we address these questions empirically. We begin by assembling data on interest-
growth differentials. In previous studies, the best sources of interest-growth differentials are based
on marginal borrowing rates from Jordà, Schularick and Taylor (2017) for advanced economies
data or author-collected bond-specific data such as Reinhart and Sbrancia (2015). We construct a
larger dataset that contains the public finances, average government borrowing costs, and economic
growth for 55 advanced and emerging countries over up to 200 years, drawing primarily on Mauro
et al. (2015) who had used similar data to analyze the determinants of countries’ primary fiscal
1
Public debts have increased substantially around the world since the outset of the GFC. At end-2018, debt-to-GDP
ratios exceeded 100 percent for the advanced economies (the highest since WWII), 50 percent for emerging markets (a
level not seen since the early 1980s), and 45 percent for the low-income countries (compared with 30 percent pre-GFC).
Rising indebtedness has engendered concerns regarding debt sustainability. Primary deficits are projected to rise in
the advanced economies as a result of aging populations, and in emerging and low-income countries as a result of the
need to invest in human and physical capital. Policymakers need to assess whether low or negative interest-growth
differentials will be enough to offset such fiscal pressures and ensuing risks.

3
surpluses. These data refer to the average effective cost of servicing debt (the ratio of the interest
bill to government debt), which is the appropriate measure for standard debt dynamics accounting
equations.2 For a somewhat smaller sample, we also use marginal borrowing rates. These react
faster to changes in market perceptions, but are an imperfect proxy for future effective interest
rates. Whenever possible, we take account of the role of exchange rate depreciation in the de facto
cost of borrowing in foreign currency, although this portion of the analysis is constrained by the
limited availability of data on the share of foreign currency public debt in total public debt.

We document five empirical regularities. First, negative interest-growth differentials occur for
prolonged periods in history in both advanced and emerging economies. Second, the often-held
view that differentials are more likely negative in emerging than in advanced economies stems
largely from the period between the first oil shock of 1973–74 and the mid-1990s: during that
time, the advanced economies liberalized their capital markets and sought to curb inflation by
allowing interest rates to rise faster than inflation, whereas the emerging economies continued to
use financial repression against the background of high inflation. Prior to the 1980s, the advanced
economies engaged in financial repression too, and by the mid-1990s, many emerging economies had
also liberalized their financial markets. Third, the fiscal stance is somewhat more expansionary, on
average, when interest-growth differentials are low: when differentials decline, the primary fiscal
deficit increases but not nearly enough to fully compensate. Fourth, differentials computed using the
average effective interest rate on government borrowing are essentially useless to predict government
defaults. Fifth, marginal interest rates (on new government borrowing or on the secondary market)
often rise sharply and abruptly but only a few months ahead of defaults.

To sum up, can we sleep more soundly as a result of low differentials? For those who lose sleep over
possible debt crises, the answer is: perhaps a little, but not really. History teaches us that many
crises have occurred after years of low differentials, and that market expectations can turn quickly
and abruptly, shutting countries out of financial markets in a matter of a few months.

Related Literature This paper intends to contribute to three strands of literature. First, several
studies have analyzed interest-growth differentials for either limited country samples or short sample
periods—for instance, Ball, Elmendorf and Mankiw (1995) and Mehrotra and Sergeyev (2019) on
the U.S., Jordà et al. (2019) and Schmelzing (2019) on advanced economies, Escolano, Shabunina
and Woo (2017) on advanced and emerging economies, and Turner and Spinelli (2011) on OECD
economies since the 1980s.3 Some of these studies (Turner and Spinelli (2011), Escolano, Shabunina
and Woo (2017), Kozlowski, Veldkamp and Venkateswaran (2019), Rachel and Summers (2019))
2 1+rt
Based on the government flow budget constraint dt − dt−1 = 1+g t
· dt−1 + pdt ≈ (rt − gt )dt−1 + pdt , where d is
the public debt as share of GDP, pd is the primary deficit as share of GDP, g is the nominal growth rate, and r is the
average effective interest rate on the public debt. For more details see, for instance, Escolano (2010).
3
Our paper focuses on the interest rate for government borrowing, not on the (usually higher) return on capital,
which relates to a different literature on dynamic efficiency (e.g., Abel et al. (1989)) or prospects for future inequality
(e.g., Piketty (2014)).

4
investigate the reasons for negative interest-growth differentials or low interest rates on “safe”
government bonds—such as financial repression, global saving glut, secular stagnation, significant
tail risks, etc., whereas others take negative interest-growth differentials as given and analyze their
implications for debt sustainability and fiscal policies (Barrett (2018), Blanchard (2019), Mehrotra
and Sergeyev (2019)). This paper extends the empirical analysis by drawing on a rich historical
cross-country dataset, giving us a broader perspective on some of the factors underlying variation in
interest-growth differentials.

Second, this paper is related to the studies on financial repression and debt sustainability, which
gauge the effects of financial repression on debt servicing costs (Giovannini and De Melo (1991),
Reinhart and Sbrancia (2015), Reinhart, Kirkegaard and Sbrancia (2011)) or establish the optimal
financial repression given sovereign default risks (Chari, Dovis and Kehoe (forthcoming)). Building
on these studies, our paper employs new ways to systematically date financial repression—including
de jure measures of financial repression and de facto measures based on deviations from uncovered
interest rate parity. Utilizing these identified country-year pairs where financial repression prevails,
this paper provides better estimates of the impact of financial repression on government borrowing
costs.

Third, this paper is linked to the studies on debt sustainability and sovereign defaults. Previous
work has documented that marginal borrowing costs (interest rates spreads) often spike in the
run-up to sovereign defaults (for example, Arellano (2008), Broner, Lorenzoni and Schmukler (2013),
Abbas, Pienkowski and Rogoff (2019)), typically drawing on data beginning in the 1980s. Our new
long time series allows us to compare the behavior of marginal and average effective rates since the
late 1800s. We find that interest-growth differentials can be negative for prolonged periods followed
by sudden spikes in marginal borrowing costs that often culminate in defaults.

The remainder of the paper is organized as follows. Section 2 describes the data. Section 3 reports
stylized facts on the prevalence of negative interest-growth differentials in long-run historical data,
notes that the divergence between advanced and emerging countries is largely confined to 1975–95,
and shows that financial repression and inflation account for the divergence. Section 4 explores the
potential association between sovereign defaults and the differences between effective (or marginal)
interest rates and economic growth. Section 5 concludes.

2 The Data

This paper draws on a dataset consisting of fiscal variables for 55 countries over up to 200 years
(Mauro et al. (2015), updated to 2018)—to our knowledge, the most comprehensive dataset currently
available for both fiscal flows (including the interest bill) and stocks. We augment these data with
information on money market rates, sovereign defaults, and financial market reforms. Full data

5
sources are reported in Appendix A. Our final dataset consists of a cross-country panel over long time
periods for interest payments, public debt stocks, gross domestic products, external public debts,
fiscal balances, money market rates, exchange rates, sovereign default indicators, and policy-based
variables on the level of liberalization in financial markets.

The key variable—the interest-growth differential—is constructed as the difference between the
effective interest rate and the nominal growth rate. The effective interest rate contains two parts:
one is the ratio between the interest bill and the average of the current and previous years’ public
debt stocks, and the other is the depreciation adjustment.4 For countries that issue public debt
in foreign currencies, exchange rate depreciation is an important factor driving changes in public
debt, as emphasized by studies on “original sin” (such as Eichengreen, Hausmann and Panizza
(2003)). We include the depreciation adjustment whenever the necessary data on foreign-currency
public debt is available—for emerging economies, this means from 1970s as the earliest. For the
final sample, we exclude domestic and external sovereign default years (where the intertemporal
government budget constraint does not apply), hyperinflation (greater than 100%), and extreme
exchange rate collapse (top 1 percentile depreciation of the whole sample).

3 Interest-Growth Differentials: Empirical Regularities

We begin by exploring the stylized facts of interest-growth differentials, considering the evolution of
interest-growth differentials in different time periods and country groups.

3.1 The Prevalence of Negative Interest-Growth Differentials in History

On average, interest-growth differentials are negative for both advanced and emerging economies.5
The differentials are approximately negative 2.5 percentage points for advanced economies on average,
and negative 6.5 percentage points for emerging economies. Across time, differentials are more
negative post-WII than Pre-WII, and more negative pre-GFC than post-GFC. Across countries,
emerging economies show lower differentials than advanced economies, although as will be shown
below this difference stems largely from 1975–1995. The medians for both country groups are less
negative than the means (Figure 1), indicating that tail events of very negative differentials are
4
rt − gt = rt + αt−1 · st − gt . αt−1 denotes the last period’s share of external
The formula for the differentials is e
public debt in total public debt and st is the depreciation (against the U.S. dollar) compared with the last period. rt
is the average interest rate on public debt, and gt is the nominal growth rate. Detailed derivation can be found in
Escolano, Shabunina and Woo (2017), for instance.
5
The classification of advanced and emerging economies is based on the present day definition from the IMF’s
World Economic Outlook. We use these country groups for illustration as customary, fully recognizing that the
distinction between advanced and emerging economies is not static throughout: for instance, Australia and Canada
were clearly emerging economies in the pre-WWI period.

6
more common than higher positive ones. For the low and high ends of the distribution, the most
negative differentials are associated with high growth (post-war, for instance), and the most positive
ones come from large depreciation.

Table 1: Summary Statistics: Interest-Growth Differentials by Time Periods

Full sample Pre-WWII Post-WWII Post-1980 Post-GFC
AE EM AE EM AE EM AE EM AE EM
Mean -2.4 -6.6 0.3 2.0 -3.1 -7.6 0.1 -5.5 0.5 -2.9
Median -1.3 -4.8 0.8 2.4 -1.7 -5.3 0.5 -3.9 -0.0 -2.2
Standard Deviation 9.1 14.3 8.5 10.4 8.0 14.4 6.2 12.3 3.8 7.4
N 2789 1468 1009 146 1579 1273 906 867 239 306
Note: This table presents the summary statistics of interest-growth differentials by time periods. AE and
EM refer to advanced economies and emerging market economies, respectively. Pre-WWII period is from
1800–1938, excluding WWI observations. Post-WWII period is from 1950–2018. Post-GFC (global financial
crisis) refers to 2009–2018.

Negative interest-growth differentials have occurred more frequently than not over the past two
centuries for both advanced and emerging economies, though the frequency of negative interest-
growth differentials varies across countries. Figure 2 presents the share of years in which the
differential was negative, for each of the 55 countries in our sample. Although negative interest-
growth differentials are the norm—occurring more than half of the time for both advanced and
emerging economies, the frequency of negative differentials of emerging economies is about 15
percentage points larger than the advanced economies.

3.2 The Divergence between Advanced and Emerging Economies (1975–95)

Interest-growth differentials for country groups vary considerably over time. Average differentials
are strongly negative during the two world wars and in the period between WWII and the first oil
shock. Indeed, advanced and emerging economy average differentials move closely with each other
until around 1975 (Figure 3). From 1975 to 1995, the differentials diverge between the two country
groups, and the average gap widens to 20 percentage points at its peak. The gap narrows in the late
1990s, as emerging economies’ differentials shrink, and it becomes insignificant in the late 2010s.
After 1995, the divergence between advanced and emerging economies emerges again around 2005.
However, it is partly due to emerging economies reintroducing financial repression (for instance,
Argentina, Indonesia, Thailand, and Venezuela), which will be shown in the next section to be an
important factor driving the divergence.

This divergence is jointly driven by the gap in inflation rates between the two country groups
and the different responses of their nominal interest rates to inflation. As an accounting identity,
interest-growth differentials can be decomposed into the differentials of nominal interest rates,

7
 Figure 1: Distribution of Interest-Growth Differentials

.08 mean=-2.4

median=-1.3

.06 mean=-6.6

median=-4.8
Density

.04

.02

0
-100 -80 -60 -40 -20 0 20 40
interest-growth differential, in percentage points

AE EM

Note: This chart plots the whole distribution of interest-growth differentials for advanced economies and emerging
economies for all the observations (2789 for advanced economies, and 1468 for emerging economies). The vertical lines
indicate means and medians, as denoted in the chart.

inflation, real growth, and depreciation adjustment. Assessing each component separately, the gap
across country groups is largely accounted for by differences in inflation during 1975–95, whereas
differences in interest rates, real growth, and depreciation adjustment are small (Figure 3). In
other words, nominal interest rates rose significantly less in response to inflation in the emerging
economies than in the advanced economies.

3.3 The Role of Financial Repression and Inflation in Interest-Growth Differentials

To understand the post-WWII episode and the divergence in differentials between advanced and
emerging economies during 1975 to 1995 requires analyzing inflation as well as financial repression,
which creates and maintains a captive domestic audience that facilitated directing credit to the
government (such as interest rate controls, capital controls, reserve requirements, and government
ownership of banks, etc.). In this section, we focus on that 1975–95 divergence episode because
many policymakers seem to view emerging economies as more prone to negative differentials than
advanced economies. Understanding this episode helps to reconfirm that negative differentials are
not the sole confine of emerging economies.

8
 Figure 2: Share of Years (in percent) with Negative Interest-Growth Differentials, by Country
Advanced Economies Emerging Economies

Denmark 45 Poland 46
Mexico 53
Belgium 46
Brazil 56
Germany 48 Argentina 56
Netherlands 52 Bulgaria 59
Italy 53 Hungary 60
mean= 61 India 62 mean= 75
United Kingdom 54 Romania 70
Austria 56 Chile 70
Canada 56 Dominican Republic 71
Peru 72
Norway 56
Pakistan 75
France 57 South Africa 75
Sweden 57 Venezuela 77
Finland 58 Colombia 78
Indonesia 79
Australia 59 Costa Rica 80
Portugal 61 Haiti 81
Spain 61 Paraguay 81
Thailand 83
Switzerland 63
Panama 83
United States 64 Bolivia 83
New Zealand 65 Philippines 83
Greece 67 Ghana 83
Uruguay 83
Japan 69 Turkey 84
Israel 71 Russian Federation 84
Ireland 77 Honduras 86
Nicaragua 86
Iceland 79
Iran 87
South Korea 97 China 100

0 20 40 60 80 100 0 20 40 60 80 100
share of years with r-g<0 share of years with r-g<0

Note: This chart plots the share of years with negative interest-growth differentials for each country. The sample
period with available data depends on the country. The full sample is from 1800 to 2018 for advanced economies and
1865 to 2018 for emerging economies. The dashed vertical line indicates the mean share across countries in each group.

Financial repression, in combination with inflation, reduces the cost of debt in significant periods
in history. In their study on 12 advanced economies, Reinhart and Sbrancia (2015) find that the
savings of annual debt interest payments amounted to up to 5 percent. On a sample of 24 countries,
Giovannini and De Melo (1991) estimate that the annual revenue gain from financial repression can
be as large as 5 percent of GDP in several countries. This effect is also supported by a comparison
of the interest-growth differentials between advanced economies and emerging economies. As shown
in Figure 3, before the early 1970s, the two country groups move along with each other, and the
gap between their interest-growth differentials is virtually nil. The more negative differentials in
emerging than in advanced economies is a phenomenon of 1975–95, a period in which the advanced
economies liberalized their capital markets, allowing interest rates to rise faster than inflation,
whereas the emerging economies continued to use financial repression to constrain the rise in nominal
interest rates against the background of increasing inflation. Prior to the mid-1970s, the advanced
economies engaged in financial repression too. By the mid-1990s, many emerging economies had
also liberalized their financial markets.

To assess the role of financial repression systematically, we begin by identifying the financial

9
repression and liberalization years, based on both de jure measures from Abiad, Detragiache and
Tressel (2008) and de facto measures as the structural breaks in the UIP deviations (see Appendix
B for more details). Utilizing the identified liberalization years, as a first look, we examine whether
financial repression has constrained interest-growth differentials. Essentially, we estimate the gap
between the interest-growth differentials before and after financial market liberalization using the
following local projection specification on a 5-year horizon:

(r − g)it+j = βj Dit + γDit−1 + ΓXit + αi + it (1)

where j = 1, ..., 5, indicating the number of years after financial liberalization. Dit denote dummies
for whether financial repression is liberalized in country i in year t or not, and X include the real
interest rate (for serial correlation), real growth (for business cycle conditions), the change in public
debt and initial public debt (for fiscal conditions), as well as commodity prices and Moody’s BAA
spreads (for global shocks and risks).

Financial repression years are indeed associated with significantly lower differentials, by 2 to 6
percentage points depending on the type of financial liberalization and the length of post-liberalization
time. We explore different types of financial repression—interest controls, capital controls, and credit
controls—and the de facto measure based on structural breaks in UIP deviations. As presented in
Figure 4, several features stand out. First, the liberalization’s effect takes time to be reflected in
an increase in interest-growth differentials. For instance, none of the liberalization shows impacts
on interest-growth differentials contemporaneously. For interest rate controls and credit controls
liberalizations, differentials do not increase until two years later, and at least one year for capital
control liberalization and de facto liberalization measure. Second, the effects are long-lasting and
remain significant after five years. Third, the de jure and the de facto measures arrive at similar
results in the estimates’ magnitudes.

Having established that financial repression constrains interest-growth differentials, we further

explore the channel through which financial repression operates. Based on the previous results that
the divergence between advanced and emerging economies mainly arises from emerging economies’
high inflation and their subdued interest rate response to high inflation, we are particularly interested
in how financial repression suppresses the response of interest rates to inflation. To this end, we
augment the last section’s specification by adding the interaction term of financial repression and
expected inflation.6
e
yit = β0 F Rit + β1 F Rit × πit + ΓXit + αi + it (2)

As financial repression mostly affects interest rates, we explore its impact not only on interest-growth
differentials but also, in separate regressions, on effective, long-term domestic, and short-term
6
Financial repression constrains the response of interest rate to expected inflation; however, the response of the
interest rate to unexpected inflation does not depend on whether financial repression is present.

10
domestic interest rates. These different dependent variables are denoted by yit .7 We utilize the
continuous financial repression indexes from Abiad, Detragiache and Tressel (2008) and the Chinn-Ito
index, denoted by F R. The control variables X are the same as before. As contemporaneous
inflation is a mismeasured proxy for expected inflation, we use lagged inflation as its instrument.8

In general, financial repression significantly suppresses nominal interest rate and constrains its
response to expected inflation, leading to low differentials (Table 2). Financial repression reduces
nominal interest rates and differentials significantly: a one standard deviation deterioration in the
financial regulation index is associated with a decrease in nominal interest rates and differentials by
about 3 percentage points. These estimates also align with the literature. For instance, using a
dynamic panel setting for a sample of 128 countries over 1999–2008, Escolano, Shabunina and Woo
(2017) estimate the coefficient on the Chinn-Ito capital control index to be around 4. Moreover,
the responses of interest rates to expected inflation are muted by financial repression: associated
with an expected 1 percentage point inflation increase, the rise in effective rates is 0.4 percentage
points lower for the most financial-repressed country (based on mean Chinn-Ito index) than for the
least one. Among different types of interest rates, the role of financial repression is most prominent
in long-term domestic interest rates, because financial repression constrains long-term domestic
interest rates by a greater extent than both effective rates, which contain external interest rates, or
short-term rates, which may not be high enough to be affected.

Based on our estimates, the effective interest rate gap between advanced and emerging economies
would have been reduced by 1.8 percentage points (out of 3.9 percentage points), on average,
if emerging countries aligned with the median level of advanced economies’ financial repression
(measured by the financial reform index), thus allowing interest rates to change freely in response to
economic fluctuations and move toward the level of advanced economies.9

To sum up, negative interest-growth differentials are a common occurrence in countries at all levels
of economic development. The presumption—common in policy circles—that negative differentials
are a phenomenon associated with emerging economies seems to be driven by the experience of
1975–95 and does not stand up to scrutiny when considering longer historical periods.
7
Long-term rate is the 10-year treasury bill rate, and short-term rate is the 3-month treasury bill rate. For the few
countries whose 10-year rates are not available, 5-year or 2-year rates are used instead.
8
Lagged inflation can serve as a valid instrument for expected inflation (McCallum (1976)): under the assumption of
rational expectations, realized inflation πt is equal to the sum of expected inflation πte and a white noise ut . Therefore,
πt−1 is correlated with πte and uncorrelated with ut .
9
One caveat is that our experiment here only aligns financial repression conditions between the two country
groups—the other factors, including inflation and fiscal variables, stay the same. Therefore, the 1.8 percentage points
represents the partial effects of financial liberalization in emerging countries as if they resemble advanced economies,
controlling for any general-equilibrium effects stemming from financial liberalization.

11
 Table 2: Impact of Financial Repression on Interest-Growth Differentials
financial regulation index capital controls index
r−g effective long-term short-term r−g effective long-term short-term
rate (r) rate rate rate (r) rate rate
financial repression -12.916∗∗ -13.306∗∗ -7.515∗∗ 0.684 -3.660∗ -4.327∗ -5.570∗ -0.363
(5.88) (6.16) (2.48) (2.14) (2.19) (2.27) (2.88) (2.17)
financial repression -0.128 0.170 -0.678∗∗ -1.094∗∗∗ -0.421∗ -0.399∗ -0.244∗ -0.424∗
× inflation (0.31) (0.36) (0.31) (0.21) (0.24) (0.21) (0.13) (0.22)
inflation 0.755∗∗ 1.759∗∗∗ 1.176∗∗∗ 0.598∗∗ 0.590∗∗∗ 1.434∗∗∗ 1.338∗∗∗ 1.404∗∗∗
(0.36) (0.40) (0.19) (0.19) (0.16) (0.19) (0.23) (0.23)
lag real interest rate 1.041∗∗∗ 1.035∗∗∗ 0.354∗∗∗ 0.319∗∗∗ 1.053∗∗∗ 1.021∗∗∗ 0.404∗∗∗ 0.622∗∗∗
(0.11) (0.13) (0.09) (0.08) (0.11) (0.10) (0.07) (0.14)
real growth -0.702∗∗ 0.571∗∗ 0.490∗∗∗ 0.259∗∗ -0.911∗∗∗ 0.226∗ 0.175 0.181
(0.22) (0.22) (0.13) (0.13) (0.11) (0.12) (0.12) (0.13)
change in public debt 0.306∗∗ -0.035 0.316∗∗∗ 0.131 0.335∗∗ -0.009 0.224∗∗∗ 0.101
(0.13) (0.13) (0.06) (0.09) (0.10) (0.09) (0.06) (0.09)
lag public debt -0.014 -0.013 0.046∗∗ 0.036∗∗ 0.031∗∗ 0.015 0.038∗∗ 0.046∗∗∗
(0.02) (0.02) (0.01) (0.01) (0.01) (0.01) (0.01) (0.01)
global risk 0.338 0.491∗∗ 0.402∗∗∗ 0.432∗∗∗ -0.264∗∗ -0.140 0.256∗∗ 0.094
(0.23) (0.23) (0.09) (0.10) (0.13) (0.11) (0.13) (0.17)
non-fuel commodity price -0.053∗∗ -0.045∗∗ 0.003 -0.013 -0.057∗∗∗ -0.038∗∗ -0.026∗∗∗ -0.060∗∗
(0.02) (0.02) (0.01) (0.01) (0.01) (0.01) (0.01) (0.02)
fuel commodity price -0.021 0.003 -0.343∗ -0.009 -0.033∗∗ -0.004 -0.067∗∗ -0.033
(0.03) (0.03) (0.20) (0.01) (0.01) (0.02) (0.03) (0.02)
N 1254 1254 837 893 2025 2025 1303 1416
Wald-stat (first stage) 18.74 18.74 31.74 5.819 71.22 71.22 20.05 29.68
Note: This table presents panel regressions of financial repression, inflation, and their interaction term while controlling for macro, fiscal, and global
variables. Financial repression is measured by the financial regulation index and Chinn-Ito index, see text for more details. Standard errors are
clustered at country level.

4 Interest-Growth Differentials, Fiscal Variables, and Sovereign Defaults

Having reviewed the stylized facts on the levels of, and variation in, interest-growth differentials,
we now turn to analyzing their implications for government debt sustainability. As changes in the
public debt ratio are determined by both interest-growth differentials (multiplied by the debt ratio)
and the primary fiscal balance, it is important to consider not only these two items separately,
but also the extent to which they move together: in principle, a decline in differentials could be
more than offset by an increase in the primary fiscal deficit. Therefore, in this section, we explore
the empirical association between differentials and fiscal variables, before turning to an analysis of
whether interest-growth differentials or fiscal variables are significantly different in the run up to
sovereign defaults compared with normal times.

12
4.1 Interest-Growth Differentials and the Fiscal Stance

Considering the whole sample, interest-growth differentials are (marginally) negatively associated
with the primary fiscal balance, with a correlation coefficient of -0.03 (Table 3). (This is the
median across countries of the country-specific correlation coefficients.) On the basis of this simple
correlation, there is tentative evidence that policymakers respond to declining differentials with a
slight expansion of primary fiscal deficits, but almost certainly not enough to fully offset the favorable
impact of lower differentials. Even so, it is worth exploring these potential relationships somewhat
further. The correlation of the primary fiscal balance is significantly positive with economic growth,
reflecting the well-known positive association between fiscal revenues and economic growth; the
correlation of the primary fiscal balance and interest rates is weaker, albeit positive, perhaps as
governments tighten fiscal policies when borrowing costs are higher.

The association between the differentials and the cyclically-adjusted fiscal balance10 is positive and
significant, with a correlation coefficient of 0.15 (0.14 with the real interest rate, suggesting a policy
response to borrowing costs, and -0.03 with real growth, suggesting slightly counter-cyclical fiscal
policies).11 Two caveats are in order when interpreting these correlations: first, the sample consists
of countries at different levels of economic development and financial integration in international
capital markets over long historical periods; second, cyclical adjustment of fiscal variables is difficult
in the presence of changes in trend economic growth—an especially relevant consideration for
emerging economies.

Table 3: Correlations between Interest-Growth Differentials and Fiscal Stance

primary balance cyclically-adjusted primary balance
r−g -0.03 0.15
real r 0.03 0.14
real g 0.09 -0.03
Note: This table reports the median (across countries) of the country-specific
correlations between interest-growth differentials and primary balances. The
sample contains 55 countries and 4257 observations.

To see whether the correlation with real growth or real interest rate drives the overall correlation
between differentials and cyclically-adjusted primary balance, we decompose the correlation as
follows:
σr σg
corr(pbca , r − g) = corr(pbca , r) · − corr(pbca , g) ·
σr−g σr−g
10
The cyclically-adjusted primary balance is calculated as: pbca = pb − eα, where pb denotes primary balance, pbca
denotes cyclically-adjusted primary balance, e denotes spending, all as share of GDP. α denotes the nominal output
gap. In other words, we assume the revenue elasticity to be one and the spending elasticity to be zero, in line with the
estimates in Girouard and André (2005). Even so, cyclical adjustment must be interpreted cautiously, especially for
emerging economies, because the business cycle fluctuations in emerging economies are primarily driven by shocks in
trend economic growth (Aguiar and Gopinath (2007)).
11
Here we abstract from the depreciation adjustment as its correlation with the differentials is found to be negligible.

13
The overall correlation is the difference between the correlations of each component adjusted by the
standard deviation (denoted by σ) ratios. As reported in Table 4, the real interest rate plays the
dominant role in the overall correlation, showing both higher correlation with cyclically-adjusted
primary balance and higher standard deviation relative to that of interest-growth differentials.
Advanced economies have a higher correlation than the emerging economies between the real interest
rate and the cyclically-adjusted primary balance, which indicates that fiscal expansions in advanced
economies when real interest rates are low exceeds those of emerging economies.

Table 4: Decomposing the Correlations between Interest-Growth Differentials and Fiscal Stance
σr σg
corr(pbca , r − g) corr(pbca , r) corr(pbca , g)
σr−g σr−g
Full sample 0.19 0.21 0.88 -0.03 0.45
Advanced Economies 0.22 0.25 0.87 -0.03 0.50
Emerging Economies 0.14 0.15 0.89 -0.02 0.36
Note: This table decomposes the correlations between interest-growth differentials and cyclically-
adjusted primary balance, and the mean of the country-specific correlations are reported. See the main
text for details on the decomposition. The sample contains 55 countries and 4257 observations.

To explore the conditional relationship between interest-growth differentials and the primary balance,
we estimate the fiscal response function following studies such as Bohn (2008) and Mauro et al.
(2015) to include the role of interest-growth differentials. The regression is specified as

pbit = β1 dit−1 + β2 (r − g)it + β3 dit−1 × (r − g)it + ΓXit + αi + it (3)

where pb denotes the primary balance and d is the public debt, both as a share of GDP. and X
includes the real output gap, the real public spending gap, and commodity prices, varying in different
specifications.12

The primary fiscal balance is tighter when interest-growth differentials are higher, with the magnitude
of tightening increasing with initial debt level (Table 5). We first replicate Bohn (2008), and the
results align with the literature—a 10 percent increase in the debt-to-GDP ratio is associated with a
0.1 percent of GDP primary balance tightening. With interest-growth differentials included, we find
that the coefficient of the interaction between debt and differentials is significantly positive; however,
the magnitude is not high enough to offset the direct impact of differentials on debt servicing cost.
Considering, for instance, a country with a 100% debt-to-GDP ratio, a 100 basis points decrease in
differentials is associated with an expansion in the primary fiscal balance by 0.1 percent of GDP,
far less than the beneficial impact on the debt ratio (1 percent of GDP) that stems through the
accounting relationship from the lower differential times the debt ratio. In other words, taking these
12
The real output gap and public spending gap are the HP-filtered cyclical components of the logarithm real GDP
and logarithm real public spending, representing the percent deviation from their trends, respectively. Real public
spending is the nominal spending deflated by GDP deflator.

14
empirical associations at face value, policymakers would seem to respond to lower differentials by
expanding the primary fiscal deficit, but not nearly enough to offset the direct, beneficial impact of
lower differentials on the debt ratio.

Table 5: Primary Balance Response Functions and Interest-Growth Differentials

(1) (2) (3) (4) (5) (6)
lag public debt 0.010 ∗ 0.010 ∗ 0.012 ∗∗ 0.011 ∗∗ 0.011∗∗
(0.01) (0.01) (0.01) (0.01) (0.01)
lag public debt × (r − g) 0.001 ∗∗ 0.001 ∗∗ 0.001 ∗∗ 0.001∗∗
(0.00) (0.00) (0.00) (0.00)
r−g -0.003 -0.000 -0.000
(0.01) (0.01) (0.01)
real output gap 0.076 0.117∗∗ 0.118∗∗
(0.05) (0.05) (0.05)
real spending gap -0.100∗∗∗ -0.103∗∗∗ -0.103∗∗∗
(0.02) (0.02) (0.02)
non-fuel commodity price 0.001
(0.00)
fuel commodity price -0.005
(0.01)
N 4007 4007 4007 4007 4007 4007
R 2 0.008 0.111 0.014 0.024 0.133 0.133
Note: This table presents panel regressions of primary balance (as share of GDP) response functions.
Column (1) and (2) are the baseline fiscal response functions in the literature. Column (3) to (6) augment
fiscal response functions with lagged public debt, r − g, and interaction term, in various forms. Standard
errors are clustered at country level, also allowing for cross-sectional dependence.

4.2 Interest-Growth Differentials in the Run-up to Default Episodes

Having explored whether the impact of changes in interest-growth differentials on debt dynamics can
be attenuated by fiscal responses, we now analyze whether unfavorable differentials are associated
with sovereign defaults. We focus on whether differentials are higher in the run-up to defaults than
in “normal times”, using an approach similar to Gourinchas and Obstfeld (2012). We define “normal
times” as all years except: (i) those when the country is in default, (ii) the three years after the
completion of debt restructuring, or (iii) the five years prior to default. The estimated equation is
as follows:
5
j
X
yit = βj Dit + λt + αi + it (4)
j=1

j
where Dit denotes j years before default. Besides the country fixed effects as in Gourinchas and
Obstfeld (2012), we also include year fixed effects to control for any global factors that may affect
interest-growth differentials, such as shocks to global risk aversion. The estimates of β1 , ..., β5 are

15
presented in Figure 5.

Interest-growth differentials in the run-up to default do not significantly differ from those in normal
times. Although there is an increase toward the onset of default, it is not significant. This pattern
holds in all of the full sample, the post-war, advanced economies, and emerging economies subsamples.
Further decomposition of interest-growth differentials into components shows that real economic
growth is significantly lower than usual the year prior to default, and that a growth deceleration is
visible—while not significant—in the years prior to defaults. Real interest rates are somewhat lower
than usual, albeit not significantly.13 On balance, we cannot reject that interest-growth differentials
are the same as in normal times.

Sovereign defaults in emerging countries are often just preceded or accompanied by large depreciation,
which could boost the debt ratio. To take account of this effect, we assess the differences in
depreciation adjustment between the run-up to default and normal times in the same specification
as before. The results (Figure 5) show that depreciations are, on average, 20 percent larger in the
year prior to default compared with normal times. This leads to higher depreciation adjustment,
8.8 percentage points one year prior to default, significant at the 90% level. However, zooming into
the months preceding default reveals that visibly large depreciations—albeit insignificant—do not
show up until a few months prior to default.

Turning
in the year before default. Specifically, in the year prior to default, the primary fiscal balance is
about 1 percent of GDP lower than in normal times, even after teasing out the cyclical component.
In the meantime, public debt is 16 percent higher, as share of GDP. These results suggest that
interest-growth differentials do not help to predict defaults, whereas primary deficits and public
debt ratios seem to have some predictive power. These results are confirmed by Moreno Badia et al.
(2020), who reach the same conclusion using a machine learning method in the context of an early
warning system for fiscal crises, based on a large sample of countries and more than 100 variables
over a shorter sample period.

4.3 Marginal Rates in the Run-up to Default Episodes

The marginal interest rate responds faster than the average effective rate to changes in market
participants’ sentiments. There is abundant evidence documenting the increase of marginal rates in
the run-up to defaults. For instance, in the cases of Greece, Argentina, Dominican Republic, etc.
(Figure 6), marginal rates skyrocketed in the run-up to default.14 A similar pattern is observed in
13
Inflation is calculated using the GDP deflator, and the (ex-post) real interest rate is the nominal rate adjusted for
this period’s inflation.
14
The marginal rates are calculated as 10-year treasury bond yields for Greece and EMBI spread plus the U.S.
10-year treasury yields for emerging markets.

16
more distant default episodes such as Uruguay in 1876 and Greece in 1894 (Figure 7).

Averaging across all default episodes, marginal rates in the run-up to defaults exceed those in
normal times by about 2 percentage points, and the differences are statistically significant (Figure 8).
This pattern holds for marginal rates measured on both domestic currency borrowing and foreign
currency borrowing, and it is slightly more pronounced on the foreign currency portion.

Although the marginal rate increases significantly preceding sovereign defaults, it does not give
much time for policy makers to react. Unpacking the year before default into months (Figure 9),
sizable gaps emerge about six months before default, and they keep growing as default approaches.
However, the increases are not robustly significant until two months prior to default. Therefore,
marginal rates do not buy much time for corrective policy measures to take place.

To recall, the average effective interest rate is the relevant rate to determine debt dynamics. The
marginal rate, which measures the borrowing cost for new issuance, reflects market sentiments more
quickly but is an imperfect proxy for future developments in the average effective interest rate. The
marginal rates are only relevant for debt dynamics when changes in sentiments are sustained for a
long time and such changes affect the whole maturity structure of the debt. The marginal rate is,
more importantly, a reflection of whether investors are willing to roll over the debt. Increases in the
marginal rate are the mirror image of a default triggered by a change in market sentiment, which is
in turn hard to predict. Fiscal variables such as debts and deficits have some predictive power, but
average effective interest-growth differentials do not.

5 Conclusion

Our empirical analysis of interest-growth differentials and their role in public finance is relevant from
the standpoint of economic models, which usually assume that the interest rate exceeds the rate
of growth of the economy. It is also relevant from perspective of policymaking, especially against
the backdrop of two features of the post-GFC setting: the prevalence of low and often negative
interest-growth differentials and high public debt ratios. We find that the negative differentials
experienced today are not unprecedented—on the contrary, they prevail in the history of both
advanced and emerging economies. Negative differentials are, if anything, the norm rather than
the exception during the past two centuries. Moreover, low differentials based on average effective
interest rates are not associated with lower frequency of sovereign defaults, whereas fiscal deficits
and debts seem to have some (albeit limited) predictive power for sovereign defaults.

In view of these findings, can we sleep more soundly given low differentials? Based on the findings
reported in this paper, our answer is: not really. Sovereign default histories demonstrate that after
prolonged periods of low differentials based on average effective interest rates, marginal borrowing

17
costs can rise suddenly and sharply, shutting countries out of financial markets at short notice.

Our paper has abstracted from analyzing a full set of exogenous contributors to interest-growth
differentials. A more complete analysis would require taking into consideration the reasons why
interest-growth differentials are currently so low, as pointed out, for example, by Garín et al. (2019).
Our objective has been to caution that negative differentials do not necessarily reduce the likelihood
of government defaults in the years ahead. Only with further reflection on the factors underlying
the low differentials, as well as prospects for the primary fiscal balance, will we be able to make
fully informed judgments on an appropriate stance of policies.

18
 Figure 3: The Divergence Between Advanced and Emerging Economies
Interest-Growth Differential

20
10
%

0
-10
-20

1800 1820 1840 1860 1880 1900 1920 1940 1960 1980 2000 2020
Real Growth

20
10
%

0
-10
-20
1800 1820 1840 1860 1880 1900 1920 1940 1960 1980 2000 2020
Interest Rate

20
10
%

0
-10
-20
1800 1820 1840 1860 1880 1900 1920 1940 1960 1980 2000 2020
Inflation

20
10
%

0
-10
-20
1800 1820 1840 1860 1880 1900 1920 1940 1960 1980 2000 2020
Depreciation Adjustment

20
10
%

0
-10
-20
1800 1820 1840 1860 1880 1900 1920 1940 1960 1980 2000 2020

WWI WWII Great Depression 1970s US, UK Recessions Oil price shock

Great Recession Bretton Woods breakdown financial liberalization EM AE

Note: This chart plots the average of interest-growth differential, real growth, effective interest rate, and inflation
of advanced economies and emerging countries, respectively. The confidence band is calculated with normal
kernel smoothing. The advanced economies include AUS, BEL, CAN, DEU, DNK, ESP, FRA, GBR, ITA, JPN,
NLD, NOR, NZL, PRT, SWE, and USA, which have at least 100 observations. The emerging countries included
are ARG, BRA, COL, CRI, IND, MEX, PAK, PHL, THA, 19VEN, and ZAF, which have at least 50 observations.
 Figure 4: Interest-Growth Differentials After Financial Liberalization, Local Projection

10
10

8
r-g, in percentage points

r-g, in percentage points

5 6

0
-5
0 1 2 3 4 5 0 1 2 3 4 5
years after liberalization (interest rate controls) years after liberalization (capital controls)

6
10

4
r-g, in percentage points

r-g, in percentage points

2
5

-2

-4
0 1 2 3 4 5 0 1 2 3 4 5
years after liberalization (credit controls) years after liberalization (UIP deviations)

Note: This chart plots the changes in interest-growth differentials after financial liberalizations, based on local
projection. Financial liberalizations are measured by de jure measures—interest rate controls removal, capital controls
removal, and credit controls removal, respectively. De facto measure is also included (right lower corner panel),
measured by structural breaks in the deviations to the uncovered interest rate parity. The shaded areas indicate 95%
(the lighter) and 90% (the darker) confidence intervals, respectively.

20
 Figure 5: Interest-Growth Differentials and Fiscal Variables in the Run-up to Sovereign Default
Interest-Growth Differential Interest-Growth Differential, no depreciation adjustment
Interest-Growth Differential: Subsamples
10.0 5.0
Post-war Advanced economies
Emerging economies
15.0
5.0
0.0 0.3
2.8 -0.1
-0.5 10.0
0.9
0.0
5.0 5.4
-1.3 -3.4
3.2
2.3 2.5 2.0 2.4
-3.9 -5.0 -5.2 1.7
-5.0 0.0 -0.8 -0.6
-1.1
-6.0
-2.5
-3.3 -3.4
-4.3 -4.5
-5.0
-10.0 -10.0
-5 -4 -3 -2 -1 -5 -4 -3 -2 -1 -10.0
years to default years to default
-5 -4 -3 -2 -1
Note: No. of default episodes with all 5 pre-default years = 33 Note: No. of default episodes with all 5 pre-default years = 33 years to default
No. of default episodes with at least 1 pre-default year = 49 No. of default episodes with at least 1 pre-default year = 49
Real Interest Rate Real Growth Inflation
5.0
2.0 5.0

1.1
1.9
0.2 1.1 0.7
0.0 0.0
-0.8 -0.3 0.0
-1.1
-1.0 -1.8 -1.6
-2.8
-3.1
-4.1 -2.0
-5.0 -5.0
-3.1

-4.0
-10.0 -10.0
-5 -4 -3 -2 -1 -5 -4 -3 -2 -1 -5 -4 -3 -2 -1
years to default years to default years to default
Note: No. of default episodes with all 5 pre-default years = 33 Note: No. of default episodes with all 5 pre-default years = 33 Note: No. of default episodes with all 5 pre-default years = 33
No. of default episodes with at least 1 pre-default year = 49 No. of default episodes with at least 1 pre-default year = 49 No. of default episodes with at least 1 pre-default year = 49
Depreciation Adjustment Depreciation Depreciation, by month
20.0 40.0 30.0

20.0
10.0 20.0 20.1
8.8

4.1 10.0 9.6

0.0 0.0
-2.3 -2.0 -1.7 -3.9 -4.8 -3.8 2.2 2.2
-6.0 1.0 1.0
0.0 -0.1 -0.4 0.4 0.0 0.0
-1.3 -1.1

-10.0 -20.0
-10.0
-5 -4 -3 -2 -1 -5 -4 -3 -2 -1
-12 -11 -10 -9 -8 -7 -6 -5 -4 -3 -2 -1
years to default years to default
months to default
Note: No. of default episodes with all 5 pre-default years = 11 Note: No. of default episodes with all 5 pre-default years = 18
No. of default episodes with at least 1 pre-default year = 17 No. of default episodes with at least 1 pre-default year = 27 Note: No. of default episodes =12
Primary Balance, in percent of GDP Cyclical-adjusted Primary Balance, in percent of GDP Public Debt, in percent of GDP
1.0 1.0 30.0

20.0
0.0 0.0 16.5
-0.3
-0.4 -0.4
10.0
-0.6 -0.7 8.4
-0.8 -0.7 7.8 7.0
-0.9 6.4
-1.0
-1.0 -1.0
-1.2
0.0

-2.0
-2.0
-10.0
-5 -4 -3 -2 -1 -5 -4 -3 -2 -1 -5 -4 -3 -2 -1
years to default years to default years to default
Note: No. of default episodes with all 5 pre-default years = 33 Note: No. of default episodes with all 5 pre-default years = 33 Note: No. of default episodes with all 5 pre-default years = 33
No. of default episodes with at least 1 pre-default year = 48 No. of default episodes with at least 1 pre-default year = 48 No. of default episodes with at least 1 pre-default year = 49

Note: This chart plots the interest-growth differentials, the real interest rate, the inflation, the real growth, the
exchange rate depreciations, the primary fiscal balance, and public debt as share of GDP in the run-up to sovereign
default. The point estimate is the value in years before the onset of sovereign default compared with normal years,
controlling for country and year fixed effects. Debt restructuring years and (three years) post debt restructuring years
are dropped from the sample. The sample contains 27 21 sovereign default episodes for annual depreciation-related
variables, 12 for monthly depreciation, and 49 for the rest. The narrower and wider bands indicate the 90% and 95%
confidence intervals, respectively.
 Figure 6: Dynamics of Marginal Interest Rate during Recent Sovereign Default Episodes
Greece Argentina
10 40
15
6000

10 4000
5 20
percentage points

percentage points
5 2000

0 0 0 0

-5 -2000
-5 -20
-10 -4000

-6000
-15
-10 -40
1 1 1 1 1 1 1 1 1 1 m1 m1 m1 m1 m1 m1 m1 m1 m1 m1 m1 m1 m1 m1
0 7m 08m 09m 10m 11m 12m 13m 14m 15m 16m 96 97 98 99 00 01 02 03 04 05 06 07 08 09
20 20 20 20 20 20 20 20 20 20 19 19 19 19 20 20 20 20 20 20 20 20 20 20

r embi (RHS) real g r embi (RHS) real g

forecast real g default forecast real g default
Dominican Republic Uruguay
10 2000 1500
10

1000
1000 5
percentage points

percentage points

5 500

0 0 0

0 -500
-1000 -5
-1000

-10
-5 -2000 -1500
m1 m1 m1 m1 m1 m1 m1 m1 m1 m1 m1 m1 m1 m1 m1 m1 m1 m1 m1 m1 m1 m1
99 00 01 02 03 04 05 06 07 08 09 97 98 99 00 01 02 03 04 05 06 07
19 20 20 20 20 20 20 20 20 20 20 19 19 19 20 20 20 20 20 20 20 20

r embi (RHS) real g r embi (RHS) real g

forecast real g default forecast real g default
Russian Federation
15 6000

10 4000
percentage points

5 2000

0 0

-5 -2000

-10 -4000

-15 -6000
m1 m1 m1 m1 m1 m1 m1 m1 m1 m1 m1 m1
93 94 95 96 97 98 99 00 01 02 03 04
19 19 19 19 19 19 19 20 20 20 20 20

r embi (RHS) real g

forecast real g default

Note: This chart plots the evolution of marginal interest rate during recent sovereign default episodes. The margin
interest rate is the sum of sovereign bond EMBI spread and the U.S. 10-year treasury bond yield.

22
 Figure 7: Dynamics of Marginal Interest Rate during Historical Sovereign Default Episodes
Greece Turkey
20
80

60
15
percentage points

percentage points
40

10

20

5
0
m1 m1 m1 m1 m1 m1 m1 m1 m1 m1 m1 2m1 4m1 6m1 8m1 0m1 2m1 4m1 6m1
88 889 890 891 892 893 894 895 896 897 70 7 7 7 7 8 8 8 8
18 1 1 1 1 1 1 1 1 1 18 18 18 18 18 18 18 18 18

embi default embi default

Colombia Costa Rica
200
30

150
percentage points

percentage points

20

100

10
50

0 0
m1 m1 m1 m1 m1 m1 m1 m 1 m1 5m1 0m1 5m1 0m1 5m1 0m1 5m1 0m1
75 80 85 90 95 00 05 10 70 7 8 8 9 9 0 0 1
18 18 18 18 18 19 19 19 18 18 18 18 18 18 19 19 19

embi default embi default

Uruguay
40

30
percentage points

20

10

0
m1 m1 m1 m1 m1 m1 m1 m1 m1 m1 m1
71 72 73 74 75 76 77 78 79 80 81
18 18 18 18 18 18 18 18 18 18 18

embi default

Note: This chart plots the evolution of marginal interest rate during historical sovereign default episodes before 1930s.
The margin interest rate is the sum of sovereign bond spread and the consol bond rate.

23
 Figure 8: Marginal Interest Rates in the Run-up to Sovereign Default

marginal (domestic currency) marginal (foreign currency)

average effective rate
4.0

2.2
2.0
1.7

0.8
0.6
0.2 0.3 0.3
0.2 0.2
0.0
-0.4 -0.3
-0.8 -0.7
-1.1 -1.0

-2.0

-5 -4 -3 -2 -1
years to default
Note: No. of default episodes with domestic marginal rates in all 5 pre-default years =17, foreign =13
No. of default episodes with domestic marginal rates in at least 1 pre-default year =21, foreign =22

Note: This chart plots the marginal interest rates in the run-up to sovereign default. Domestic marginal rates are the
10-year treasury bond yields, and foreign marginal rates are the sum of EMBI spreads and 10-year U.S. treasury bond
yields. The point estimate is the value in years before the onset of sovereign default compared with normal years,
controlling for country and year fixed effects. Debt restructuring years and (three years) post debt restructuring years
are dropped from the sample. The band indicates the 95% confidence interval.

Figure 9: Marginal Interest Rates in the Run-up to Sovereign Default, by Month

EM marginal rate (foreign currency)

10.0

5.8
5.0 4.9

2.7 2.8 2.9 3.0

2.0
1.3
0.6 0.7
0.0 0.1 0.2

-5.0
-12 -11 -10 -9 -8 -7 -6 -5 -4 -3 -2 -1
months to default
Note: No. of default episodes =15

Note: This chart plots the marginal rates in the twelve months preceding sovereign default. The sample covers 15
default episodes, 8 cases in the late 1800s and early 1900s, and the rest in the post-1985 years. The point is the
value in months before the onset of sovereign default compared with normal months, controlling for country and year
fixed effects. In-default months and three years post debt restructuring are dropped out from the sample. The band
indicates the 95% confidence interval.

24
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Appendix

A Data Appendix

A.1 Fiscal Variables

The centerpiece of our data consists of fiscal variables and, in particular, the interest bill from which
we compute the effective interest rate on government debt, covering an unbalanced panel of 55
countries (24 advanced economies and 31 emerging economies, using the present-day classification
from the IMF’s World Economic Outlook classification) over 1800-2018.15

An important issue in the construction of long-term fiscal data series relates to the choice of
government sector coverage. In order to refer to the most comprehensive sector of government for
which they were available, the data at the general government level are collected wherever available.
In most cases, general government data are unavailable before 1960—not surprisingly, given that
for most countries the share of spending by sub-national governments has risen significantly only
since then. As a result, the sector reported switches (in most cases, simultaneously for all variables—
including the interest bill and the debt stock—for a given country) from central government to
general government in nearly all final spliced series, and this switch generally happens in the 1960s
or 70s. Breaks in series are recorded in the database.

The average effective interest rate on debt is computed as the ratio of the interest bill in year t
to the stock of government debt (average of debt stocks of year-end t and t − 1) from the sources
above. The marginal cost of borrowing (in most cases, yield to maturity on the secondary market)
is compiled from Mauro, Sussman and Yafeh (2002, 2006) for 1870-1914 and Datastream—updated
to June 2019.

External public debt comes from a dataset assembled by the IMF staff using the WB-IMF Quarterly
Public Sector Debt, OECD Central Government Debt, WEO, Guscina and Jeanne (2006), Morsy
et al. (2007), Abbas and Christensen (2010), Abbas et al. (2010), and Abbas et al. (2014). We
extend it back to 1970 using the World Bank’s International Debt Statistics when possible.
15
Half of the observations for the fiscal variables in the dataset are drawn from various cross-country sources,
including the IMF’s World Economic Outlook (WEO) and International Financial Statistics (IFS) and the OECD
Analytical Database for the past 20 to 50 years (subject to availability); the Statistical Yearbooks of the League of
Nations and the United Nations (as well as their Public Debt Supplements) for the period between World War I
and the 1970s; and Flandreau and Zumer (2004) for the pre-World War I era; in addition, long-run historical series
are drawn from Mitchell’s International Historical Statistics and the Montevideo-Oxford Latin American Database
(MOXLAD). The other half of the data is hand-collected from country-specific sources, such as official government
publications or economic histories that included public finance statistics. Examples of such data sources include
Fregert and Gustafsson (2005) for Sweden over 1800-2004; Fernandez and Acha (1976) for Spain over 1850–1975; and
Junguito and Rincon (2004) for Colombia over 1923-2003.

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A.2 GDP

For nominal GDP data from the distant past, the main sources are Mitchell and MOXLAD. For
most countries, GDP data do not exist before World War I: in these years, GDP is proxied by
variables such as Gross National Product or Net National Product from Mitchell’s International
Historical Statistics. In a few cases, UN statistical yearbooks are used to fill in gaps in coverage
between 1940 and 1975. GDP data are drawn from the OECD database for a few member countries
beginning as early as 1960. For some countries, such as the United States, the United Kingdom,
Italy, the Netherlands, Japan, Canada, and India, GDP is based on government publications or
other country-specific sources. Starting in the mid 1990s, GDP data for almost all countries are
taken from the WEO. Many sources, both cross-country and country-specific, provided fiscal data
already expressed in terms of GDP as well. To ensure the quality of our fiscal and GDP data, we
crosscheck with Jordà, Schularick and Taylor (2017) for 17 advanced economies from 1870 to 2016.

Based on the fiscal variables and GDP data, the interest-growth differentials are calculated as the
differences between average effective interest rates on debt and nominal growth rates. To take
account of the revaluation impact of exchange rate depreciation on public debt denominated in
foreign currency, we later allow for depreciation adjustment, and more details can be found in
Section 3.3.

A.3 Other Financial Variables

Money market rates, exchange rate. Drawn from Global Financial Data. Money market rate is the
3-month treasury yield in the secondary market, and 3-month interbank overnight borrowing rate is
used if 3-month treasury yield not available.

Sovereign defaults. Years of default are drawn from Reinhart and Rogoff (2009) and, for 2009 to
2018, Moody’s “Sovereign Default and Recovery Rates, 1983-2018” over 2009 to 2018. Months of
default are from Mauro, Sussman and Yafeh (2002) and Asonuma and Trebesch (2016).

Financial repression. Based on a dataset of financial reforms from Abiad, Detragiache and Tressel
(2008), covering 91 countries since 1973. The database recognizes the multi-faceted nature of
financial reform and records financial policy changes along seven different dimensions: credit controls
and reserve requirements, interest rate controls, entry barriers, state ownership, policies on securities
markets, banking regulations, and restrictions on the capital account. Liberalization scores for each
category are combined in a graded index that is normalized between zero and one.

29
B Identify Financial Repression Years

To analyze the role of financial repression in reducing debt cost, we being with identifying the
financial repression years for each country. We employ both de jure and de facto measures. The de
jure measures come from Abiad, Detragiache and Tressel (2008), as illustrated before, they cover
inclusive aspects of financial sector policy such as interest rate controls and capital controls. We
define the liberalization year as the first year that the index of interest rate controls and capital
controls reach the highest category, meaning free market. For the case the index decreases after
reaching the highest category, we set the most recent year when the highest value is first reached.
Therefore, our estimates can be viewed as a lower bound. The de facto measures are the structural
breaks in the UIP deviations, which we identify by applying Bai and Perron (1998). The motivation
comes from that frictions in the financial market imposed by finance repression can lead to UIP
deviations. We calculate the 3-month horizon UIP deviation using the second market yields of
the sovereign bonds. We set the 3-month horizon as the 3-month interest rates provide the largest
country and year coverage, and the 3-month provides sufficient frequency to identify structure breaks.
Note that as we use the 3-month interest rates, their structure breaks are neither automatically nor
substantially lead to structure breaks on the effective interest rate which is used in interest-growth
differentials.

The de jure and the de facto measures complement each other and provide ways for cross-validation.
The advantage of the de jure measures is that they are objectively defined by the change in the policy
regulations. However, the available policy measures still miss certain types of financial repression.
For instance, financial repression can take the non-legislated form, such as moral suasion by putting
pressure on banks to extend material support to the government. For instance, in the late 1940s, the
Bank of England can make recommendations to bankers to take actions in the public interest and if
these recommendations were not followed, with the approval of the Treasury, to issue directions
to any banker. The de facto measures are market-based, which are able to capture the changes in
interest rate resulted from all explicit and implicit regulations. That said, there are a couple of
challenges. First, the UIP deviation suffer from measurement errors because the expected exchange
rate is unobservable. To minimize measurement errors in using the UIP deviations and work around
the benchmark, we employ various approaches to calculate expected future exchange rates, namely,
the actual exchange rate, last period’s exchange rate, the average of last three periods, and the
expected future exchange rate backed from the Purchasing Power Parity. Second, as UIP usually
does not hold, it is difficult to benchmark a counterfactual for no financial repression. Therefore, we
only focus on the structure breaks rather than all deviations from UIP. The liberalization years
identified by de facto measures are considerably close to those by the de jure. For instance, the
median difference of the liberalization years between the UIP deviation and the capital controls
abolishment is 2-year. Also, different measures of UIP deviation result in very similar liberalization

30
years, with the largest difference of 2-year.

As presented in Figure 10, the de jure measures show that there is a significant wave of financial
liberalization starting from the early 1980s for advanced economies (earliest as 1963, latest as 1988)
and from the late 1980s for emerging countries (earliest as 1974, latest as 2004). For instance, the
Bank of England stopped publishing the Minimum Lending Rate in 1981, interest rates ceilings were
abolished om 1967 in Canada, deposit rates were liberalized in 1988-89 in Mexico, and restrictions
on capital movements were lifted after August 1989 in Turkey. By the end of 1990s, the majority of
advanced economies have abolished interest controls and capital controls. The liberalization process
in emerging economies is still ongoing.

Figure 10: De jure measures of Financial Repression

Advanced Economies
1 3

.8 2.5

2
.6
1.5

.4
1

.2 .5
1970 1980 1990 2000 2010
Emerging Economies
.8 3

.6
2

.4
1
.2

0
0
1970 1980 1990 2000 2010

financial reform index (LHS) interest rate controls

credit controls capital controls
Note: This chart plots the average of financial repression indexes across years. The financial indexes include interest
rate controls, credit controls, capital controls, and an overall financial reform index. The shaded area is the 95%
confidence band calculated by normal kernal smoothing. For all the indexes, the higher the value, the less regulated.

31