## _wp0616

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---

### Introduction — research question and contribution
- Research question: How do financial markets react to fiscal policy decisions of sovereign borrowers, and how are sovereign bond spreads affected by the composition of fiscal adjustment?
- Two contributions:
  - Introduces fiscal policy (disaggregated into revenue, current expenditure, public investment) into an empirical model of sovereign spreads.
  - Investigates pricing of two types of fiscal adjustments (Alesina and Perotti, 1996): Type I (expenditure-based, current expenditure cuts) and Type II (tax increases and public investment cuts).

### Key empirical findings
- Type I adjustments (expenditure-based, mainly current expenditure cuts) significantly lower spreads; Type II adjustments have no statistically significant impact on spreads.
- Debt versus tax financing of current spending:
  - Debt-financed current spending increases sovereign risk by more than tax-financed current spending.
  - Example (based on specification 3 in Table 4): a 1 percentage point increase in current spending raises spreads by about 4 percent if financed by debt, and by about 2.9 percent if financed by taxes.
- Disaggregated fiscal effects:
  - Higher revenues: no statistically significant effect on spreads (point estimates generally negative but not significant).
  - Higher current expenditure: increases country spreads.
  - Public (capital) investment: no statistically significant effect on spreads.
- Macroeconomic and balance-sheet determinants:
  - Debt-to-GNI is positively associated with spreads.
    - Table 3 country-and-year fixed effects: Debt to GNI coefficients 1.253*** (column 3) and 1.288*** (column 4).
    - Table 4 fixed effects: Debt to GNI coefficients range 1.067*** to 1.216*** across specifications.
    - Paper text: a 1 percentage point increase in debt to GNI leads to about 1.3 percent increase in spreads (Table 3) and a range of 1.1–1.2 percent in Table 4 specifications.
  - Reserves-to-GDP: negatively related to spreads.
    - Table 3: Reserves to GDP coefficients -3.806*** and -3.745*** (columns 3–4).
    - Table 4: Reserves to GDP coefficients range -3.380*** to -3.824***.
  - Inflation: higher inflation increases sovereign risk (log inflation coefficients positive and significant).
    - Table 3: Log inflation coefficients 0.123*** and 0.128*** (columns 3–4).
    - Table 5 (Arellano-Bond): Log inflation 0.092** to 0.086** across specifications.
  - Default history: positive and significant association with spreads in fixed-effects models (Indefault coefficients 0.258***, 0.253*** in Table 4); less significant when dynamic lag is included (Table 5).
  - Contagion (regional spread index, Regionexself): becomes significant at the 5 percent level when fiscal variables are included (Table 4) and is significant in Arellano-Bond (Table 5: 2.32E-04**).

### Analytical framework and empirical model
- Core equation (panel regression derived from a logistic specification of default probability):
  - Log(s_it) = α_i + λ_t + Σ_k β_k Z_kit + η_it (equation 5).
- Explanatory variables (Z_it) include:
  - Ratio of total debt outstanding to GNI.
  - Total foreign exchange reserves as a percentage of GDP.
  - Inflation rate (log inflation).
  - Default history (Indefault dummy).
  - Regional spread index excluding the country (Regionexself).
  - Total revenue-to-GDP, government current spending-to-GDP, public investment-to-GDP.

### Data and estimation
- Dependent variable: stripped spread from the Emerging Markets Bond Index Global (EMBI Global).
  - EMBI Global covers 32 countries; includes U.S. dollar-denominated Brady bonds, loans, and Eurobonds with face value over US$500 million and maturity over 2½ years.
- Sample: all country-year observations available from the EMBI Global between 1994 and 2003 with covariates available.
  - Total Observations: 185 (Table 1).
  - N=143 reported in Table 3 baseline OLS with year fixed effects; N=185 in Table 4 fixed effects including fiscal policy; N=129 in Table 5 Arellano-Bond dynamic panel.
- Estimators used:
  - Pooled OLS, country and year fixed effects.
  - Arellano-Bond dynamic panel estimator (first-difference GMM) to address short-term dynamics and endogeneity concerns; instruments chosen with three lags (xtabond2 referenced).

### Selected quantitative results (tables and key coefficients)
- Table 3 (baseline, country and year fixed effects, N=143):
  - Debt to GNI: 1.253*** (0.258) and 1.288*** (0.246).
  - Reserves to GDP: -3.806*** (1.112) and -3.745*** (1.105).
  - Log inflation: 0.123*** (0.044) and 0.128*** (0.045).
  - Indefault: 0.292*** (0.082) and 0.282*** (0.079).
  - R-squared ≈ 0.66–0.68.
- Table 4 (fixed effects with fiscal variables, N=185):
  - Debt to GNI: 1.216*** (0.270), 1.067*** (0.279), 1.083*** (0.271) across columns 1–3.
  - Reserves to GDP: -3.380*** (1.132), -3.824*** (1.110), -3.600*** (1.095).
  - Current expenditure to GDP: 2.690*** (0.926), 2.841*** (0.891), 2.938*** (0.882).
  - Government revenue to GDP: coefficients not statistically significant (0.713 (1.143), -0.298 (1.248), -0.254 (1.239)).
  - Public investment to GDP: not statistically significant.
  - R-squared 0.67–0.70.
- Table 5 (Arellano-Bond dynamic panel, N=129):
  - Lagged dependent variable: 0.435*** (0.088), 0.423*** (0.017), 0.431*** (0.084).
  - Debt to GNI: 0.959*** (0.279), 0.810*** (0.265), 0.838*** (0.252).
  - Reserves to GDP: -3.881*** (1.369), -3.887*** (1.399), -3.460*** (1.242).
  - Current expenditure to GDP: 1.002** (0.483), 1.687*** (0.620), 2.096*** (0.745).
  - Hansen test p-value = 1.00 in all specifications; Arellano-Bond AR(1) p-values 0.009–0.013, AR(2) p-values 0.425–0.476.

### Robustness and sensitivity checks
- Results robust to alternative measures of solvency and liquidity (e.g., total debt-export ratio, reserve-to-import ratio, share of short-term debt).
- Election dummies (presidential and parliamentary) and a currency crisis dummy (devaluation ≥ 25 percent and inflation > 10 percent) were tested and found not statistically significant.
- Dynamic estimator checks performed to mitigate finite-sample bias from instrument proliferation; three lags chosen for instruments following sensitivity analysis.

### Policy implications and recommendations
- Prefer current expenditure-based fiscal adjustments (Type I) to reduce sovereign spreads when reassuring international financial markets is the objective.
- Aim to increase foreign reserves (reserves-to-GDP) through appropriate macroeconomic and structural policies, given markets’ sensitivity to reserves.
- Pursue sound fiscal policy and prudent debt management to lower debt-to-GDP ratios and reduce borrowing costs.
- Recognize that tax-financed spending is preferred by international investors over debt-financed spending, all else equal.

*Source: _wp0616 - 1. List of Countries and Number of Annual Observations; Descriptive Statistics; Regression Results—Baseline; Fixed Effects Estimates—Effects of Fiscal Policy on Spreads; Arellano-Bond Estimates—Effects of Fiscal Policy on Spreads; Correlation Matrix Deviations from Country Means; REFERENCES.*

### 1. List of Countries and Number of Annual Observations ......................................................15

### 1. List of Countries and Number of Annual Observations ......................................................15

### Sections listed in this content unit
- 1. List of Countries and Number of Annual Observations ......................................................15
- 2. Descriptive Statistics............................................................................................................16
- 3. Regression Results—Baseline .............................................................................................17
- 4. Fixed Effects Estimates—Effects of Fiscal Policy on Spreads ...........................................18
- 5. Arellano-Bond Estimates—Effects of Fiscal Policy on Spreads .........................................19
- 6. Correlation Matrix Deviations from Country Means...........................................................20

### Key numeric markers (page references)
- 15
- 16
- 17
- 18
- 19
- 20

*Source: _wp0616 - 1. List of Countries and Number of Annual Observations ......................................................15*

### References..............................................................................................................

### _wp0616 - References

### Introduction — research question and contribution
- Research question: How do financial markets react to fiscal policy decisions of sovereign borrowers, and how are sovereign bond spreads affected by the composition of fiscal adjustment?
- Two contributions:
  - Introduces fiscal policy (disaggregated into revenue, current expenditure, public investment) into an empirical model of sovereign spreads.
  - Investigates pricing of two types of fiscal adjustments (Alesina and Perotti, 1996): Type I (expenditure-based, current expenditure cuts) and Type II (tax increases and public investment cuts).

### Key empirical findings
- Type I adjustments (expenditure-based, mainly current expenditure cuts) significantly lower spreads; Type II adjustments have no statistically significant impact on spreads.
- Debt versus tax financing of current spending:
  - Debt-financed current spending increases sovereign risk by more than tax-financed current spending.
  - Example (based on specification 3 in Table 4): a 1 percentage point increase in current spending raises spreads by about 4 percent if financed by debt, and by about 2.9 percent if financed by taxes.
- Disaggregated fiscal effects:
  - Higher revenues: no statistically significant effect on spreads (point estimates generally negative but not significant).
  - Higher current expenditure: increases country spreads.
  - Public (capital) investment: no statistically significant effect on spreads.
- Macroeconomic and balance-sheet determinants:
  - Total debt outstanding to Gross National Income (debt-to-GNI) is positively associated with spreads. Table 3 and Table 4 evidence:
    - Table 3 country-and-year fixed effects: Debt to GNI coefficients 1.253*** (column 3) and 1.288*** (column 4).
    - Table 4 fixed effects: Debt to GNI coefficients range 1.067*** to 1.216*** across specifications.
    - Paper text: a 1 percentage point increase in debt to GNI leads to about 1.3 percent increase in spreads (Table 3) and a range of 1.1–1.2 percent in Table 4 specifications.
  - Total foreign exchange reserves as a percentage of GDP (reserves-to-GDP): negatively related to spreads.
    - Table 3: Reserves to GDP coefficients -3.806*** and -3.745*** (columns 3–4).
    - Table 4: Reserves to GDP coefficients range -3.380*** to -3.824***.
  - Inflation: higher inflation increases sovereign risk (log inflation coefficients positive and significant).
    - Table 3: Log inflation coefficients 0.123*** and 0.128*** (columns 3–4).
    - Table 5 (Arellano-Bond): Log inflation 0.092** to 0.086** across specifications.
  - Default history: positive and significant association with spreads in fixed-effects models (Indefault coefficients 0.258***, 0.253*** in Table 4); less significant when dynamic lag is included (Table 5).
  - Contagion (regional spread index, Regionexself): becomes significant at the 5 percent level when fiscal variables are included (Table 4) and is significant in Arellano-Bond (Table 5: 2.32E-04**).

### Analytical framework and empirical model
- The model derives the log of spreads from a logistic specification of the probability of default and yields a panel regression:
  - Log(s_it) = α_i + λ_t + Σ_k β_k Z_kit + η_it (equation 5).
- Explanatory variables (Z_it) include:
  - Ratio of total debt outstanding to GNI.
  - Total foreign exchange reserves as a percentage of GDP.
  - Inflation rate (log inflation).
  - Default history (Indefault dummy).
  - Regional spread index excluding the country (Regionexself).
  - Total revenue-to-GDP, government current spending-to-GDP, public investment-to-GDP.

### Data and estimation
- Dependent variable: stripped spread from the Emerging Markets Bond Index Global (EMBI Global).
  - EMBI Global covers 32 countries; includes U.S. dollar-denominated Brady bonds, loans, and Eurobonds with face value over US$500 million and maturity over 2½ years.
- Sample: all country-year observations available from the EMBI Global between 1994 and 2003 with covariates available.
  - Total Observations: 185 (Table 1).
  - N=143 reported in Table 3 baseline OLS with year fixed effects; N=185 in Table 4 fixed effects including fiscal policy; N=129 in Table 5 Arellano-Bond dynamic panel.
- Estimators used:
  - Pooled OLS, country and year fixed effects.
  - Arellano-Bond dynamic panel estimator (first-difference GMM) to address short-term dynamics and endogeneity concerns; instruments chosen with three lags (xtabond2 referenced).

### Selected quantitative results (tables)
- Table 3 (baseline, country and year fixed effects, N=143):
  - Debt to GNI: 1.253*** (0.258) and 1.288*** (0.246).
  - Reserves to GDP: -3.806*** (1.112) and -3.745*** (1.105).
  - Log inflation: 0.123*** (0.044) and 0.128*** (0.045).
  - Indefault: 0.292*** (0.082) and 0.282*** (0.079).
  - R-squared ≈ 0.66–0.68.
- Table 4 (fixed effects with fiscal variables, N=185):
  - Debt to GNI: 1.216*** (0.270), 1.067*** (0.279), 1.083*** (0.271) across columns 1–3.
  - Reserves to GDP: -3.380*** (1.132), -3.824*** (1.110), -3.600*** (1.095).
  - Current expenditure to GDP: 2.690*** (0.926), 2.841*** (0.891), 2.938*** (0.882).
  - Government revenue to GDP: coefficients not statistically significant (0.713 (1.143), -0.298 (1.248), -0.254 (1.239)).
  - Public investment to GDP: not statistically significant.
  - R-squared 0.67–0.70.
- Table 5 (Arellano-Bond dynamic panel, N=129):
  - Lagged dependent variable: 0.435*** (0.088), 0.423*** (0.017), 0.431*** (0.084).
  - Debt to GNI: 0.959*** (0.279), 0.810*** (0.265), 0.838*** (0.252).
  - Reserves to GDP: -3.881*** (1.369), -3.887*** (1.399), -3.460*** (1.242).
  - Current expenditure to GDP: 1.002** (0.483), 1.687*** (0.620), 2.096*** (0.745).
  - Hansen test p-value = 1.00 in all specifications; Arellano-Bond AR(1) p-values 0.009–0.013, AR(2) p-values 0.425–0.476.

### Robustness and sensitivity checks
- Results robust to alternative measures of solvency and liquidity (e.g., total debt-export ratio, reserve-to-import ratio, share of short-term debt).
- Election dummies (presidential and parliamentary) and a currency crisis dummy (devaluation ≥ 25 percent and inflation > 10 percent) were tested and found not statistically significant.
- Dynamic estimator checks performed to mitigate finite-sample bias from instrument proliferation; three lags chosen for instruments following sensitivity analysis.

### Policy implications and recommendations
- Prefer current expenditure-based fiscal adjustments (Type I) to reduce sovereign spreads when reassuring international financial markets is the objective.
- Aim to increase foreign reserves (reserves-to-GDP) through appropriate macroeconomic and structural policies, given markets’ sensitivity to reserves.
- Pursue sound fiscal policy and prudent debt management to lower debt-to-GDP ratios and reduce borrowing costs.
- Recognize that tax-financed spending is preferred by international investors over debt-financed spending, all else equal.

*Source: _wp0616 - References (content unit provided).*

### REFERENCES

### REFERENCES

### Fiscal policy and sovereign spreads
- Afonso, António, and Rolf Strauch, 2004, “Fiscal Policy Events and Interest Rate Swap Spreads: Evidence from the EU,” ECB Working Paper 303 (Frankfurt: European Central Bank).
- Alesina, Alberto, and Roberto Perotti, 1996, “Budget Deficits and Budget Institutions,” NBER Working Paper 5556 (Cambridge, Massachusetts: National Bureau of Economic Research).
- Alesina, Alberto, and others, 1999, “Fiscal Policy, Profits, and Investment,” NBER Working Paper 7207 (Cambridge, Massachusetts: National Bureau of Economic Research).
- Uribe, Martin, 2002, “A Fiscal Theory of Sovereign Risk,” NBER Working Paper 9221 (Cambridge, Massachusetts: National Bureau of Economic Research).

### Sovereign default, debt crises, and debt intolerance
- Catão, Luis, and Sandeep Kapur, 2004, “Missing Link: Volatility and the Debt Intolerance Paradox,” IMF Working Paper 04/51 (Washington: International Monetary Fund).
- Catão, Luis, and Bennett Sutton, 2002, “Sovereign Defaults: The Role of Volatility,” IMF Working Paper 02/149 (Washington: International Monetary Fund).
- Manasse, Paolo, and others, 2003, “Predicting Sovereign Debt Crises,” IMF Working Paper 03/221 (Washington: International Monetary Fund).
- Manasse, Paolo, and Nouriel Roubini, 2005, “Rules of Thumb for Sovereign Debt Crises,” IMF Working Paper 05/42 (Washington: International Monetary Fund).
- Reinhart, Carmen, and others, 2003, “Debt Intolerance,” NBER Working Paper 9908 (Cambridge, Massachusetts: National Bureau of Economic Research).
- Edwards, Sebastian, 1984, “LDC’s Foreign Borrowing and Default Risk: An Empirical Investigation,” American Economic Review, Vol. 74, No. 4, pp. 726–34.
- Eichengreen, Barry, and Richard Portes, 1986, “Debt and Default in the 1930s: Causes and Consequences,” European Economic Review, Vol. 30, pp. 599–640.

### Emerging market spreads, sovereign ratings, and market access
- Arora, Vivek, and Martín Cerisola, 2001, “How Does U.S. Monetary Policy Influence Sovereign Spreads in Emerging Markets,” Staff Papers, International Monetary Fund, Vol. 48, No. 3, pp. 474–98.
- Bayoumi, Tamin, and others, 1995, “Do Credit Markets Discipline Sovereign Borrowers? Evidence from U.S. States,” Journal of Money, Credit and Banking, Vol. 27, No. 4, pp. 1046–59.
- Block, Steven A., and Paul M. Vaaler, 2004, “The Price of Democracy: Sovereign Risk Ratings, Bond Spreads, and Political Business Cycles in Developing Countries,” Journal of International Money and Finance, No. 23, pp. 917–46.
- Cantor, Richard, and Frank Parker, 1996, “Determinants and Inputs of Sovereign Credit Ratings,” Economic Policy Review, Federal Reserve Board of New York, Vol. 2, pp. 37–53.
- Cline, William, and Kevin J. S. Barnes, 1997, “Spreads and Risk in Emerging Markets Lending,” IFF Research Paper 97, No.1 (Washington: Institute of International Finance).
- Gelos, R. Gaston, and others, 2004, Sovereign Borrowing by Developing Countries: What Determine Market Access? IMF Research Workshop, October 23–24, 2003.
- Mauro, Paolo, and others, 2002, “Emerging Market Spreads: Then Versus Now,” The Quarterly Journal of Economics, Vol. 117, No. 2, pp. 695–720.
- McGuire, Patrick, and Martijn Schrijvers, 2003, “Common Factors in Emerging Market Spreads,” BIS Quarterly Review, pp. 65–78.
- Min, Hong, 1998, “Determinants of Emerging Market Bond Spread: Do Economic Fundamentals Matter?” World Bank Working Paper 1899 (Washington: World Bank).
- Reinhart, Carmen, 2002, “Default, Currency Crises, and Sovereign Credit Ratings,” World Bank Economic Review, Vol. 16, No. 2, pp. 151–70.
- Sobrinho, Nelson F. Souza, 2004, “Sovereign Risk in Developing Countries,” Mimeo, (Los Angeles: University of California, UCLA).
- Zhang, Xiaoming Alain, 1999, “Testing for ‘Moral Hazard’ in Emerging Markets Lending,” IIF Research Paper 99/1 (Washington: Institute of International Finance).

### Contagion, crises, and capital flows
- Calvo, Sara, and Carmen Reinhart, 1996, “Capital Flows to Latin America: Is There Evidence of Contagion Effects?” in Private Capital Flows to Emerging Markets, ed. by G. Calvo and others (Washington: Institute for International Economics).
- Kaminsky, Graciela, and Sergio Schmukler, 1999, “What Triggers Market Jitters?: A Chronicle of the Asian Crisis,” Journal of International Money and Finance, Volume 18, No. 4, pp. 537–60.
- Kaminsky, Graciela, and Sergio Schmukler, 2001, “Emerging Markets Instability: Do Sovereign Ratings Affect Country Risk and Stock Returns?” World Bank Research Working Paper 2678 (Washington: World Bank).
- Kaminsky, Graciela, and others, 1997, “Leading Indicators of Currency Crises,” IMF Working Paper 97/79 (Washington: World Bank).
- Kaminsky, Graciela, and Carmen M. Reinhart, 2000, “On Crises, Contagion, and Confusion,” Journal of International Economics, Vol. 51 (June), pp. 145–68.
- Detragiache, Enrica, and Antonio Spilimbergo, 2001, “Crises and Liquidity: Evidence and Interpretation,” IMF Working Paper 01/02 (Washington: International Monetary Fund).
- Dell’Ariccia, Giovanni, and others, 2002, “Moral Hazard and International Crisis Lending: A Test,” IMF Working Paper 02/181 (Washington: International Monetary Fund).
- Lane, Timothy, and Steven Phillips, 2000, “Does IMF Financing Result in Moral Hazard?” IMF Working Paper 00/168 (Washington: International Monetary Fund).
- Zhang, Xiaoming Alain, 1999, “Testing for ‘Moral Hazard’ in Emerging Markets Lending,” IIF Research Paper 99/1 (Washington: Institute of International Finance).

### Political instability, corruption, and political economy factors
- Aisen, Ari, and Francisco José Veiga, 2005 “Does Political Instability Lead to Higher Inflation? A Panel Data Analysis,” IMF Working Paper 05/49 (Washington: International Monetary Fund).
- Block, Steven A., and Paul M. Vaaler, 2004, “The Price of Democracy: Sovereign Risk Ratings, Bond Spreads, and Political Business Cycles in Developing Countries,” Journal of International Money and Finance, No. 23, pp. 917–46.
- Ciocchini, Francisco, and others, 2003, “Does Corruption Increase Emerging Market Bond Spreads?” Working Paper 2003/03 (New York: Cornell University).

### Methodology and econometric tools
- Arellano, Manuel, and Stephen Bond, 1991, “Some Tests of Specification for Panel Data: Monte Carlo Evidence and an Application to Employment Equations,” Review of Economic Studies, Vol. 58, No. 2, pp. 277–97.
- Bond, Stephen, 2002, “Dynamic Panel Data Models: A Guide to Micro Data Methods and Practice,” Portuguese Economic Journal, Vol. 1, pp. 141–62.
- Roodman, David, 2005, Xtabond2: Stata Module to Extend Xtabond Dynamic Panel Data Estimator. (Washington: Center for Global Development). Available via the Internet: http://econpapers.repec.org/software/bocbocode/s435901.htm

### Other empirical studies on sovereign spreads and market behavior
- Arora, Vivek, and Martín Cerisola, 2001, “How Does U.S. Monetary Policy Influence Sovereign Spreads in Emerging Markets,” Staff Papers, International Monetary Fund, Vol. 48, No. 3, pp. 474–98.
- Jahjad, Samir, and Vivian Yue, 2004, “Exchange Rate Policy and Sovereign Bond Spreads in Developing Countries,” IMF Working Paper 04/210 (Washington: International Monetary Fund).
- Cline, William, and Kevin J. S. Barnes, 1997, “Spreads and Risk in Emerging Markets Lending,” IFF Research Paper 97, No.1 (Washington: Institute of International Finance).
- Gelos, R. Gaston, and others, 2004, Sovereign Borrowing by Developing Countries: What Determine Market Access? IMF Research Workshop, October 23–24, 2003.
- McGuire, Patrick, and Martijn Schrijvers, 2003, “Common Factors in Emerging Market Spreads,” BIS Quarterly Review, pp. 65–78.
- Min, Hong, 1998, “Determinants of Emerging Market Bond Spread: Do Economic Fundamentals Matter?” World Bank Working Paper 1899 (Washington: World Bank).

*Source: _wp0616 - REFERENCES (PDF chapter/section).*

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