When Balassa-Samuelson comes to Maastricht: debt-sustainability, growth and transition

Abstract

A dynamic stability approach is applied to show how the debt-servicing ability of transition/developing economies exceeds that of mature market economies. At the core of this debt-servicing advantage lies not only relatively higher growth but more importantly the productivity- and efficiency gains released by the re-allocation and restructuring activities originating in the developing economies’ unbalanced sectoral growth. First, the dynamic stability approach is extended to allow for two sectors of production, allowing both growth and sectoral composition to matter for stability and the debt-to-GDP ratio. Second, sector sizes are endogenized to depend on the productivity growth difference. The model shows how the equilibrium debt-to-GDP ratio depends on both an economy’s existing industrial structure as well as on its structural flexibility and how it varies along a country’s transition trajectory. All things considered, how much debt relative to GDP a country can (or should) sustain is highly context specific and depends on the prevailing economic structure, composition of growth, structural flexibility, and the prevailing incentives for restructuring. Hence this paper delivers a cautionary note toward the one-size-fits-all approach to debt sustainability