Contemporary studies on public debt sustainability policies that employs statistical tests commenced with the work by Hamilton & Flavin (1986) who investigated if America’s public debt series had a bubble. Since then, numerous articles have been published that endeavour to answer the question of if certain debt policies can be deemed sustainable. The concern in that question is partly owing to the fact that the latter question is not merely of academinc importance but that it has practical significance as well. Therefore, if tests concludes that certain debt policies cannot be deemed sustainable, government must embark on corrective measures (Greiner & Fincke 2015).
A vital role in most of those studies on public debt sustainability is the role of interest rate, a feature that was pointed out by Wilcox (1989). Bringing to mind that the interporal budget constraint of the government necessitates that the present value of public debt asymptotically converge to zero, the function of interest rate that is employed so as to discount the flow of public debt becomes obvious right away. Thus, several tests have been formulated that arrived at results which are not dependent on interest rate. One of such test is to examine if public debts inclusive of interest rate mainly increase linearly as put forward by Trehan & Walsh (1991). If this feature is satisfied, a given series of public debt is sustainable since any time series that increases linearly converges to zero if it is exponentially discounted, given that the real interest rate is positive. Representing public debt by β and interest rate by r, another test suggested by Trehan & Walsh (1991) is to examine if a quasi-difference of public debt βt – Өβt−1 with 0 ≤ Ө < 1 + r, is stationary and if public debt and primary surpluses are co-integrated. If government debt is quasi-difference stationary and public debt as well as primary surpluses are co-integrated, public debt is sustainable. Therefore, these two test offer options where the result is independent of the precise numerical value of the interest rate. A survey on studies that tested public debt sustainability can be obtained in Afonso (2005), Bohn (2008), Neck & Sturm (2008).
Another test that has gotten huge awareness in economics literature is that offered by Bohn (1995). He proposed to test if the primary surplus relative to GDP is a direct function of the debt to GDP ratio. If this feature holds, a certain public debt policy can be deemed sustainable. This test is very credible since it possess a good economic instinct: if government experience debt now, they have to embark on corrective measures in the future by raising the primary surplus, or else, public debt will not be sustainable (Greiner & Fincke 2015). Examining real world debt policies for this feature, we can certainly obtain proof that countries act in this manner (see for instance, Bohn 1998, for the USA and Ballabriga & Martinez-Mongay 2005, Greiner, Köller & Semmler 2007, Greiner & Kauermann 2008, Fincke & Greiner 2011, for some selected counries in the euro area).
From a statistical viewpoint, an increase in primary surpluses as a response to larger government debts means that the series of public debt relative to GDP ought to become a mean-regressing procedure. This process holds since higher debt ratios bring about a rise in the primary surplus relative to GDP, causing the debt ratio to fall and go back to its mean. Nonetheless, mean-regression only takes place if the response coefficient, that determines how strongly the primary surpluses reacts as public debt increases is adequate.
2.1 Empirical Literature
The relationship between fiscal policy and public debt sustainability has generated empirical studies with mixed up results using ordinary least square (OLS) method, vector autoregressive (VAR) method, panel data method and vector error correction(VECM) method employing data that ranges from time series to cross-sectional and panel. In a cross-country study, Kalulumia (2002) examined the effect of government debt on interest rates of United States, Germany, the United Kingdom and Canada with the aid of the error-correction model (ECM) and the general portfolio balance model. The variables employed for the study were interest rate, exchange rate, stock of domestic assets and real GDP. The proof in general showed the absence of causality in the long-run, between government debt and interest-rate related variables for the four countries, which signified that government debt had no permanent positive impact on any of the variables of interest, for instance, interest rates, money demand and the exchange rate.
In order to examine the debt servicing capacity of the Nigerian economy, Adam (2007) used survey method and the accounting measurement of debt to GDP ratio and asserted that the debt situation in the country to a large extent is highly unsustainable. He opined that the Nigeria’s debt being not sustainable could be related with huge trade deficits, inadequate real GDP growth, high interest rates and high initial debt stock. He concluded that the country’s debt being highly unsustainable might be partly right because the debt/export ratios and external debt /GDP with values of 64.4 and 176.9 were high against the international benchmark of 50 and 150 respectively.
Foneska & Ranasinghe (2007) performed a research on sustainability of Sri Lanka’s public debt employing the conventional maximum ratios as well as the theoretical model method to measure liquidity and solvency of domestic and external debt. Their result showed that Sri Lanka was unsuccessful in achieving the debt sustainability placed by international agencies as every macroeconomic indicator surpassed the upper threshold limits. In addition, they contended that if such conditions continue, the nation will fall into a severe debt trap, and will not be able to obtain funds from both local and international sources at reasonable cost.
In an empirical assessment of the relationship between domestic debt and Nigeria’s economic growth, Adofu & Abula (2010) employed ordinary least square regression techniques in examining the relationship between the country’s domestic debt and economic growth. Their result revealed that domestic debt has a negative impact on the growth of the economy. Thus, they recommended that government domestic borrowing ought to be discouraged and that increasing the revenue base via tax reform programmes should be encouraged.
Curtasu (2011) carried out a study on how to access public debt sustainability: empirical evidence from advanced European countries, employing annual time series data from 1970–2012. His findings showed that few countries, for instance, Sweden, Netherlands, Finland and Denmark would not encounter the solvency risk in the future, as the sustainability of their fiscal stance was created by public debt ratio that did not exceed the limit by a primary surplus large enough to conceal the stabilizer one(apart from the Netherlands).Though the study revealed that the remaining countries such as UK, Ireland, Spain, France, Italy and Portugal were over-indebted and the credit markets were by now worried about their capability to service their debts, shown by their enormous debt ratios and the fact that they as well operate primary deficits or depleted surpluses, that cannot go with the primary balance-to-GDP ratio needed to stabilize debt.
The ordinary least square technique in an augmented Cobb Douglas model was employed by Obademi (2012) in examining the effect of public debt on Nigeria’s economic growth. Total debt, external debt, budget deficit and domestic debt were the variables utilized for this study. He discovered that there was a significant negative relationship between debt and economic growth in the long-run although in the short-run the effect was positive. Thus, he came to conclusion that although the effect of public debt on the Nigerian economy was positive in the short-run, its effect in the long-run slow down the growth of the economy due to inefficient debt management.
Udoka & Ogege (2012) analyzed the degree of public debt crisis and its effects on economic development in Nigeria from 1970 to 2010. They used the error correction modeling framework with co-integration techniques to examine the relationship between debt service payment, foreign reserve, investment, debt stock and per-capita GDP. They discovered that political instability might decrease the level of development and that other independent variables were responsible for the country’s level of underdevelopment. Thus, they proposed that public debt ought to be reduced to a minimal level in order to avoid underdevelopment of the Nigerian economy.
The sustainability of fiscal policy in Nigeria from 1980–2010 was examined by Oyeleke & Ajilore (2014) using the Error Correction Model (ECM) with the aim of finding out if the government has breached inter temporal government budget restrictions. Their findings showed that fiscal policy was inadequately sustainable in Nigeria’s economy. Thus, they recommended improvement on tax revenue generation as well as other sources of income by the government with restriction of its spending to growth enhancing projects
Essien,Onumonu, Agboegbulem & Mba (2016) examined the effect of public debt on the Nigerian economy employing a number of important macroeconomic variables such as prime lending rate, headline inflation and GDP growth,. Their findings revealed that while the level of external and domestic debts had no significant effect on economic growth and inflation, they had an impact on the level of interest rates prevailing in the economy during the period of study. Thus, they recommended that the present method of borrowing from the long-term market by the government through the DMO should be sustained.
Nigeria’s fiscal policy and public debt sustainability was analyzed from 1990 and 2017 by Nya & Onyimadu (2019) using econometric techniques and the IMF/World Bank debt burden indicators. The results from the IMF/World Bank debt burden indicators showed that the country’s debt was sustainable in the last 8–10 years implying its ability to meet its long term debt liabilities. In addition, the liquidity indicator revealed that Nigeria was able to meet its short term liabilities. With regards to fiscal policy sustainability, the empirical result using co-integration test showed that government revenues and expenditures were co-integrated; implying that fiscal policy in Nigeria was sustainable, though it was weak. Thus, they recommended that government should introduced debt ceilings so as to avert explosion of the initial stock of debt arising from arbitrary borrowings by state governments.