Cyclical Behavior of Public Debt in Iran Considering the Role of Natural Resource Rent: Fourier Approximation Approach

Purpose: Keynesian economics defines the optimal fiscal policy as a countercyclical policy, and the neoclassical theory supports a neutral policy with expenditure and tax smoothing. However, many empirical studies illustrate that fiscal policy in most resource-rich developing countries is highly procyclical in that fiscal policy variables in government expenditures follow booms and busts of natural resource revenues. These booms and busts generally emanate from resource price fluctuations, resulting in highly procyclical external capital inflows. Especially during the downturns, most of these economies have liquidity and borrowing constraints due to the lack of developed domestic financial markets and remarkable foreign assets. The unpredictable fluctuations in resource or commodity prices significantly impact the fiscal policy performance of natural resource-rich countries. Most of these countries cannot diversify their exports, constituting a big part of their total incomes; a slight decrease in commodity prices can create considerable financing needs. Apart from this issue, inadequate levels of institutional quality, budget structures lacking sufficient automatic stabilizers as well as restricted access to credit markets compel governments to implement procyclical fiscal policies. Natural resource endowment is considered as one of the sources of the procyclical nature of public debts. Explaining the mechanism by which natural resource endowments affect the cyclicality of public debts are based on the collateral aspect of natural resources. From this perspective, when commodity prices rise, creditors are ready to offer more loans to resource-exporting countries, while these countries have the least need for them during this period. Moreover, during periods of price decline, the value of collateral decreases, but the debt needs of resource countries increase. Therefore, the creditors’ action reinforces the willingness of resource-rich countries to take on debts. Despite theoretical arguments on the importance of natural resources in the cyclical orientation of public debts, the role of natural resources in the cyclical orientation of public debts is largely ignored in the empirical literature. In this regard, the main objective of the present study is to investigate the cyclical behavior of public debts and the role of natural resource rents in strengthening or weakening the cyclicality behavior of public debts in Iran.
Methodology: The time series data used in this study are the annual data from 1996 to 2023. They regard public debts, business cycles, natural resource rents, inflation, and unemployment. In the present study, the business cycle is approximated by the gap between the real GDP (constant 2015 US$) and its potential level, which is a measure widely used in the literature. With this in mind, the potential GDP used in the calculation of the business cycle (CYCLE) is obtained through HP and CF filters. The data on GDP, natural resource rents (% of GDP), trade (% of GDP), inflation (annual %), and total unemployment (% of population) are obtained from the World Bank. The data on public debts (% of GDP) are taken from the IMF. Time series analyses in this study, including unit root and co-integration tests and estimation of the co-integration vectors and causality relationship, are performed using the Fourier approximation. Fourier approximation-based analyses enable the detection of both smooth and sharp breaks without requiring the prior determination of the form, location, and number of structural breaks. Since the series contains structural breaks, Fourier unit root tests have been used to model the structural breaks. As the method of this study, the relationships between variables in the long term are examined by using the Fourier Shin and the Fourier Autoregressive Distributed Lag (F-ADL) with fractional frequencies co-integration tests. Also, the Fourier Fully Modified Ordinary Least Squares (F-FMOLS) is employed to analyze the relationship between the variables.
Findings and Discussion: The results of estimating co-integration vectors using the Fourier FMOLS method show that the business cycle has a positive and significant impact on the total public debts in the Iranian economy, which refers to the pro-cyclical behavior of public debts. Resource rents also have a negative and significant effect on public debts across all models. Furthermore, our results show that the interactive effect of natural resource rents and business cycles on public debts is positive and significant, indicating that natural resource rents help to strengthen the pro-cyclical behavior of public debts. In other words, the positive effect of the business cycle on public debts increases when the business cycle interacts with natural resource rents across all models. The results of Toda and Yamamoto's Fourier causality test also indicate a one-way causality relationship from natural resource rents to business cycles and from business cycles to public debts, as well as a two-way causality relationship between natural resource rents and public debts. The results obtained are robust to changes in the model and how business cycles are extracted.
Conclusions and Policy Implications: Based on the results, it is necessary to accumulate a portion of natural resource revenues in stabilization funds that have sufficiently high institutional quality to cover budget deficits using the assets of these funds during recessions. Also, the Iranian economy should move towards the production and export of complex products, as these are predictive of economic development. It is because the public debts of developing countries can take on a counter-cyclical orientation, as it is recognized that the fiscal policy of developed countries is counter-cyclical.