The credibility of fiscal policy and cost of public debt

Abstract

This paper investigates the potential relationship between the credibility of fiscal policy and the cost of public debt. We analyze how a key component of fiscal governance, the ability of governments to commit the planned budget, affects the government borrowing cost. To test the hypothesis, we take the case in Indonesia over the period 2001-2013. Based on the quarterly data analysis, we found that the noncredible deficit rule tends to induce the interest rate. In contrast, the credible debt rule policy significantly reduces the borrowing cost for about 28 basis points. More interestingly, to reduce the interest cost burden of government debt, strengthening commitment to the fiscal rules is as effective as decreasing the size of debt. Those findings suggest that the credibility of fiscal policy matters to restore the fiscal burden in order to maintain fiscal sustainability in the long-run. Accordingly, improving the credibility of fiscal policy should be an integral part of the public sector reformation program in the country.