## wp17141 ## Source details **Canonical URL:** [wp17141](https://www.imf.org/-/media/files/publications/wp/2017/wp17141.pdf) ## Other formats - [Markdown version](/-/media/files/publications/wp/2017/wp17141.pdf.md) - [Structured JSON version](/-/media/files/publications/wp/2017/wp17141.pdf.json) --- ### INTRODUCTION — empirical background and research approach - Repeated cross-country findings about macroeconomic impact of structural reforms on advanced economies: - (i) most structural reforms tend to occur in crisis times, - (ii) associated costs are frontloaded but the gains come later, - (iii) the environment prevailing at the start of reforms matters — reforms implemented in good times and/or with additional support from demand policies (fiscal and monetary) lead to superior economic outcomes. - Policymaker concerns: - (i) short-term contractionary effects of structural reforms may trigger social tensions, - (ii) uncertainty about future benefits while short-term costs are immediate, - (iii) the cost of building national consensus for reform plans, - (iv) investors’ reaction to reform package, implementation, and feasibility. - Factors shaping investors’ ex ante views (affecting government bond yields): - (i) usefulness of the reform proposal, - (ii) political acceptance and implementation, - (iii) economic cost, - (iv) risk of future reform reversal. - Timing considerations: - Reforms launched in bad times can be more disruptive and increase market skepticism, potentially raising bond yields. - Reforms launched in countries already facing higher borrowing costs can lead to a fast reduction in spreads or yields if markets perceive the reform as necessary and appropriate. - Core objective: - Estimate dynamic effects of labor market reforms on long-term government bond yields in a sample of advanced economies, with focus on Employment Protection Legislation of Regular Workers (EPLR). - Reform identification and methodological innovation: - Uses OECD indices to identify major reform shocks and link to macro outcomes. - Extends average treatment-effect estimation by proposing estimation of conditional effects (dependence on country characteristics such as strength of social partners, initial macro conditions including financial stress level, and fiscal stance). - Methodological challenges and identification strategy: - Choice of reform variable is crucial; reforms entailing direct fiscal costs raise stronger endogeneity concerns. - Even non-fiscally related reforms (EPLR) may suffer endogeneity from unobservable policymaker characteristics. - Identification: quasi-experimental approaches; uses Augmented Inverse Probability Weighting (AIPW) following Jorda and Taylor (2016) and Bordon et al (2016) to estimate robust dynamic average treatment effects. - Exclusion restrictions considered (examples): initial level of employment protection, electoral cycle, educational background of the leader — argued to have minimal direct impact on long-term yields after controlling for growth, output gap, crises, exchange rate, government debt, and overall balance ratios. - Literature links: - Cardoso and Domenech (2010): structural capacity negatively correlated with sovereign risk premium. - Findlay et al. (2016): structural capacity indicators explain a higher share of variation in CDS spreads. - Banerji et al. (2017): labor and product market reforms have a positive and significant medium-term effect on debt-to-GDP reduction. - Terminology: - "Reforms" refers to reforms of employment protection legislations of regular workers, unless clarified otherwise. ### KEY FINDINGS — effects on yields, ratings, and conditional heterogeneity - Average effects: - Structural reforms lead over time to a reduction in government bond yields and to an improvement in countries’ credit rating. - Conditional and heterogeneous effects: - Effect is stronger in stressed countries, including countries where reforms are needed the most, and when reforms are launched in good times. - Low-debt countries that launch reforms with some fiscal stimulus seem to benefit from a larger reduction of yields. - Social context matters: structural reforms followed by social discontent (strikes, lockouts) lead to an overshooting of yields in the short run. - Timing and investor behavior: - Investors price in expected long-term benefits from reforms; benefits can be felt earlier than usually thought. - Markets translate expected future benefits into lower risk premiums when reforms are perceived as appropriate and credible. ### SECTION V — alternative specifications using countries’ credit ratings - Purpose: - Test channel that reforms reduce long-term sovereign yields via improvement in market perceptions captured by sovereign credit ratings. - Sovereign rating measure and frequency: - Institutional Investor dataset; ratings range from 0 to 100, rising with increased creditworthiness. - Ratings are country-specific annual averages of bi-annual (March and September) ratings. - Estimation strategy: - Baseline local projection (LP) method (annual frequency) with same control variables as earlier yield specifications. - Robust re-estimation using Augmented Inverse Propensity-Score Weighting (AIPW) to attenuate endogeneity concerns (treatment-effect framework). - Rationale: A strong positive relationship between reforms and private-agency sovereign ratings would indicate that yield reductions are partly driven by improved investor perceptions. - Main empirical findings on ratings: - Baseline LP estimates (Table 11): - Positive correlation between reforms and sovereign ratings gradually strengthens quantitatively and statistically in the medium term. - Effect becomes statistically significant in the 5th year. - AIPW estimates (Table 12): - Re-estimation with AIPW shows a statistically significant effect of reforms on sovereign ratings starting in the 3rd year and persisting thereafter. - Pattern is consistent with the effect being mainly a level-shift in the country’s rating. - Interpretation: - Results support that part of reduction in long-term sovereign yields following structural reforms is driven by improved market perceptions as reflected in higher sovereign ratings. - Use of AIPW strengthens evidence by reducing endogeneity bias relative to baseline LP estimates. - Complementary quantitative context from earlier sections: - Baseline yield effects: - Estimates show a statistically significant reduction of yields adding up to a decline of 140 bps 5 years after the reform (estimates become more precise in year 3). - The average cumulative reduction in long-term sovereign yields after 5 years is 200 bps in the sample (broadly shared by several countries), representing about 70 percent of the unconditional sample average. - Role of endogeneity correction: - AIPW-based average treatment effects on yields are larger than baseline LP estimates, indicating that neglecting endogeneity induced an upward endogeneity bias in baseline results. ### CONCLUSION — interpretation and policy implications - Main findings summarized: - On average, structural reforms lead to a non-trivial reduction of long-term government yields and help improve countries’ creditworthiness. - Results are robust and can be amplified or attenuated by conditional factors: state of the business cycle, strength of social partners, initial level of financial stress, and fiscal stance. - Reforms are likely to trigger a reduction of long-term government yield when risks of social discontent are low, in good times, in countries facing high borrowing costs, and in presence of supportive fiscal policy provided that public debt is not too high. - Interpretation and timing: - Investors tend to price in future gains from reforms; expected long-term benefits are reflected in lower risk premiums and higher credit ratings. - Policy implications and recommendations: - Reforming economies in need has merit; investors tend to look favorably on reform efforts. - It is wise to launch reforms when economic conditions are relatively supportive. - Building political and social consensus is crucial to minimize social discontent and improve reform effectiveness. - Complementing structural reform with some fiscal stimulus can be beneficial, subject to the constraint that public debt is not too high. *Source: wp17141* ### INTRODUCTION ### INTRODUCTION ### Empirical background - Repeated cross-country findings about the macroeconomic impact of structural reforms on advanced economies: - (i) most structural reforms tend to occur in crisis times, - (ii) associated costs are frontloaded but the gains come later, - (iii) the environment prevailing at the start of reforms matters - reforms implemented in good times and/or with additional support from demand policies (fiscal and monetary) lead to superior economic outcomes. - Policymakers and politicians fear short-term disruption from bold reforms. Specific fears include: - (i) the risk that the short-term contractionary effects of structural reforms will trigger social tensions, - (ii) the uncertainty surrounding the future benefits of reforms while short-term uncertainty will be felt immediately, - (iii) the cost of building a national consensus for the reform plans, - (iv) investors’ reaction to the reform package, its implementation, and importantly its feasibility. - Factors influencing investors’ ex ante views on reforms (thereby affecting government bond yields) include: - (i) the usefulness of the reform proposal, - (ii) its political acceptance and implementation, - (iii) the economic cost, - (iv) the risk of future reform reversal. - Timing matters: reforms launched in bad times can be more disruptive and increase market skepticism, potentially raising bond yields; reforms launched in countries already facing higher borrowing costs can instead lead to a fast reduction in spreads or yields if markets perceive the reform as necessary and appropriate. ### Research question and approach - Core objective: estimate the dynamic effects of labor market reforms on long-term government bond yields in a sample of advanced economies. - Reform identification: follows prior literature using OECD indices to (i) identify major reform shocks and (ii) link these reforms to macroeconomic outcomes. - Paper extends average treatment-effect estimation by proposing estimation of conditional effects: whether the average treatment effect of structural reforms on long-term yields depends on country characteristics such as strength of social partners, initial macroeconomic conditions including financial stress level, or the fiscal stance at the time of the reform. - Reform focus: emphasizes structural reforms that do not ex ante lead to obvious budgetary impacts; primary reform of interest is reduction in the protection of regular workers — Employment Protection Legislation of Regular Workers (EPLR). ### Methodological challenges - Choice of the reform variable ("treatment") is crucial. Structural reforms entailing direct fiscal costs raise stronger endogeneity concerns (reverse causality from credit risk to reform indicators). - Even focusing on non-fiscally related reforms (e.g., EPLR reform), endogeneity may remain due to unobservable country or policymaker characteristics (e.g., politicians elected with a mandate to reform). - Identification strategy: use quasi-experimental approaches. Specifically, following Jorda and Taylor (2016) and Bordon et al (2016), the paper uses the Augmented Inverted Probability Weighting (AIPW) model to estimate robust dynamic average treatment effects. - Exclusion restrictions (possible key explanatory factors for an EPLR reform) can include for example initial level of employment protection, electoral cycle, and the educational background of the leader — with minimal reasons why these should impact long-term yields directly after controlling for macro determinants such as growth, output gap, crises, exchange rate, government debt, and overall balance ratios. ### Literature links and innovations - Related empirical findings: - Cardoso and Domenech (2010): structural capacity negatively correlated with sovereign risk premium. - Findlay et al. (2016): structural capacity indicators explain a higher share of variation in CDS spreads. - Banerji et al. (2017): labor and product market reforms have a positive and significant medium-term effect on debt-to-GDP reduction. - Innovations of this paper: - Estimates the dynamic average effect of reforms on government long-term yields (effects over time rather than one coefficient). - Proposes an identification strategy aimed at reducing endogeneity concerns. - Tests for significant conditional factors that shape the relationship between structural reforms and creditworthiness. - Terminology: throughout the rest of the paper, "reforms" refers to reforms of employment protection legislations of regular workers, unless clarified otherwise. ### Key findings - Structural reforms: - (i) do lead over time to a reduction in government bond yields and to an improvement in countries’ credit rating, - (ii) this effect is stronger in stressed countries, including in countries where reforms are needed the most, and when reforms are launched in good times, - (iii) low-debt countries which launch reforms with some fiscal stimulus seem to benefit from a larger reduction of yields, - (iv) the social context matters: structural reforms when followed by social discontent (strikes, lockouts) lead to an overshooting of yields in the short run. ### Policy implications - There is a merit in reforming economies in need: benefits of reforms can be felt earlier than usually thought, including in countries facing high borrowing costs, or in countries complementing reforms with some fiscal support (while markets remain attentive to debt levels). - It is wiser to launch reforms when economic conditions are relatively supportive, and it is crucial to build political consensus. Markets will translate expected future benefits into lower risk premiums when reforms are perceived as appropriate and credible. ### Organization of the paper - Section II: baseline empirical specification using local projection techniques to identify the effect of reforms on long-term yields. - Section III: conditional factors that strengthen or weaken the relationship between reforms and long-term yields. - Section IV: identification strategy to better estimate the average treatment effects after reducing endogeneity concerns. *Source: wp17141 - INTRODUCTION* ### Section V discusses the results from alternative specifications using countries’ credit ratings ### wp17141 - Section V discusses the results from alternative specifications using countries’ credit ratings ### Purpose and identification of the channel - Objective: test one plausible channel through which structural reforms reduce long-term sovereign yields — improvement in market perceptions captured by sovereign credit ratings. - Sovereign rating measure: Institutional Investor dataset; ratings range from 0 to 100, rising with increased creditworthiness. - Rating frequency: country-specific annual averages of bi-annual (March and September) ratings. ### Estimation strategy and data - Methods used: - Baseline local projection (LP) method (annual frequency), with the same control variables as in earlier yield specifications to purge confounding factors. - Robust re-estimation using the Augmented Inverse Propensity-Score Weighting (AIPW) approach to attenuate endogeneity concerns (treatment-effect framework). - Rationale: A strong positive relationship between reforms and private-agency sovereign ratings would indicate that yield reductions are partly driven by improved investor perceptions. ### Main empirical findings on ratings - Baseline LP estimates (Table 11): - The positive correlation between reforms and sovereign ratings gradually strengthens quantitatively and statistically in the medium term. - The effect becomes statistically significant in the 5th year. - AIPW (robust) estimates (Table 12): - Re-estimation with AIPW shows a statistically significant effect of reforms on sovereign ratings starting in the 3rd year and persisting thereafter. - The pattern is consistent with the effect being mainly a level-shift in the country’s rating. - Interpretation: - The results support the hypothesis that part of the reduction in long-term sovereign yields following structural reforms is driven by an improvement in market perceptions as reflected in higher sovereign ratings. - Use of AIPW strengthens the evidence by reducing endogeneity bias relative to the baseline LP estimates. ### Relevant complementary quantitative context from prior sections - Baseline yield effects (from earlier sections of the study): - Estimates show a statistically significant reduction of yields adding up to a decline of 140 bps 5 years after the reform (estimates become more precise in year 3). - The average cumulative reduction in long-term sovereign yields after 5 years is 200 bps in the sample (broadly shared by several countries), representing about 70 percent of the unconditional sample average. - Role of endogeneity correction: - AIPW-based average treatment effects on yields are larger than baseline LP estimates, indicating that neglecting endogeneity induced an upward endogeneity bias in baseline results. *Source: wp17141 - Section V discusses the results from alternative specifications using countries’ credit ratings* ### CONCLUSION ### CONCLUSION ### Main findings on reform effects - On average, structural reforms lead to a non-trivial reduction of long-term government yields and help improve countries’ creditworthiness. - This is interpreted as investors pricing in the expected long-term benefits of structural reforms which is stronger in certain context well identified in the paper. - The results are robust and can be amplified or attenuated by conditional factors such as: the state of the business cycle, the strength of social partners, the initial level of financial stress, and the fiscal stance. - Overall, reforms are likely to trigger a reduction of long-term government yield when risks of social discontent are low, in good times, in countries facing high borrowing costs, and in the presence of supportive fiscal policy provided that public debt is not too high. ### Interpretation and timing of benefits - Investors tend to price in future gains from reforms, so benefits can be felt earlier than usually thought. - The expected long-term benefits are reflected in lower risk premiums and higher credit ratings as markets “translate the future benefits into lower risk premiums and higher credit rating.” ### Conditional factors that modify effects - State of the business cycle: reforms perform better in “good times.” - Strength of social partners and political/social consensus: low risks of social discontent amplify positive market responses. - Initial financial stress and borrowing costs: countries facing high borrowing costs can still experience reductions in long-term yields. - Fiscal stance and public debt: supportive fiscal policy complements reforms, provided public debt is not too high. ### Policy implications and recommendations - There is a merit in reforming economies in need, and investors tend to look kindly on reform efforts. - It is wise to launch reforms when economic conditions are relatively supportive. - It is crucial to build political and social consensus to minimize social discontent and improve reform effectiveness. - Complementing structural reform with some fiscal stimulus can be beneficial, subject to the constraint that public debt is not too high. *CONCLUSION — wp17141* --- _Source: https://www.imf.org/-/media/files/publications/wp/2017/wp17141.pdf_