Do institutions matter in the fiscal reaction function? The case of Egypt

Abstract The present study estimates a Fiscal Reaction Function (FRF) to assess the sustainability of Egypt’s gross domestic debt from 1990 to 2022. A further focus of the study is to examine the institutional quality’s impact on the relationship between primary balance and debt stock, which is largely believed to significantly influence debt sustainability. Based on the World Development Indicators, World Governance Indicators, the International Monetary Fund, and the Central Bank of Egypt, we used the Autoregressive Distributed Lag (ARDL) and Error Correction (EC) techniques to model non-stationary time-series data. When examining institutional variables, we found that the fiscal deficit is negatively associated with both government effectiveness and regulatory quality. Nevertheless, the primary balance situation remained largely unaffected by indicators such as government corruption, political stability, and VA. To check robustness, we constructed an institutional quality index (IQI) that combines the six institutional indicators using Principal Component Analysis (PCA). The outcomes show that our findings are robust, as they support most of the baseline model results. It is now established that if the institutional quality in Egypt improves over time, fiscal sustainability can be achieved, implying that institutional reforms may mitigate the negative effects of debt rises, which proves that debt sustainability would not be possible without institutional improvements and reforms. Most notably, a negative short-run and a positive long-run interaction effects (DebtxIQI) suggest that debt can promote growth. In other words, austerity worsens the primary balance temporarily in the presence of high IQ; however, debt is paid off sustainably over time, enhancing fiscal health. Nevertheless, the results suggested that, whereas Egypt’s fiscal policy may be sustainable in the long run, there is a considerable challenge in ensuring long-term debt sustainability as evidenced by the slow speed of adjustment, which is depicted by the Error Correction Term “ECT”. To ensure fiscal sustainability, policymakers should focus on key reforms in Government Effectiveness and regulatory quality, while ensuring transparency and accountability through an independent fiscal council with citizen monitoring and legally mandated participatory budgets. Debt rises should also be strictly controlled, kept to less than 80% of GDP, with borrowing specifically directed toward productive projects and worthwhile endeavors.