Policy responses to the global financial crisis and subsequent global economic downturn have seen a marked deterioration in budget balances and debt positions across most advanced economies. The IMF projects a rise in the average net general government debt-to-GDP ratio for the advanced economies from around 63 per cent at end-2009 to around 86 per cent by 2015 (IMF 2010).
In Australia, the Federal Government underlying cash budget is estimated to have peaked at 4.4 per cent of GDP in 2009-10, while net debt is projected to peak at 6 per cent of GDP in 2011-12 — which is relatively low by international standards (Commonwealth of Australia 2010). However, the increase in budget deficits and debt in response to the global financial crisis (particularly in the major advanced economies) has ignited debate on the link between fiscal policy and interest rates.
The empirical literature focusing on the link between fiscal policy and interest rates in Australia is relatively scant. Comley et al. (2002) explored the impact of public sector net foreign debt on interest rates for Australia by investigating the responsiveness of the real interest margin (or premium) between Australian and US 10-year government bond yields to a deterioration in the Australian budget balance and public debt. Comley’s results indicate that the real interest margin increases by around 20 basis points in response to a one percentage point of GDP deterioration in the headline budget balance in the short run, while a one percentage point of GDP increase in the stock of public debt was found to increase the long-run real interest margin by around 15 basis points.
This paper reassesses the link between fiscal policy and interest rates in Australia. The work of Comley et al. is extended using a more recent data sample and, more importantly, incorporating external influences on the real interest differential.
The remainder of this paper is organised as follows. A review of the empirical literature on the link between fiscal policy and interest rates is conducted in Section 2. Section 3 extends the real interest margin model specified by Comley et al. by including US variables to capture external influences on the real interest margin. Section 4 presents data and results, while the final section concludes.