Fiscal reaction functions augmented with bespoke debt indicators: evidence from small island states

Developing countries have a higher propensity for debt distress than their developed counterparts and small economies are more vulnerable to external shocks than larger ones. We examine the primary balances of two economies at the intersection of developing and smallness classifications – so-called small island developing states (SIDS) – T&T and Mauritius. These countries have comparable characteristics (smallness, openness, populations, and are former plantation economies with similar colonial histories) but differ in their natural resource wealth status (the former is resource-rich and the latter is resource-poor). Given the myopic insights provided by single metrics of government indebtedness, such as the debt-to-GDP ratio, we augment standard fiscal reaction functions with purpose-built debt sustainability measures that use principal component analysis to consolidate the information content imbedded in a comprehensive range of country-relevant fiscal ratios. Our results show while debt is sustainable in both countries, fiscal policy is procyclical. We also find that debt volatility is positive and significant for T&T’s primary balance but is insignificant for Mauritius, which we attribute to the differing degrees of export-diversification between the countries. Policy recommendations include greater commitments to counter-cyclical fiscal policy in both SIDS and greater export-diversification initiatives in T&T.