How fiscal rules can reduce sovereign debt default risk

The economic literature has been forceful on the role of fiscal institutions in attenuating economic fluctuations. In particular, the implementation of fiscal rules has gained importance in the toolkit of macroeconomic stabilization policies. This paper studies the effect of fiscal rule implementation on sovereign default risk and on the probability of capital flow reversals for a large sample of countries including both developed and emerging market economies. Results indicate that fiscal rules are beneficial for macroeconomic stability, as they significantly reduce both sovereign risk and the probability of a sudden stop in countries that implement them. These results, which are robust to various empirical specifications, have important policy implications specially for countries that have relaxed their fiscal rules in response to the Covid-19 pandemic.