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Fiscal Policy and Financial Markets

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Author Info
Thomas Stratmann
Bernardin Akitoby

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Abstract

This paper introduces fiscal policy in a model of sovereign risk spreads ("spreads"). Using panel data from emerging market countries, we find that reductions in public expenditure are a more powerful tool for reducing spreads than increases in revenues. Specifically, cuts in current spending lower spreads by more than cuts in investment spending, and they also lower spreads by more than increases in revenue. We also show that debt-financed current spending increases sovereign risk by more than tax-financed current spending, suggesting that international investors have some preference for the latter. In line with the empirical literature on the determinants of spreads, we find that liquidity and solvency indicators, as well as macroeconomic fundamentals, are also important determinants of spreads.

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Paper provided by International Monetary Fund in its series IMF Working Papers with number 06/16.

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Length: 26 pages
Date of creation: 30 Jan 2006
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Handle: RePEc:imf:imfwpa:06/16

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Keywords: Fiscal policy Risk premium Bond markets Emerging markets Financial systems Government expenditures Revenues

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This paper has been announced in the following NEP Reports: References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Paolo Mauro & Nathan Sussman & Yishay Yafeh, 2002. "Emerging Market Spreads: Then Versus Now," The Quarterly Journal of Economics, MIT Press, vol. 117(2), pages 695-733, May. [Downloadable!] (restricted)
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  2. Block, Steven A. & Vaaler, Paul M., 2004. "The price of democracy: sovereign risk ratings, bond spreads and political business cycles in developing countries," Journal of International Money and Finance, Elsevier, vol. 23(6), pages 917-946, October. [Downloadable!] (restricted)
  3. Ari Aisen & Francisco José Veiga, 2005. "Does Political Instability Lead to Higher Inflation? A Panel Data Analysis," IMF Working Papers 05/49, International Monetary Fund. [Downloadable!]
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  4. Arellano, Manuel & Bond, Stephen, 1991. "Some Tests of Specification for Panel Data: Monte Carlo Evidence and an Application to Employment Equations," Review of Economic Studies, Blackwell Publishing, vol. 58(2), pages 277-97, April. [Downloadable!] (restricted)
  5. Vivian Z. Yue & Samir Jahjah, 2004. "Exchange Rate Policy and Sovereign Bond Spreads in Developing Countries," IMF Working Papers 04/210, International Monetary Fund. [Downloadable!]
  6. Alberto Alesina & Roberto Perotti, 1996. "Budget Deficits and Budget Institutions," IMF Working Papers 96/52, International Monetary Fund.
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  7. Carmen M. Reinhart & Kenneth S. Rogoff & Miguel A. Savastano, 2003. "Debt Intolerance," NBER Working Papers 9908, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  8. Patrick McGuire & Martijn A Schrijvers, 2003. "Common factors in emerging market spreads," BIS Quarterly Review, Bank for International Settlements, December. [Downloadable!]
  9. Timothy D. Lane & Steven Phillips, 2000. "Does IMF Financing Result in Moral Hazard?," IMF Working Papers 00/168, International Monetary Fund.
  10. Kaminsky, Graciela & Lizondo, Saul & Reinhart, Carmen M., 1997. "Leading indicators of currency crises," Policy Research Working Paper Series 1852, The World Bank. [Downloadable!]
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  11. Reinhart, Carmen & Calvo, Sara, 1996. "Capital Flows to Latin America: Is There Evidence of Contagion Effects?”," MPRA Paper 7124, University Library of Munich, Germany. [Downloadable!]
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  12. Sandeep Kapur & Luis Catão, 2004. "Missing Link: Volatility and the Debt Intolerance Paradox," IMF Working Papers 04/51, International Monetary Fund. [Downloadable!]
  13. Luis Catão & Bennett Sutton, 2002. "Sovereign Defaults: The Role of Volatility," IMF Working Papers 02/149, International Monetary Fund. [Downloadable!]
  14. Paolo Manasse & Nouriel Roubini, 2005. "'Rules of Thumb' for Sovereign Debt Crises," International Finance 0509003, EconWPA. [Downloadable!]
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  15. Sebastian Edwards, 1986. "The Pricing of Bonds and Bank Loans in International Markets: An Empirical Analysis of Developing Countries' Foreign Borrowing," NBER Working Papers 1689, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  16. Eichengreen, Barry & Mody, Ashoka, 1998. "Interest Rates in the North and Capital Flows to the South: Is There a Missing Link?," International Finance, Blackwell Publishing, vol. 1(1), pages 35-57, October. [Downloadable!] (restricted)
  17. Kaminsky, Graciela L. & Schmukler, Sergio L., 1999. "What triggers market jitters?: A chronicle of the Asian crisis," Journal of International Money and Finance, Elsevier, vol. 18(4), pages 537-560, August. [Downloadable!] (restricted)
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  18. Isabel Schnabel & Giovanni Dell'Ariccia & Jeromin Zettelmeyer, 2002. "Moral Hazard and International Crisis Lending: A Test," IMF Working Papers 02/181, International Monetary Fund. [Downloadable!]
  19. Ciocchini, Francisco & Durbin, Erik & Ng, David T. C., 2003. "Does corruption increase emerging market bond spreads?," Journal of Economics and Business, Elsevier, vol. 55(5-6), pages 503-528. [Downloadable!] (restricted)
  20. Paolo Manasse & Axel Schimmelpfennig & Nouriel Roubini, 2003. "Predicting Sovereign Debt Crises," IMF Working Papers 03/221, International Monetary Fund. [Downloadable!]
  21. Carmen M. Reinhart, 2002. "Default, Currency Crises, and Sovereign Credit Ratings," World Bank Economic Review, Oxford University Press, vol. 16(2), pages 151-170, August.
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  22. Richard Cantor & Frank Packer, 1995. "Sovereign credit ratings," Current Issues in Economics and Finance, Federal Reserve Bank of New York, issue Jun. [Downloadable!]
  23. Alesina, Alberto F & Ardagna, Silvia & Perotti, Roberto & Schiantarelli, Fabio, 1999. "Fiscal Policy, Profits and Investment," CEPR Discussion Papers 2250, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  24. Martin Uribe, 2002. "A fiscal theory of sovereign risk," Working Paper Series 187, European Central Bank. [Downloadable!]
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  25. Sebastian Edwards, 1984. "LDC's Foreign Borrowing and Default Risk: An Empirical Investigation," NBER Working Papers 1172, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  26. Bayoumi, Tamim & Goldstein, Morris & Woglom, Geoffrey, 1995. "Do Credit Markets Discipline Sovereign Borrowers? Evidence from US States," CEPR Discussion Papers 1088, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
  27. António Afonso & Rolf Strauch, 2004. "Fiscal policy events and interest rate swap spreads - evidence from the EU," Working Paper Series 303, European Central Bank. [Downloadable!]
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  28. repec:rus:hseeco:123922 is not listed on IDEAS
  29. Kaminsky, Graciela L. & Reinhart, Carmen M., 2000. "On crises, contagion, and confusion," Journal of International Economics, Elsevier, vol. 51(1), pages 145-168, June. [Downloadable!] (restricted)
  30. Steve Bond, 2002. "Dynamic panel data models: a guide to microdata methods and practice," CeMMAP working papers CWP09/02, Centre for Microdata Methods and Practice, Institute for Fiscal Studies. [Downloadable!]
  31. Hong G. Min, 1998. "Determinants of emerging market bond spread : do economic fundamentals matter?," Policy Research Working Paper Series 1899, The World Bank. [Downloadable!]
  32. Enrica Detragiache & Antonio Spilimbergo, 2001. "Crises and Liquidity - Evidence and Interpretation," IMF Working Papers 01/2, International Monetary Fund. [Downloadable!]
Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. David Hauner & Jirí Jonáš & Manmohan S. Kumar, 2007. "Policy Credibility and Sovereign Credit--The Case of New EU Member States," IMF Working Papers 07/1, International Monetary Fund. [Downloadable!]
  2. Philipp Paulus, 2006. "The final blow to the Stability Pact? EMU enlargement and government debt," Otto-Wolff-Institut Discussion Paper Series 03/2006, Otto-Wolff-Institut für Wirtschaftsordnung, Köln, Deutschland. [Downloadable!]
  3. Moser, Christoph, 2007. "The Impact of Political Risk on Sovereign Bond Spreads - Evidence from Latin America," Proceedings of the German Development Economics Conference, Göttingen 2007 24, Verein für Socialpolitik, Research Committee Development Economics. [Downloadable!]
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