Public Sector Debt and Financial Development

Abstract

The great financial crisis of 2008 established a new monetary and financial system internationally. The changes manifested themselves, in advanced economies, in three relevant aspects an enduring low-interest rates, liquid and deep derivatives and money markets, and an inherited high level of private debt. Therefore, the relationship between financial, monetary, and fiscal variables are subject to foundational changes. The conventional view is that public debt crowds out financial development by raising interest rates. An opposing view is that government debt can enhance the financial underpinning and will eventually improve the financial sector. This paper tests for both views taking into account potential non-monotonic effects in the relationship. The paper takes annual data for the period of 2010 to 2019 for 31 countries (14 advanced and 17 emerging and low-income economies). Using least square estimator and Simonsohn (2018) two-line test, we found that, for advanced economies, public sector debt always crowds in financial development. However, for emerging and low-income economies, when domestic debt is lower than 30% of GDP it crowds out financial development, but at 30% of GDP or more it can induce developments in the financial sector.