Fiscal Consolidation and Growth: The Role of Banking and Currency Crises in Developing Economies

Abstract

This paper assesses the state-dependent effects of fiscal consolidation on growth in a sample of 102 developing economies over the period 1990-2017. Fiscal consolidation shocks are identified using changes in the cyclically adjusted primary balance (CAPB), and their effects are estimated using the local projection method. The baseline results indicate that a consolidation shock reduces growth by approximately 0.6 percent after one year, though is not statistically significant, signaling that this average effect masks heterogeneity driven by the state of the macroeconomic environment. The paper finds that during crises, the contractionary effect of consolidation is significantly amplified, with output declining by approximately 9 percent during banking crises and 5 percent during currency crises at a two-year horizon, both significant and persistent. Transmission channel analysis identifies private investment as the primary channel through which consolidation impacts growth. During banking crises, private investment drops by approximately 12 percent two years after the shock, remaining around 5 percent below baseline four years later. Private consumption is also negatively affected, however is less sensitive than investment, operating as a secondary channel. For currency crises, higher external debt amplifies output losses, with twin crises representing the most contractionary environment examined. Robustness checks across alternative clustering methods, fixed effects specifications, lag structures, and estimation horizons confirm the stability of the results. These findings underscore that the growth effects of fiscal consolidation in developing economies are highly state-dependent, cautioning against adjustment during crises, highlighting the importance of crisis type and financial conditions in the design and timing of fiscal adjustment.