## sovereign

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---

### Introduction and research objective
- Background: fiscal space and sovereign risk in LAC
  - The fall in global commodity prices has negatively affected fiscal revenues of LAC countries that produce oil, gas, agricultural, and metal products.
  - The subsequent slowdown in economic activity and the continued growth of real public expenditure (particularly public consumption) have reduced the region’s fiscal buffers.
  - Most LAC countries closed fiscal year 2018 with primary deficits that exceed their debt-stabilizing levels, and as a result, public debt continues to rise.
  - At a regional level, debt ratios in LAC now stand well above the average for other emerging economies.
  - Amid deteriorating fiscal positions, sovereign spreads in the region increased significantly last year, and in the last five years the gap between spreads faced by LAC economies and other emerging economies has widened.
- Research objective and dataset
  - Presents evidence on the effect of fiscal policy actions on perceived sovereign risk using a novel dataset on fiscal news.
  - Dataset: compilation of fiscal consolidation announcements based on news articles from domestic sources in Dow Jones’ Factiva for 21 Emerging Market and Developing Economies (EMDEs) over the period 2000 to 2018.
  - David, Guajardo, and Yépez (2019) identify 90 announcements from congress about fiscal consolidation actions in 14 LAC economies between 2000 and 2018.
  - Dates identify the parliamentary approval of fiscal consolidation packages, allowing tight event windows for high-frequency analysis.
- Identification strategy
  - High-frequency identification uses the precise date of congressional approval to construct narrow windows around announcements.
  - Local projection method (Jordà (2005)) estimates responses of J.P. Morgan’s Emerging Market Bond Index Global (EMBIG) spreads to fiscal announcements.
  - Approach addresses reverse causality concerns (for example, sudden spread increases prompting policymakers to announce consolidations).

### Short-term effects of fiscal consolidation announcements on sovereign spreads
- Unrestricted sample:
  - Once congress agrees on a consolidation package, spreads fall by around 15 basis points within a 30-day window after the announcement, with a confidence interval between 3 and 26 basis points at a 90 percent confidence level.
- Conditional on high sovereign stress:
  - If EMBIG levels are at or above the 75th percentile of the sample distribution, spreads decline by more than 35 basis points in the four weeks following the announcement.
- Conditional on IMF program support:
  - When fiscal measures are supported by an IMF program, spreads decline by around 30 basis points 30 days after congressional approval; reductions are larger and more persistent compared with the unrestricted sample.

### Composition and size of fiscal adjustment
- Classification:
  - Consolidation packages classified as “expenditure-based” if expenditure cuts account for 50 percent or more of the total size of the adjustment; otherwise classified as tax-based when tax measures predominate.
- Composition effects:
  - Expenditure-based consolidations: the estimated fall in spreads in the month after the announcement is larger and more protracted than the average unrestricted sample response.
  - Tax-based consolidations: the fall in spreads following tax-based announcements is smaller and less persistent than for expenditure-based consolidations.
- Size effects:
  - Large adjustments: for economies with large consolidations (about 1 percentage point of GDP in average), the adjustment significantly reduces sovereign spreads, particularly in the first week after the announcement.
  - Small adjustments: smaller adjustment programs produce an insignificant reduction in spreads.
- Institutional constraint note:
  - Rigidities in public expenditure (for example because of constitutionally mandated expenditure) are pervasive across Latin American countries, often making the implementation of tax measures more feasible in practice.

### Medium-term effects and the role of confidence
- Definition and theory:
  - Effective fiscal consolidation episodes are typically defined as large fiscal adjustments associated with limited output losses and substantial debt reduction.
  - Theory and prior evidence suggest that reductions in sovereign spreads (increased confidence) can offset direct contractionary effects of fiscal consolidation and mitigate output losses.
- PVAR evidence:
  - A panel vector autoregression (PVAR) embeds announcement dates with changes in EMBIG spreads and industrial production using monthly data; impulse responses are conditioned on EMBIG levels.
  - In periods of high perceived sovereign risk (EMBIG at or above the 75th percentile), spreads decline significantly after announcements by around 100 basis points in a 12-month window, but announcements are typically followed by a large and protracted output loss of around 4 percent.
  - The reduction in sovereign spreads is instrumental in the success of fiscal consolidation actions to limit the recessionary effects of fiscal adjustment and stabilize the debt-to-GDP ratios.

### Key findings and policy implications (summary)
- Parliamentary approval of fiscal consolidation measures is associated with significant declines in sovereign spreads: around 15 basis points on average within 30 days.
- Impact is larger in stress and IMF contexts:
  - More than 35 basis points in periods of high sovereign stress.
  - Around 30 basis points when measures are supported by an IMF program.
- Composition and growth:
  - Expenditure-based consolidations reduce spreads more and more persistently than tax-based consolidations and are associated with milder output losses, partly because they ease financing conditions and stimulate private demand.
- Size matters:
  - Large consolidations (about 1 percentage point of GDP on average) are effective in reducing spreads, especially immediately after approval; small consolidations show insignificant effects.
- Confidence effects:
  - Reductions in sovereign spreads play a crucial role in making fiscal consolidations less recessionary and in stabilizing debt-to-GDP ratios; decisive and credible adjustments are more likely to improve funding conditions and free up resources for consumption and investment.

### Spreads — empirical framework, data, and detailed findings
- Estimation methods:
  - Estimates based on a PVAR; local projection (LP) methods (Jordà (2005)) used for annual real GDP and debt-to-GDP analyses; state-dependent LP specification allows for non-linearities and scenarios.
- Data and sample:
  - Daily sovereign bond spreads for 11 Latin American and Caribbean economies between January 3, 2000, and December 31, 2018, using JP Morgan’s Emerging Market Bond Index – Global (EMBIG).
  - EMBIG spread 75th percentile of the sample distribution = 420 basis points.
  - IMF program indicator: takes the value of 1 if the country is under an IMF supported program or in the year before board approval.
- Findings on output and debt dynamics:
  - Confidence effects through sovereign spreads materially alter output responses to fiscal consolidations: "The 12-month cumulative output loss in the unconstrained specification [was] almost half of the output loss in the counterfactual scenario" in which spreads do not respond.
  - Benefits from lower borrowing costs accrue mainly in high risk economies (higher EMBIG percentiles) and when the adjustment plans are supported by an IMF program.
  - Composition matters:
    - Expenditure-based consolidations: "negligible effect on economic activity a year after the shock."
    - Tax-based consolidations: "output contracting by close to 4 percent in the 12-month window after the announcement."
  - Narrative-based episodes (two-step approach; local projections):
    - In episodes where spreads did not decline following the consolidation announcement, "output fell by about 3 percentage points over a three-year window."
    - In episodes where spreads declined, "output increased by almost two percent" (the estimate is not significantly different than zero).
  - Debt dynamics:
    - "Public debt declined only in episodes in which there was a significant reduction in sovereign spreads."
    - "In the absence of lower spreads, fiscal consolidation fails to stabilize debt dynamics, with the debt-to-GDP ratio continuing to rise even after the fiscal adjustment."

### Scenario and state-dependency results
- Scenario descriptions (text summary of Figure 7):
  - Ratio of counterfactual to unconstrained output response presented across EMBIG percentiles for two scenarios:
    - "Baseline" scenario: effects of a generic fiscal consolidation package (solid line).
    - IMF-supported program scenario (dashed line): larger benefits from lower borrowing costs when adjustment plans are supported by an IMF program.
- State-dependent indicators:
  - High fiscal stress state: EMBIG spread at or above the 75th percentile (420 basis points).
  - IMF program state: country under IMF supported program (or year before board approval).

### Methodological notes and robustness
- Local Projection (LP) advantages:
  - Flexible for panel structure, does not constrain impulse response shapes, less sensitive to misspecification, accommodates non-linearities and state dependency.
- Benchmark LP specification:
  - Days, h = 0,...,30, models daily changes in EMBIG sovereign spreads (basis points) with country fixed effects (α_i,h) and time fixed effects (γ_t,h).
  - Dummy D_i,t = 1 on day of fiscal consolidation announcement; X_i,t contains seven lags of daily changes in EMBIG spreads.
  - Confidence bands based on estimated standard errors; alternative confidence bands use 90 percent bootstrap or HAC standard errors depending on exercise.
- Data construction:
  - EMBIG index includes sovereign and quasi-sovereign instruments satisfying liquidity criteria; uses stripped spreads; country spread index is market-capitalization weighted average of qualifying bond spreads.
  - IMF program dates from the Monitoring of Fund Arrangements (MONA) database.
  - Real GDP and debt-to-GDP ratios obtained from the IMF’s World Economic Outlook (WEO) database.

### Annex 2 — Estimation using a Panel VAR (PVAR)
- Model specification:
  - Panel VAR for a panel of 11 EMDEs, monthly frequency, three variables: fiscal consolidation announcement dates D_{i,t}, EMBIG spreads Δr_{i,t} (monthly change; average over the month), and index of economic activity Δy_{i,t} (log change in monthly industrial production or other activity indicators).
  - Lag length p; empirical implementation uses 6 lags following the Schwartz Criterion.
  - Each equation estimated by OLS allowing for country fixed effects.
- Identification and timing assumptions:
  - Timing/ordering: fiscal policy variable ordered first, EMBIG spreads second, output third (standard Cholesky decomposition).
  - Identifying assumption (following Blanchard and Perotti (2002)): output or other variables react immediately to fiscal policy shocks, whereas fiscal policy does not react on impact to other shocks in the system.
  - Additional restriction: α_{i,2,3} set to zero to identify α_{i,3,2} and α_{i,2,3}; shocks ε_{i,t}^{1}, ε_{i,t}^{2}, ε_{i,t}^{3} correspond to fiscal announcement, sovereign spread, and residual output shocks respectively.
- Transmission channels and counterfactual analysis:
  - Direct and indirect effects decomposed: contemporaneous direct effect α_{i,3,1}; indirect channel via spreads through α_{i,2,1} and α_{i,3,2}.
  - Counterfactual strategy (Bachmann and Sims (2012)): construct hypothetical impulse response of output to an announcement while holding changes in EMBIG spreads fixed at zero at all horizons and compare to baseline.
- Heterogeneity and conditioning:
  - Coefficients allowed to vary depending on level of EMBIG spreads and IMF program support; impulse responses estimated for full empirical distribution of EMBIG spread levels.
- Estimation and inference:
  - Each equation estimated by OLS with country fixed effects and 6 lags.
  - Runkle (1987) bootstrapping method employed to adjust inference for non-linear impulse responses in panel format with interaction terms.

*Source: sovereign - Introduction; IMF staff calculations; Annex 2.   Estimation using a Panel VAR*

### Introduction

### Introduction

### Background: fiscal space and sovereign risk in LAC
- The fall in global commodity prices has negatively affected fiscal revenues of LAC countries that produce oil, gas, agricultural, and metal products.
- The subsequent slowdown in economic activity and the continued growth of real public expenditure (particularly public consumption) have reduced the region’s fiscal buffers.
- Most LAC countries closed fiscal year 2018 with primary deficits that exceed their debt-stabilizing levels, and as a result, public debt continues to rise.
- At a regional level, debt ratios in LAC now stand well above the average for other emerging economies.
- Amid deteriorating fiscal positions, sovereign spreads in the region increased significantly last year, and in the last five years the gap between spreads faced by LAC economies and other emerging economies has widened.

### Research objective and dataset
- The chapter presents evidence on the effect of fiscal policy actions on perceived sovereign risk using a novel dataset on fiscal news.
- The dataset is a compilation of fiscal consolidation announcements based on news articles from domestic sources contained in the Dow Jones’ Factiva online database for 21 Emerging Market and Developing Economies (EMDEs) over the period 2000 to 2018.
- In total, David, Guajardo, and Yépez (2019) identify 90 announcements from congress about fiscal consolidation actions in 14 LAC economies between 2000 and 2018.
- Dates identify the parliamentary approval of fiscal consolidation packages, allowing tight event windows for high-frequency analysis.

### Identification strategy
- A high-frequency identification approach is employed to mitigate endogeneity: the precise date of congressional approval is used to construct narrow windows around announcements.
- The analysis uses the local projection method proposed by Jordà (2005) and estimates responses of J.P. Morgan’s Emerging Market Bond Index Global (EMBIG) spreads to fiscal announcements.
- The approach addresses reverse causality concerns (for example, sudden spread increases prompting policymakers to announce consolidations).

### Short-term effects of fiscal consolidation announcements on sovereign spreads
- Unrestricted sample: Once congress agrees on a consolidation package, spreads fall by around 15 basis points within a 30-day window after the announcement, with a confidence interval between 3 and 26 basis points at a 90 percent confidence level.
- Conditional on high sovereign stress: If EMBIG levels are at or above the 75th percentile of the sample distribution, spreads decline by more than 35 basis points in the four weeks following the announcement.
- Conditional on IMF program support: When fiscal measures are supported by an IMF program, spreads decline by around 30 basis points 30 days after congressional approval; reductions are larger and more persistent compared with the unrestricted sample.

### Composition and size of fiscal adjustment
- Classification: Consolidation packages are classified as “expenditure-based” if expenditure cuts account for 50 percent or more of the total size of the adjustment; otherwise classified as tax-based when tax measures predominate.
- Composition effects:
  - Expenditure-based consolidations: The estimated fall in spreads in the month after the announcement is larger and more protracted than the average unrestricted sample response.
  - Tax-based consolidations: The fall in spreads following tax-based announcements is smaller and less persistent than for expenditure-based consolidations.
- Size effects:
  - Large adjustments: For economies with large consolidations (about 1 percentage point of GDP in average), the adjustment significantly reduces sovereign spreads, particularly in the first week after the announcement.
  - Small adjustments: Smaller adjustment programs produce an insignificant reduction in spreads.
- Institutional constraint note: Rigidities in public expenditure (for example because of constitutionally mandated expenditure) are pervasive across Latin American countries, often making the implementation of tax measures more feasible in practice.

### Medium-term effects and the role of confidence
- Effective fiscal consolidation episodes are typically defined as large fiscal adjustments associated with limited output losses and substantial debt reduction.
- Theory and prior evidence suggest that reductions in sovereign spreads (increased confidence) can offset direct contractionary effects of fiscal consolidation and mitigate output losses.
- A panel vector autoregression (PVAR) is used embedding announcement dates with changes in EMBIG spreads and industrial production using monthly data; impulse responses are conditioned on EMBIG levels.
- In periods of high perceived sovereign risk (EMBIG at or above the 75th percentile), spreads decline significantly after announcements by around 100 basis points in a 12-month window, but announcements are typically followed by a large and protracted output loss of around 4 percent.
- The chapter finds that the reduction in sovereign spreads is instrumental in the success of fiscal consolidation actions to limit the recessionary effects of fiscal adjustment and stabilize the debt-to-GDP ratios.

### Key findings and policy implications
- Parliamentary approval of fiscal consolidation measures is associated with significant declines in sovereign spreads: around 15 basis points on average within 30 days.
- The impact on spreads is substantially larger in periods of high sovereign stress (more than 35 basis points) and when measures are supported by an IMF program (around 30 basis points).
- Expenditure-based consolidations reduce spreads more and more persistently than tax-based consolidations and are associated with milder output losses, in part because they ease financing conditions and stimulate private demand.
- Large consolidations (about 1 percentage point of GDP on average) are effective in reducing spreads, especially immediately after approval; small consolidations show insignificant effects.
- Confidence effects (reductions in sovereign spreads) play a crucial role in making fiscal consolidations less recessionary and in stabilizing debt-to-GDP ratios; decisive and credible adjustments are more likely to improve funding conditions and free up resources for consumption and investment.

*Source: sovereign - Introduction*

### 1.  Spreads

### 1.  Spreads

### Key empirical framework and data
- Estimation methods:
  - Estimates based on a PVAR; Annex 2 describes the PVAR framework.
  - Local Projection (LP) methods (Jordà (2005)) used for annual real GDP and debt-to-GDP analyses; benchmark LP specification shown in Equation (1).
  - State-dependent LP specification shown in Equation (2) to allow for non-linearities and scenarios.
- Data and sample:
  - Daily sovereign bond spreads for 11 Latin American and Caribbean economies between January 3, 2000, and December 31, 2018, using JP Morgan’s Emerging Market Bond Index – Global (EMBIG).
  - EMBIG spread 75th percentile of the sample distribution = 420 basis points.
  - IMF program indicator: takes the value of 1 if the country is under an IMF supported program or in the year before board approval.
  - For the analysis using annual data, the dummy D_i,t takes the value of one in the year of the announcement and the horizon (h) is equal to three years.

### Findings: spreads, output, and fiscal consolidations
- Confidence effects through sovereign spreads materially alter output responses to fiscal consolidations:
  - "The 12-month cumulative output loss in the unconstrained specification [was] almost half of the output loss in the counterfactual scenario" in which spreads do not respond.
  - Benefits from lower borrowing costs accrue mainly in high risk economies (higher EMBIG percentiles) and when the adjustment plans are supported by an IMF program.
- Composition of adjustment matters:
  - Expenditure-based consolidations: estimated responses suggest they are less harmful to growth, "with a negligible effect on economic activity a year after the shock."
  - Tax-based consolidations: "output contracting by close to 4 percent in the 12-month window after the announcement."
- Narrative-based episodes (two-step approach; local projections):
  - In episodes where spreads did not decline following the consolidation announcement, "output fell by about 3 percentage points over a three-year window."
  - In episodes where spreads declined, "output increased by almost two percent" (the estimate is not significantly different than zero).
  - These results support that reductions in spreads are instrumental in limiting contractionary effects of fiscal adjustments.
- Debt dynamics:
  - Using gross debt-to-GDP ratios at the general government level, "public debt declined only in episodes in which there was a significant reduction in sovereign spreads."
  - "In the absence of lower spreads, fiscal consolidation fails to stabilize debt dynamics, with the debt-to-GDP ratio continuing to rise even after the fiscal adjustment."

### Scenario and state-dependency results illustrated
- Figure 7 scenario summaries (text description):
  - Ratio of counterfactual to unconstrained output response presented across EMBIG percentiles under two scenarios:
    - "Baseline" scenario: effects of a generic fiscal consolidation package (solid line).
    - IMF-supported program scenario (dashed line): larger benefits from lower borrowing costs when adjustment plans are supported by an IMF program.
- State-dependent indicators used in specifications:
  - High fiscal stress state: EMBIG spread at or above the 75th percentile (420 basis points).
  - IMF program state: country under IMF supported program (or year before board approval).

### Methodological notes and robustness
- LP advantages:
  - Flexible for panel structure, does not constrain impulse response shapes, less sensitive to misspecification, accommodates non-linearities and state dependency.
- Benchmark LP specification (days, h = 0,...,30) models daily changes in EMBIG sovereign spreads (basis points) with:
  - Country fixed effects (α_i,h) and time fixed effects (γ_t,h).
  - Dummy D_i,t = 1 on day of fiscal consolidation announcement; X_i,t contains seven lags of daily changes in EMBIG spreads.
  - Confidence bands based on estimated standard errors; alternative confidence bands use 90 percent bootstrap or HAC standard errors depending on exercise.
- Data construction:
  - EMBIG index includes sovereign and quasi-sovereign instruments satisfying liquidity criteria; uses stripped spreads; country spread index is market-capitalization weighted average of qualifying bond spreads.
  - IMF program dates from the Monitoring of Fund Arrangements (MONA) database.
  - Real GDP and debt-to-GDP ratios obtained from the IMF’s World Economic Outlook (WEO) database.

### Policy takeaways (roadmap to improve consolidation effectiveness)
- First:
  - "Periods of high perceived sovereign default risk are a particularly opportune moment to undertake fiscal consolidation, as the contractionary effects tend to be mitigated by easier financial conditions—resulting from lower sovereign spreads—when these policies are deployed."
  - Given higher perceived sovereign default risk in LAC than in other regions, "there is greater scope for a reduction in funding costs in the region."
  - "IMF program support has been instrumental in allowing countries to restore investor confidence and lower sovereign risk premia."
- Second:
  - Policymakers can design the composition and size of plans to boost sovereign confidence while mitigating growth drag and accelerate debt stabilization.
  - Findings suggest "fiscal consolidations implemented mainly by reducing government expenditures tend to lead to smaller output losses than those based on raising taxes" partly because they are more effective in easing financing conditions.
  - Institutional constraints and rigidities in public expenditure often make tax-based adjustments more feasible in practice; governments should favor plans that preserve public investment where possible.
- Finally:
  - "Public support for fiscal adjustment is likely to be another key determinant of a government’s ability to meet ambitious fiscal consolidation objectives."
  - Building public support through transparency and clear communication—educating the public about rationale, scale, and realistic outcomes—can help sustain implementation without unduly curtailing necessary public services or affecting the most vulnerable.

*Source: IMF staff calculations; estimates based on PVAR and local projection methods, Regional Economic Outlook: Western Hemisphere, October 2019.*

### Annex 2.   Estimation using a Panel VAR

### Annex 2.   Estimation using a Panel VAR

### Model specification
- Panel VAR (PVAR) for a panel of 11 EMDEs, monthly frequency.
- Three variables in the system:
  - Fiscal consolidation announcement dates: D_{i,t} (dummy = 1 in month of announcement; with the exception of Jamaica, for which a monthly interpolation of the quarterly GDP series is used).
  - EMBIG spreads: Δr_{i,t} (monthly change; average over the month).
  - Index of economic activity: Δy_{i,t} (log change in monthly industrial production or other economic activity volume indicators; seasonally adjusted; obtained from Haver Analytics).
- Lag length denoted by p; empirical implementation uses 6 lags following the Schwartz Criterion.
- Each equation estimated by ordinary least squares (OLS) allowing for country fixed effects.

### Identification and timing assumptions
- Timing/ordering: fiscal policy variable ordered first in the VAR (standard Cholesky decomposition), EMBIG spreads ordered second, output ordered third.
- Identifying assumption (following Blanchard and Perotti (2002)): output or other variables react immediately to fiscal policy shocks, whereas fiscal policy does not react on impact to other shocks in the system (plausibility increases at monthly frequency).
- Additional restriction: α_{i,2,3} is set to zero to identify α_{i,3,2} and α_{i,2,3}. Under this restriction:
  - ε_{i,t}^{1} denotes the fiscal consolidation announcement shock.
  - ε_{i,t}^{2} denotes a sovereign spread shock.
  - ε_{i,t}^{3} denotes a residual output shock.
- Note on endogeneity risk: procyclicality of fiscal policy in EMDEs (Frankel, Végh, and Vuletin, 2013) may imply announcements are motivated by persistently deteriorated economic conditions; dynamics in the system are intended to capture most such effects even if within-month reaction is restricted.

### Transmission channels and counterfactual analysis
- Direct and indirect effects of fiscal announcements on output:
  - Contemporaneous direct effect: α_{i,3,1}.
  - Dynamic direct effects: relevant coefficients in A_{i,j} matrices (lagged interactions).
  - Indirect channel via spreads: fiscal announcements affect spreads contemporaneously through α_{i,2,1}; spreads affect output through α_{i,3,2}; lagged spreads in the output equation can propagate fiscal shocks further.
- Objective: isolate the role of changes in sovereign spreads in mitigating the effects of fiscal consolidation announcements on economic activity.
- Counterfactual strategy (following Bachmann and Sims (2012)):
  - Construct hypothetical impulse response of output to a fiscal consolidation announcement while holding changes in EMBIG spreads fixed at zero at all forecast horizons.
  - Compare this counterfactual response to the baseline response to quantify the importance of sovereign borrowing cost changes as a transmission mechanism.

### Heterogeneity and conditioning on initial conditions
- Coefficients in A_{i,j} allowed to vary depending on:
  - The level of EMBIG spreads.
  - Whether a consolidation announcement was done under IMF program support.
- Impulse responses are estimated for the full empirical distribution of EMBIG spread levels.

### Estimation and statistical inference
- Each equation estimated by OLS with country fixed effects and 6 lags (Schwartz Criterion).
- Because impulse responses are non-linear functions of OLS estimates and data are in panel format with interaction terms, Runkle (1987) bootstrapping method is employed to adjust inference.
- Related methodological references: Burnside, Eichenbaum, and Fisher (2004); Cavallo (2005); Blanchard and Perotti (2002); Bachmann and Sims (2012); Bernanke et al. (1998); Sims and Zha (2006); Kilian and Lewis (2011); Towbin and Weber (2013).

*Source: Annex 2.   Estimation using a Panel VAR, sovereign - Annex 2.   Estimation using a Panel VAR*

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_Source: https://www.imf.org/-/media/files/publications/reo/whd/2019/october/english/sovereign.pdf_