INSTITUTIONAL DYNAMICS IN THE ASYMMETRIC RELATIONSHIP BETWEEN FINANCIAL AND FISCAL CYCLES: EVIDENCE FROM NIGERIA USING NARDL TECHNIQUE

Abstract

Extant studies barely consider the link between financial cycle and fiscal cycle without taking cognisance of the role of institutions. This study uses the non-linear autoregressive distributed lag (NARDL) technique to examine the asymmetric effects of financial cycle on fiscal cycle in Nigeria with cognisance to the role of institutions. It uses total debt service as a proxy for fiscal cycle, equity prices as a proxy for financial cycle, while institution is measured by rule of law, political stability and absence of violence, control of corruption, regulatory quality, voice and accountability, and government effectiveness. The study uses principal component analysis (PCA) to transform all the six measures of institutions into a single index. The short-run result reveals that positive equity price has significant negative effect on total debt service while negative equity price has significant adverse effect on total debt service. Meanwhile, the long-run result reveals that both positive and negative equity price do not have significant effect on total debt service. Since positive financial cycle has the tendency of decreasing fiscal cycle, positive financial cycle is not to be worried about in the country while policies should be set up to correct negative financial cycle as it is capable of aggravating fiscal cycle. However, the interaction of institution with equity price portrays significant negative effect on total debt service in the short-run but insignificant effect in the long-run. This suggests that the existing level of institutions is insufficient to effectively ameliorate the impact of financial cycle on fiscal cycle. Governments should be moderate in their spending during booms while being sceptical about borrowing during recessions so as not to jeopardise the future generations with debt burdens. Also, correcting financial shocks should not be left for macro-prudential measures alone, there is need to improve the institutional measures to complement other economic measures meant to enhance fiscal stability.