Institutions, Reforms, and Country Risk: Lessons from Japanese Government Debt in the Meiji Period

We evaluate the effect of the establishment of modern state institutions (e.g. a central bank or a constitution) on the risk premium associated with government debt traded abroad. Drawing on evidence from one of the most dramatic reform periods in modern history, and using data on sovereign debt traded in London between 1870 and 1914, we investigate the impact of major reforms on the yields of Japanese government debt following the Meiji Restoration. We show that, although the risk premium on Japanese debt declined during the period, the establishment of modern, western institutions did not elicit an immediate market response. The one institutional reform that significantly reduced the perceived risk associated with Japanese bonds was the adoption of the Gold Standard in 1897. In addition, political events such as the Anglo-Japanese treaty (1902) and the military victory over Russia (1905) improved Japan's debt capacity, and led to a substantial increase in the volume of Japanese debt. We conclude that, at least in the short run, well understood monetary rules as well as military achievements matter more for the perception of a country by foreign investors than modern state institutions, although we do not rule out the possibility that in the long run institutions do affect a country's credit rating.