Do central banks engage in public debt management? The case of emerging markets inflation targeters with floating exchange rates

In this chapter, we analyze the response of central banks in emerging inflation targeting countries with floating exchange rates to changes in public debt. Using panel data we estimate Taylor-rule type central banks’ reaction functions including government debt as one of the determinants of the policy interest rates. We argue that, on the one hand, the central bank observing increasing public debt may try to discipline fiscal authorities by increasing interest rates. On the other hand, increasing public debt may threaten macroeconomic stability and high interest rates translate into higher interest payments that in turn increase public debt further. In this situation, the central bank, trying to prevent the accumulation of debt, may react by lowering interest rates. However, this dilemma is complicated further if a significant proportion of the public debt is denominated in foreign currency as it is often the case of emerging market economies. Our findings suggest that central banks in emerging economies tend to lower interest rates in response to increase in government debt denominated in domestic currency and to increase interest rates in response to an increase in government debt denominated in foreign currency. This reaction may suggest a fiscal dominance regime.