## _wp13216

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---

### I. Introduction — context, objectives, and key framing
- Context and challenge:
  - Achieving fiscal discipline in a monetary union without a central fiscal authority is challenging and crucial for stability.
  - A monetary union increases economic and financial interconnectedness and creates risks that debt sustainability issues in one country can affect other members.
  - Financial linkages (large holdings of public debt by banks in other member countries) can transmit a fiscal crisis across the union (e.g., euro area experience).
- Moral hazard and incentives:
  - Some members may have incentives to overborrow absent a credible commitment of no bailout.
  - Countries with weaker fiscal situations benefit from credibility of stronger members, facing lower interest rates than otherwise.
- Policy instruments:
  - Fiscal rules can anchor expectations and provide macroeconomic stability, but must allow scope for countercyclical policies.
  - Market discipline helps if: free capital movement, credible no bail-out commitment, no monetization of debt, and sensitivity of sovereign interest rates to fiscal behavior.
- Paper objectives:
  - Evaluate responsiveness of sovereign bond rates to governments’ fiscal behavior in the WAEMU regional financial market.
  - Assess design and enforcement of fiscal rules in WAEMU via comparative analysis.
  - Discuss possible changes to regional fiscal supervision architecture and ways to improve the regional financial market’s ability to better discriminate based on fiscal behavior.

### II. Market discipline — theory and WAEMU-specific assessment
- Definition:
  - Market discipline: market pricing of government bonds according to perceived default risk; differences in perceived default risks translate into interest rate variation.
- Necessary conditions for effective market discipline (Alexander and Anker [1997]):
  1. Capital should be allowed to move freely.
  2. National government debt must not be monetized by the central bank.
  3. Member countries should be solely responsible for their own debt (the "no bail-out clause").
  4. Interest rates must react strongly enough to put pressure on governments’ fiscal behavior.
- WAEMU-specific assessments:
  - Capital movement: no restrictions on capital movement within WAEMU; intra-WAEMU cross-border transactions in the T-bills market are high especially for countries with smaller banking systems.
  - Monetization: BCEAO has price stability as primary objective and does not engage in direct monetary financing; BCEAO’s cash advances to national treasuries were discontinued in 2003.
  - No-bailout: de facto realistic assumption historically—resources for a bailout would be difficult to mobilize within WAEMU where per capita GDP in 2012 is estimated at about 770 US dollars.
  - Stability fund: authorities are working on a stability fund to address liquidity, but it would not address solvency problems.
  - Historical evidence: no cross-country bailout occurred during major crises (1980s/1990s HIPC; 2011 Côte d’Ivoire crisis restructuring executed without cost to other WAEMU governments).

### III. WAEMU sovereign debt market — structure, participants, and liquidity
- Market development and instruments:
  - Regional government securities market expanded after elimination of BCEAO statutory advances in 2003, sustained by excess liquidity in the banking system.
  - Market dominated by Treasury bills and bonds; Treasury bills maturities: 3/24 months; Treasury bonds maturities: 2/7 years.
  - Government securities are tax free, carry zero risk weight in capital adequacy calculations, and are tradable across WAEMU.
- Investor base and market features:
  - Banks are predominant investors.
  - Cross-border transactions non-negligible; foreign participation marginal; no organized secondary market.
  - Excess bank reserves are short-term, making short-term (3-month and 6-month) bills attractive.
- Issuance concentration (Treasury Bills Issuance in billions of CFA francs, selected figures):
  - WAEMU total: 2001 54.9; 2002 51.9; 2003 85.4; 2004 123.5; 2005 300.5; 2006 221.4; 2007 382.0; 2008 342.7; 2009 843.5; 2010 1668.5; 2011 3160.2
  - Côte d’Ivoire: 2001 0.0; 2002 0.0; 2003 16.3; 2004 15.7; 2005 47.5; 2006 0.0; 2007 164.8; 2008 103.0; 2009 538.3; 2010 1245.9; 2011 2278.8
  - Benin: 2005 23.4; 2006 45.6; 2008 40.1; 2009 119.7; 2010 119.8; 2011 237.7
  - Mali: 2001 12.0; 2003 15.2; 2004 21.0; 2005 114.9; 2011 119.6
  - Senegal: 2001 42.9; 2003 23.0; 2004 45.3; 2011 238.8
  - Burkina Faso: 2002 51.9; 2011 160.8
  - Niger: 2005 30.0; 2011 64.5
  - Togo: 2008 10.0; 2009 15.0; 2010 30.0; 2011 60.0
  - Guinea-Bissau: mostly 0.0 or negligible values across 2001–2011
- Market implications:
  - High concentration of issuance (three largest issuers ≈ 88 percent of T-bills during 2009/2011; Côte d’Ivoire ≈ 70 percent) and limited secondary market reduce price discovery and market depth.

### IV. Empirical model, data, and estimation methodology
- Data set:
  - Countries: Benin, Burkina Faso, Côte d’Ivoire, Guinea-Bissau, Mali, Niger, Senegal, Togo.
  - Period: 1997/2011.
  - Frequency: yearly.
  - Dependent variable: average short-term annualized interest rate a country is charged by markets (annualized yield at issuance). Source: BCEAO.
  - Political risk index: International Country Risk Guide (ICRG) by the PRS Group.
- Baseline econometric specification:
  - Unbalanced panel: Y_it = β X_it + λ E_t + γ O_it + μ_it with country fixed effects and dynamic extensions.
  - Dynamic specification includes lagged dependent variable: Y_it = α Y_i,t−1 + β X_it + λ E_t + γ O_it + μ_it.
  - Blundell and Bond [1998] System GMM estimator used to address dynamic panel endogeneity and time-invariant country characteristics.
- Key explanatory variables:
  1. Overall fiscal balance as share of GDP.
  2. General government’s debt-to-GDP ratio (domestic debt used).
  3. Inflation rate.
  4. Excess bank reserves to GDP (WAEMU).
  5. WAEMU area overall fiscal balance-to-GDP ratio (GDP-weighted excluding the country itself).
  6. Political risk index (ICRG).

### V. Baseline regression results (selected System GMM findings and diagnostics)
- Estimation methods reported: pooled OLS; Fixed Effects OLS; System GMM (Blundell-Bond). Dynamic specification with one lag chosen.
- Reported coefficients (selected, from Table 2 — p-values in parentheses; significance codes: * p<0.10, ** p<0.05, *** p<0.01):
  - Overall balance to GDP: -0.153*** (0.001) in one Sys GMM column; -0.0577 (0.274) in another.
  - Domestic debt to GDP: 0.0944** (0.013); 0.103*** (0.006) in Sys GMM columns.
  - Inflation: 0.0608** (0.016) in one Sys GMM column; -0.0201 (0.487) in another.
  - Excess reserves to GDP: -1.314*** (0.000); -1.351*** (0.000) in FE columns; -0.787*** (0.000); -1.290*** (0.000) in Sys GMM columns.
  - WAEMU overall balance to GDP: -0.498*** (0.000) in one Sys GMM column; -0.228* (0.099) in another.
  - Political risk Rating: 0.0502*** (0.000) in one column; -0.0946 (0.114) in another.
  - Lagged interest rate: 0.736*** (0.000); 0.528*** (0.000).
  - Constant terms: 6.081*** (0.000); 11.84*** (0.001).
- Observations reported per column: 57, 52, 52, 47.
- R2 reported for first two columns: 0.3970, 0.4593.
- Estimation choice and robustness:
  - Durbin-Watson test indicated autocorrelation in FE OLS residuals; dynamic System GMM preferred.
  - Results robust to alternative fiscal balance measure (Table 6).

### VI. Key empirical findings and interpretation
- Dominant determinants:
  - Market liquidity indicators dominate: excess bank reserves to GDP and WAEMU area overall deficit (excluding the country) have the largest coefficients and strongest statistical significance.
  - Excess reserves coefficients are strongly significant with p-values 0.000 and magnitudes at least 10 times larger than either fiscal variable coefficients (text assertion).
- Fiscal variables:
  - Domestic debt to GDP increases are associated with higher interest rates in System GMM estimates (coefficients 0.0944** and 0.103***).
  - Improvements in a country’s overall fiscal balance tend to reduce interest rates (e.g., -0.153***), but significance weakens once political risk is included in some specifications.
  - WAEMU-wide average fiscal balance (excluding own country) improvement reduces interest rates in certain specifications (e.g., -0.498***).
- Inflation:
  - Rise in inflation does not consistently affect interest rates significantly, consistent with expectations in a currency union with cross-border transactions.
- Political risk:
  - Political risk rating is significant in explaining variation in interest rates in some System GMM specifications (e.g., coefficient 0.0502***), implying higher political instability is associated with higher market yields.
- Market structure implications:
  - Large excess liquidity suggests sovereign borrowing constraints are not binding; private sector faces higher borrowing costs due to non-performing loans and legal costs.
  - High share of concessional financing reduces recourse to market borrowing and may weaken market discipline.

### VII. Limitations and recommendations for market development
- Limitations noted in the analysis:
  - Interest rate measure: annualized yield at issuance is imperfect but the only available measure.
  - High share of concessional debt and reliance on foreign financing distort market signals.
  - Lack of bond market depth and absence of a secondary market violate assumptions of perfectly competitive lenders and limit price discovery.
- Market development recommendations:
  - Deepen and diversify the regional financial market to improve sovereign bond pricing and market oversight.
  - Inform and educate market participants about sovereign risks.
  - Introduce, based on debt-sustainability assessments, a non-zero risk weight for government paper in financial institutions’ capital adequacy calculations.

### VIII. Fiscal rules and institutional design — WAEMU versus EMU
- EMU fiscal framework (high-level features):
  - Maastricht criteria: deficit < 3 percent of GDP; debt < 60 percent of GDP.
  - Stability and Growth Pact (SGP) and later reforms: medium-term objectives (MTO); 2005 SGP reform; 2012 Fiscal Compact with structural deficit limit of 0.5 percent of GDP (expandable to 1 percent) and debt-correcting mechanism (1/20th rule).
- WAEMU fiscal rules and monitoring:
  - First-order criteria: basic fiscal balance-to-GDP ratio should be zero or positive; overall debt-to-GDP ratio < 70 percent; no accumulation of arrears into the next year.
  - Fourth criterion: average annual inflation rate should not exceed 3 percent.
  - Second-order criteria: wage bill ≤ 35 percent of tax revenue; domestically financed investment ≥ 20 percent of tax revenue.
  - Monitoring and enforcement: WAEMU Commission prepares half-yearly progress reports; National Committees for Economic Policy produce quarterly country reports.
  - Correction mechanism: country given 30 days to prepare corrective strategy; council may publish violations, withdraw assistance, recommend changes to West African Development Bank interventions, or suspend union resources. Sequence of sanctions has, to the authors’ knowledge, never been implemented.
  - Ambiguities: no clear timelines between steps, unclear criteria for acceptable adjustments, and unspecified monetary value of sanctions in steps iii and iv.
  - Article 71 leeway: WAEMU Council can exempt a member from criteria by unanimity for exceptional circumstances (economic distress, droughts, terms-of-trade shocks, political instability).
- Observations on WAEMU limits:
  - WAEMU debt limit of 70 percent of GDP is higher than EMU’s 60 percent; with a high share of concessional debt, nominal ceilings may overstate tax burden.
  - WAEMU average debt-to-GDP ratio in 2012 estimated at 40.9 percent, making the 70 percent limit largely non-binding at the aggregate level.

### IX. Policy discussion and recommendations
- Fiscal-rule adjustments and targets:
  - Consider lowering debt ceiling closer to 50 percent of GDP (World Bank and IMF DSF suggestion for countries with CPIA between 3.25 and 3.75).
  - Treat debt ceiling as a level to avoid, not an optimal target.
  - Reassess exclusion of foreign-financed capital expenditure from basic balance definition because it:
    - Excludes a substantial source of debt accumulation.
    - Discriminates against regional financing, potentially hindering regional market development.
  - Suggest adopting an overall deficit target to better control debt accumulation and avoid distortions.
  - Structural (cyclically-adjusted) balance is an option but challenging due to weakly defined business cycles and data limitations in WAEMU.
  - Practical steady-state benchmark example: assuming nominal GDP growth of 7 percent at steady state (5 percent real growth and 2 percent inflation), a deficit of 3.5 percent stabilizes the debt ratio at 50 percent; ceiling could be set slightly below this level and allow temporary limited exceedances.
- Monitoring and enforcement improvements:
  - Improve availability, quality, and timeliness of fiscal information (e.g., data on fiscal arrears).
  - Better define sequencing and deadlines in the Excessive Deficit Procedure (EDP) correction mechanism.
  - Specify monetary penalties with possible escalation as deviation duration increases.
  - Recognize political economy constraint: member states’ willingness to accept strong oversight and sanctions is a fundamental challenge.

### X. Conclusion — synthesis of empirical and policy messages
- Empirical synthesis:
  - Panel evidence for 1997/2011 indicates limited sensitivity of sovereign interest rates to fluctuations in domestic debt and fiscal deficits; liquidity variables dominate.
  - Variables with largest coefficients and strongest effects: WAEMU area overall deficit and excess bank reserves — pointing to liquidity supply/demand in the WAEMU banking system as the dominant determinant of interest rates.
- Policy implication:
  - Market discipline is more effective in competitive, well-functioning markets; deeper regional banking and financial markets are needed to improve sovereign bond pricing and market oversight.
  - WAEMU’s fiscal supervision architecture is similar in spirit to EMU rules but weaker in enforcement; debt and deficit criteria could be modified to better reflect WAEMU economic characteristics and improve enforceability.

*Source: _wp13216 (IMF working paper excerpt as provided).*

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

### _wp13216 - References .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .

### I. INTRODUCTION
- Context and challenge:
  - Achieving fiscal discipline in a monetary union without a central fiscal authority is challenging and crucial for stability.
  - A monetary union increases economic and financial interconnectedness and creates risks that debt sustainability issues in one country can affect other members.
  - Financial linkages (large holdings of public debt by banks in other member countries) can transmit a fiscal crisis across the union, as seen in the euro area.
- Moral hazard and incentives:
  - Some members may have incentives to overborrow absent a credible commitment of no bailout.
  - Countries with weaker fiscal situations benefit from credibility of stronger members, facing lower interest rates than otherwise.
- Policy instruments:
  - Fiscal rules can anchor expectations and provide macroeconomic stability [Morris, Ongena, and Schuknecht, 2006], but must allow scope for countercyclical policies.
  - Market discipline helps if: free capital movement, credible no bail-out commitment, no monetization of debt, and sensitivity of sovereign interest rates to fiscal behavior [Alexander and Anker, 1997].
- Paper objectives:
  - Evaluate responsiveness of sovereign bond rates to governments’ fiscal behavior in the WAEMU regional financial market.
  - Assess design and enforcement of fiscal rules in WAEMU via comparative analysis.
  - Discuss possible changes to regional fiscal supervision architecture and ways to improve the regional financial market’s ability to better discriminate based on fiscal behavior.

### II. MARKET DISCIPLINE REVIEWED
- Definition:
  - Market discipline: market pricing of government bonds according to perceived default risk; differences in perceived default risks translate into interest rate variation.
- Necessary conditions for effective market discipline (Alexander and Anker [1997]):
  1. Capital should be allowed to move freely.
  2. National government debt must not be monetized by the central bank.
  3. Member countries should be solely responsible for their own debt (the "no bail-out clause").
  4. Interest rates must react strongly enough to put pressure on governments’ fiscal behavior.
- WAEMU-specific assessments:
  - Capital movement: no restrictions on capital movement within WAEMU; Sy [2010] finds intra-WAEMU cross-border transactions in the T-bills market are high especially for countries with smaller banking systems.
  - Monetization: BCEAO has price stability as primary objective and does not engage in direct monetary financing; BCEAO’s cash advances to national treasuries were discontinued in 2003.
  - No-bailout: de facto realistic assumption historically — resources for a bailout would be difficult to mobilize within WAEMU where per capita GDP in 2012 is estimated at about 770 US dollars.
  - Stability fund: WAEMU authorities are working on a stability fund, which would address liquidity, but not solvency problems.
  - Historical evidence: absence of a viable bailout mechanism was evident during the debt crises of the 1980s and 1990s (HIPC Initiative). During the 2011 Côte d’Ivoire crisis, no bailout occurred; BCEAO helped rollover Ivorian debt which was restructured "into 2-year T-bills, 3- and 5-year bonds with interest rates of 4.75-5.25 percent (slightly below prevailing market rates)" [IMF, 2012]. The bulk of creditors were WAEMU-area commercial banks; restructuring was done at no cost to governments of other WAEMU countries. Malian government also rolled over debt during the 2012 crisis.
- Focus of remaining section:
  - Examine the fourth condition: responsiveness of sovereign interest rates to fiscal behavior.
  - Structure: literature review on determinants of interest rates; overview of regional government debt market; empirical model and regression results (theoretical model in appendix).

### II.A Literature Review (selected points)
- Theoretical approaches:
  - Eaton and Gersovitz [1981] and Arellano [2008] develop debt repudiation models where main determinants of interest rate spreads are debt and fiscal deficit levels; opportunity cost of default is key.
- Empirical heterogeneity:
  - Gale and Orszag [2002] review 58 papers: in half, fiscal deficit displays a predominantly positive and significant effect on interest rates; the rest show mixed or insignificant effects. Engen and Hubbard [2004] reach similar conclusions.
  - Edwards [1984] finds external debt and debt service, GDP growth, and export growth important for interest rate variation.
  - Inflation: higher inflation should increase borrowing costs, but in a monetary union with cross-border transactions the link between inflation and interest rate differentiation across members is less direct.
- Global factors:
  - Global liquidity and world-interest-rate shocks can affect spreads even with sound domestic policies; the Federal Reserve funds rate is often used to capture global liquidity effects (Uribe and Yue [2006]).
- Currency area spillovers:
  - Limited treatment in empirical literature; if no-bailout clause is perceived as unrealistic, deterioration in one member’s fiscal balance may raise interest rates in other members. Faini [2006] finds substantial spillovers among EU member countries.

### II.B An Overview of the WAEMU Sovereign Debt Market
- Market development:
  - Regional government debt market became an important financing source; elimination of BCEAO statutory advances in 2003 catalyzed government securities market growth, sustained by excess liquidity in the banking system [Sy, 2010].
- Investor base and instruments:
  - Banks are predominant investors. Government securities are tax free, carry zero risk weight in capital adequacy ratio calculation, and are tradable across WAEMU.
  - Market dominated by Treasury bills and bonds; Treasury bills have a maturity of 3/24 months, and Treasury bonds of 2/7 years.
  - Securities also include bills and bonds by regional institutions, non-WAEMU institutions, and corporates [Diouf and Boutin-Dufresne, 2012].
- Concentration and participation:
  - Three largest issuers accounted for about 88 percent of T-bills issued during 2009/2011, with Côte d’Ivoire alone issuing about 70 percent.
  - Excess bank reserves are short-term, rendering 3/month and 6/month bills particularly attractive.
  - Cross-border transactions are non-negligible, but foreign participation is marginal and there is no organized secondary market [Diouf and Boutin-Dufresne, 2012].
- Table excerpt (Treasury Bills Issuance in billions of CFA francs):
  - Benin: 2001 0.0; 2002 0.0; 2003 0.0; 2004 0.0; 2005 23.4; 2006 45.6; 2007 0.0; 2008 40.1; 2009 119.7; 2010 119.8; 2011 237.7
  - Côte d’Ivoire: 2001 0.0; 2002 0.0; 2003 16.3; 2004 15.7; 2005 47.5; 2006 0.0; 2007 164.8; 2008 103.0; 2009 538.3; 2010 1245.9; 2011 2278.8
  - Mali: 2001 12.0; 2002 0.0; 2003 15.2; 2004 21.0; 2005 114.9; 2006 44.1; 2007 53.1; 2008 30.5; 2009 54.1; 2010 99.5; 2011 119.6
  - Senegal: 2001 42.9; 2002 0.0; 2003 23.0; 2004 45.3; 2005 35.5; 2006 50.8; 2007 67.2; 2008 63.2; 2009 82.0; 2010 94.7; 2011 238.8
  - Burkina Faso: 2001 0.0; 2002 51.9; 2003 30.9; 2004 41.5; 2005 43.3; 2006 50.9; 2007 46.9; 2008 61.0; 2009 34.3; 2010 43.6; 2011 160.8
  - Niger: 2001 0.0; 2002 0.0; 2003 0.0; 2004 0.0; 2005 30.0; 2006 23.3; 2007 0.0; 2008 35.0; 2009 0.0; 2010 35.0; 2011 64.5
  - Guinea-Bissau: 2001–2011 mostly 0.0 or negligible values; 2005 6.0; 2006 6.7
  - Togo: 2001–2006 0.0; 2007 0.0; 2008 10.0; 2009 15.0; 2010 30.0; 2011 60.0
  - WAEMU total: 2001 54.9; 2002 51.9; 2003 85.4; 2004 123.5; 2005 300.5; 2006 221.4; 2007 382.0; 2008 342.7; 2009 843.5; 2010 1668.5; 2011 3160.2

### II.C Empirical Model Specification
- Baseline econometric setup:
  - Unbalanced panel specification:
    - Y_it = β X_it + λ E_t + γ O_it + μ_it, i = 1,...,N; t = 1,...,T (equation (1))
    - Y_it: interest rate for country i and year t.
    - X_it: menu of explanatory variables.
    - E_t: ratio of excess reserves to GDP in the WAEMU area.
    - O_it: WAEMU area overall fiscal balance to GDP ratio (GDP-weighted WAEMU area overall fiscal balance to GDP calculated separately for each country excluding that country’s own fiscal balance, thus varying across countries and years).
  - Country-specific unobservable characteristics v_i can bias estimators if correlated with X_it:
    - μ_it = v_i + ε_it (equation (2))
  - Fixed-effects (FE) estimation via within transformation eliminates v_i:
    - Demeaned equation:  ̈Y_it = β ̈X_it + λ ̈E_t + γ ̈O_it + ̈ε_it (equation (3))
- Dynamic specification and endogeneity:
  - Interest rates may depend on their own lagged values:
    - Y_it = α Y_i,t−1 + β X_it + λ E_t + γ O_it + μ_it (equation (4))
  - First-differencing eliminates fixed effects:
    - ΔY_it = α ΔY_i,t−1 + β ΔX_it + λ ΔE_t + γ ΔO_it + Δμ_it (equation (5))
    - Δμ_it = ε_it − ε_i,t−1 (equation (6))
    - Resulting equation: ΔY_it = α ΔY_i,t−1 + β ΔX_it + λ ΔE_t + γ ΔO_it + Δε_it (equation (7))
  - Inclusion of lagged dependent variable introduces autocorrelation and endogeneity.
  - Blundell and Bond [1998] GMM estimator is employed to accommodate dynamic specification while accounting for time-invariant country characteristics; the first-differenced lagged dependent variable is instrumented with further lagged levels.
- Explanatory variables included:
  1. Macroeconomic characteristics:
     - Overall fiscal balance as share of GDP.
     - General government’s debt-to-GDP ratio (domestic debt used, issued almost exclusively in the WAEMU market).
     - Inflation rate.
  2. Level of excess bank reserves in the regional market (influences liquidity and interest rates).
  3. WAEMU area overall fiscal balance-to-GDP ratio (proxy for liquidity demand in the region).

*Source: _wp13216 - References .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .  .*

### 4.  The paper gauges political risk by including an index provided by the International

### _wp13216 - 4.  The paper gauges political risk by including an index provided by the International

### Political risk measure
- Political risk index source: International Country Risk Guide (ICRG) prepared by the PRS Group.
- Construction: assigning risk points to a weighted non-linear combination of various dimensions including government stability, internal conflict, corruption, and religious tensions.
- Limitation noted: the index is compiled on the basis of subjective analysis of the available information.

### Data set and dependent variable
- Countries: all WAEMU countries (Benin, Burkina Faso, Côte d’Ivoire, Guinea-Bissau, Mali, Niger, Senegal, Togo).
- Period: 1997/2011.
- Frequency: yearly.
- Dependent variable: the average short-term annualized interest rate a country is charged by markets (annualized yield at issuance).
- Interest rate data source: BCEAO.
- Political risk variable source: PRS Group.
- Descriptive statistics: shown in Table 5 in Appendix B (table not reproduced here).

### Estimation methodology
- Methods reported: pooled OLS; Blundell-Bond (System GMM).
- Dynamic specification: model with one lag is deemed the most appropriate specification.
- Durbin-Watson test: points to autocorrelation in the residuals of the Fixed-Effects OLS regression; dynamic specification chosen as a model choice believed to better reflect the data generation process.
- Robustness: results do not change when one uses an alternative measure of fiscal balance (Table 6 in Appendix A).

### Baseline regression results (Table 2. WAEMU: Baseline Results)
- Columns: (OLS, fe), (OLS, fe), (Sys GMM), (Sys GMM).
- Reported coefficients and p-values (p-values in parentheses). Significance codes: * p<0.10, ** p<0.05, *** p<0.01.
- Coefficients (as presented, aligned by variable and column):
  - Overall balance to GDP: -0.125 (0.178), -0.0816 (0.407), -0.153*** (0.001), -0.0577 (0.274)
  - Domestic debt to GDP: -0.000632 (0.992), -0.0101 (0.874), 0.0944** (0.013), 0.103*** (0.006)
  - Inflation: -0.0464 (0.383), -0.0534 (0.323), 0.0608** (0.016), -0.0201 (0.487)
  - Excess reserves to GDP: -1.314*** (0.000), -1.351*** (0.000), -0.787*** (0.000), -1.290*** (0.000)
  - WAEMU overall balance to GDP: -0.154 (0.537), 0.0367 (0.892), -0.498*** (0.000), -0.228* (0.099)
  - Political risk Rating: -0.0946 (0.114), 0.0502*** (0.000)
  - Lagged interest rate: 0.736*** (0.000), 0.528*** (0.000)
  - Constant: 6.081*** (0.000), 11.84*** (0.001)
- Observations: 57, 52, 52, 47 (as listed: 57525247 — interpreted as four values corresponding to columns).
- R2: 0.3970, 0.4593 (reported for first two columns).
- Interpretation focus: discussion is based on Blundell-Bond estimation results.

### Key empirical findings
- Domestic debt:
  - An increase in the level of domestic debt has a positive and significant effect on the interest rate in System GMM specifications (coefficients 0.0944** and 0.103***).
  - Effect remains robust to the inclusion of the political risk variable.
- Overall fiscal balance:
  - Improvement in overall fiscal balance has an expected negative effect on interest rates but loses significance once political risk is accounted for.
- Excess bank reserves:
  - An increase in excess bank reserves has a significant and relatively large negative effect on interest rates.
  - Magnitude: coefficients on excess reserves are at least 10 times larger than that of either fiscal variable above (as noted in text).
  - Excess reserves coefficients are strongly significant (p-values 0.000).
- WAEMU-wide average fiscal balance (excluding own country):
  - Improvement has a negative and significant effect on interest rates in some specifications (e.g., -0.498***).
- Inflation:
  - Rise in inflation does not affect interest rates significantly, consistent with expectations in a currency union.
- Political risk:
  - Political risk rating plays a significant role in explaining variation in interest rates in System GMM (positive and significant coefficient 0.0502*** in one column; negative coefficient -0.0946 with p-value 0.114 in another).
  - Interpretation: as political instability rises, markets demand higher interest rates due to loss of confidence in government’s ability to repay.

### Market structure and liquidity as dominant determinants
- Main conclusion: relative supply and demand of loanable funds in the regional financial sector are the main determinants of sovereign borrowing costs in WAEMU.
- Evidence:
  - Largest coefficients are WAEMU area overall deficit and excess bank reserves.
  - Large amount of excess liquidity indicates sovereign borrowing constraints are not binding.
  - Differential between sovereign borrowing rates and private sector rates: private rates remain considerably higher owing to high ratios of non-performing loans and legal costs.
- Concessional financing:
  - High share of concessional debt (illustrated in Figure 4 and Figure 5) reduces recourse to market borrowing and may reduce sovereign borrowing costs in the regional market.
  - Reliance on foreign and concessional financing relaxes governments’ borrowing constraints and weakens market discipline.

### Limitations and market development
- Limitations identified:
  - Interest rate measure: annualized yield at issuance is an imperfect measure but the only one available.
  - High share of concessional debt.
  - Lack of bond market depth and absence of a secondary market for trading government bonds, violating perfectly competitive lenders assumption.
- Market development recommendation:
  - Development, deepening, and diversification of the regional financial market is key to improving market oversight and market discipline.
  - Suggested measures: informing and educating market participants about sovereign risks; introducing, based on debt-sustainability assessments, a non-zero risk weight for government paper in financial institutions’ capital adequacy calculations.

### Fiscal rules and institutions: EMU experience and WAEMU comparison
- EMU fiscal framework highlights:
  - Maastricht Treaty fiscal criteria: deficit < 3 percent of GDP; debt < 60 percent of GDP.
  - Stability and Growth Pact (SGP) aimed at preserving fiscal consolidation; no-bailout clause.
  - 2005 SGP reform: introduced medium-term objectives (MTO) set by individual countries; kept 3 percent and 60 percent limits but relaxed exceptional circumstances and minimum annual correction of 0.5 percent of GDP.
  - 2012 Fiscal Compact: structural deficit limit of 0.5 percent of GDP (expandable to 1 percent in some cases); debt-correcting mechanism requiring countries with debt above 60 percent of GDP to reduce excess debt by 5 percent yearly (1/20th rule).
- WAEMU fiscal rules:
  - First-order fiscal criteria include: basic fiscal balance-to-GDP ratio should be zero or positive; overall debt-to-GDP ratio should be less than 70 percent; governments prohibited from accumulating arrears into the following year.
  - Fourth first-order criterion: average annual inflation rate should not exceed 3 percent.
  - Second-order criteria: limit wage bill to 35 percent of tax revenue; set a 20 percent floor on domestically financed investment to tax revenue.
- Observations and concerns:
  - WAEMU debt limit 70 percent of GDP is higher than EMU’s 60 percent; however, much of WAEMU debt is concessional, so nominal ceilings may overstate tax burden.
  - With Côte d’Ivoire completing HIPC, WAEMU average debt-to-GDP ratio in 2012 estimated at 40.9 percent, rendering the 70 percent limit largely non-binding.
  - WAEMU monitoring and enforcement:
    - WAEMU Commission monitors compliance, prepares half-yearly progress reports.
    - National Committees for Economic Policy (NCEP) produce quarterly country reports.
    - Correction mechanism: country given 30 days to develop corrective strategy; council may publish, withdraw assistance, recommend changes to West African Development Bank interventions, or suspend union resources to member state.
    - Sequence of sanctions has, to the authors’ best knowledge, never been implemented.
  - Ambiguities in WAEMU EDP:
    - No clear timelines between steps.
    - Unclear criteria for acceptable adjustments.
    - Monetary value of sanctions in steps iii and iv unspecified.
  - Article 71 leeway: WAEMU Council can, by unanimity, exempt a member from criteria for exceptional circumstances (economic distress, droughts, terms-of-trade shocks, political instability).

### Policy discussion and recommendations
- Fiscal-rule adjustments:
  - Consider lowering the debt ceiling closer to 50 percent of GDP (World Bank and IMF DSF suggestion for countries with CPIA between 3.25 and 3.75).
  - Treat debt ceiling as a level to avoid, not an optimal target.
- Fiscal balance definition:
  - Reconsider exclusion of foreign-financed capital expenditure from basic balance definition because:
    - It excludes a substantial source of debt accumulation.
    - It discriminates against regional financing, potentially hindering regional market development.
  - Suggestion: adopt an overall deficit target to better control debt accumulation and avoid distortions.
  - Alternative targeting: structural (cyclically-adjusted) balance is an option but challenging due to lack of clear business cycles and data issues in WAEMU.
  - Practical steady-state benchmark example: assuming nominal GDP growth of 7 percent at steady state (5 percent real growth and 2 percent inflation), a deficit of 3.5 percent stabilizes the debt ratio at 50 percent; ceiling could be set slightly below this level and allow temporary limited exceedances.
- Monitoring and enforcement improvements:
  - Improve availability, quality, and timeliness of information (e.g., data on fiscal arrears).
  - Better define sequencing and deadlines in the EDP correction mechanism.
  - Specify monetary penalties with possible escalation as deviation duration increases.
  - Recognize political economy constraint: member states’ willingness to accept strong oversight and sanctions is a fundamental challenge.

### Conclusion (summary of main messages)
- Empirical results (1997/2011 yearly panel) indicate limited sensitivity of interest rates to fluctuations in domestic debt and deficit.
- Variables with largest coefficients and strongest effects: WAEMU area overall deficit and excess bank reserves—pointing to liquidity supply/demand in the WAEMU banking system as the dominant determinant of interest rates.
- Market discipline is more effective in competitive, well-functioning markets; therefore, deeper regional banking and financial markets are needed to improve sovereign bond pricing and market oversight.
- WAEMU’s fiscal supervision architecture is similar in spirit to EMU rules but weaker in enforcement; debt and deficit criteria could be modified to better reflect WAEMU economic characteristics and improve enforceability.

*Source: IMF working paper content (excerpt provided).*

### REFERENCES

### _wp13216 - REFERENCES

### References (selected authors and works)
- Alexander, V., and P. Anker, 1997, “Fiscal discipline and the question of convergence of national interest rates in the European Union,” Open economies review, Vol. 8, No. 4, pp. 335–352.
- Arellano, Cristina, 2008, “Default Risk and Income Fluctuations in Emerging Economies,” American Economic Review, Vol. 98, No. 3, pp. 690–712.
- Blundell, R., and S. Bond, 1998, “Initial Conditions and Moment Restrictions in Dynamic Panel Data Models,” Journal of Econometrics, Vol. 87, pp. 115–43.
- Diouf, Mame Astou, and Mr Francois Boutin-Dufresne, 2012, “Financing Growth in the WAEMU Through the Regional Securities Market: Past Successes and Current Challenges.”
- Dufrénot, G., E. Houessou, and E. Nonfodji, 2007, Politique budgétaire et dette dans les pays de l’UEMOA (Economica).
- Eaton, Jonathan, and Mark Gersovitz, 1981, “Debt with potential repudiation: theoretical and empirical analysis,” Review of Economic Studies, Vol. 48, pp. 289–309.
- ECB, 2005, “The Reform of the Stability and Growth Pact,” ECB Monthly Bulletin, pp. 59–74.
- Edwards, S., 1984, “LDC Foreign Borrowing and Default Risk: An Empirical Investigation,” American Economic Review, pp. 726–34.
- Engen, Eric M., and R. Glenn Hubbard, 2004, “Federal Government Debt and Interest Rates,” NBER Macroeconomic Annual.
- EU, 2007, “Treaty on the Functioning of the European Union.”
- Faini, Riccardo, 2006, “Fiscal Policy and Interest Rates in Europe,” Economic Policy, Vol. 21, No. 47, pp. 443–489.
- Gale, William G., and Peter R. Orszag, 2002, “The Economic Effects of Long-Term Fiscal Discipline,” Urban-Brookings Tax Policy Center Discussion Paper.
- Hauptmeier, S., A.J. Sanchez-Fuentes, and L. Schuknecht, 2011, “Towards expenditure rules and fiscal sanity in the euro area,” Journal of Policy Modeling, Vol. 33, No. 4, pp. 597–617.
- IMF, 2012, “Côte d’Ivoire - First Review Under the Three-Year Arrangement Under the Extended Credit Facility, Request for Modification of Performance Criteria, and Financing Assurances Review; Press Release,” IMF Country Report, No. 12/117.
- Manganelli, S., and G. Wolswijk, 2009, “What drives spreads in the euro area government bond market?” Economic Policy, Vol. 24, No. 58, pp. 191–240.
- Masson, P.R., and O. Doré, 2002, “Experience with budgetary convergence in the WAEMU,” Techn. rep., IMF Working Paper WP/02/108. International Monetary Fund, Washington, DC.
- Milesi-Ferretti, Gian Maria, 2004, “Good, bad or ugly? On the effects of fiscal rules with creative accounting,” Journal of Public Economics, Vol. 88, No. 1, pp. 377–394.
- Morris, R., H. Ongena, and L. Schuknecht, 2006, “The reform and implementation of the Stability and Growth Pact,” ECB Occasional Paper Series.
- Schuknecht, L., P. Moutot, P. Rother, and J. Stark, 2011, “The Stability and Growth Pact: crisis and reform,” ECB Occasional Paper, No. 129.
- Sy, A.N.R., 2010, “Government Securities Markets in the West African Economic and Monetary Union: A Review,” African Development Review, Vol. 22, No. 2, pp. 292–302.
- Uribe, Martin, and Vivian Z. Yue, 2006, “Country Spreads and Emerging Countries: Who Drives Whom?” Journal of International Economics, Vol. 69, pp. 6–36.

### Appendix A — Tables and Figures: Key empirical tables and statistics
- Table 3. WAEMU: Convergence Criteria — Baseline Fiscal Balance/GDP (selected rows)
  - WAEMU: -0.8 -0.9 -1.1 -1.3 -1.8 -2.1 -1.6 -1.8 -1.3 -0.6 -2.2 -2.4
  - violators: 6 6 6 7 8 6 7 7 6 3 6 7
  - Benin: -3.0 -2.8 -0.1 -0.5 -1.4 0.1 1.5 -1.1 -1.5 1.5 -0.2 0.4
  - Burkina Faso: -2.5 -3.7 -2.9 -3.2 -3.5 -4.5 -5.8 -4.9 -1.9 0.4 1.2 -1.5
  - Côte d’Ivoire: 1.1 -0.4 -1.7 -1.3 -1.6 -1.6 -0.6 -1.6 -1.0 -1.6 -4.0 -3.8
  - Guinea-Bissau: -6.9 -5.8 -7.0 -12.0 -7.2 -6.2 -7.7 -6.7 3.2 1.0 0.0 -1.4
  - Mali: -1.7 -1.3 -0.3 -0.7 -1.2 -0.4 -1.2 -1.2 0.4 0.2 -1.1 -1.1
  - Niger: -3.7 -1.9 -2.1 -2.2 -1.5 1.1 -0.2 1.9 -2.8 -1.0 -1.4 -0.4
  - Senegal: -1.2 1.2 0.2 -0.5 -1.2 -4.7 -2.6 -2.4 -2.1 -1.8 -4.0 -3.7
  - Togo: 1.5 0.3 2.7 1.4 -2.0 -2.8 -2.7 -0.7 -1.4 1.3 -1.7 -3.8

- Table 3. WAEMU: Convergence Criteria — Total debt/GDP (selected rows)
  - WAEMU: 110.1 96.4 82.9 75.3 67.0 54.9 48.4 48.4 45.4 43.5 43.7 39.7
  - violators: 6 5 3 3 3 3 3 2 0 1 0
  - Benin: 54.0 47.9 36.6 33.8 37.3 11.6 21.9 25.7 28.7 30.1 30.3 32.4
  - Burkina Faso: 0.0 0.0 0.0 0.0 0.0 0.0 23.3 22.1 27.2 27.2 28.0 30.9
  - Côte d’Ivoire: 175.2 150.7 133.6 120.4 107.2 107.1 75.6 75.3 66.5 66.4 71.2 49.5
  - Guinea-Bissau: 208.3 230.7 217.3 195.6 179.6 176.9 187.5 157.6 163.8 49.0 44.2 46.9
  - Mali: 88.7 56.1 51.6 48.4 48.3 19.9 21.0 20.8 22.9 32.8 30.1 31.4
  - Niger: 85.2 88.9 69.9 58.8 52.3 17.2 25.1 21.0 27.8 24.3 23.1 27.1
  - Senegal: 77.3 80.3 69.2 68.0 57.3 37.2 23.5 23.9 34.2 35.7 40.0 45.0
  - Togo: 108.0 93.4 92.4 82.5 72.6 82.5 112.9 84.0 75.9 48.5 46.3 45.6

- Table 3. WAEMU: Convergence Criteria — Overall Fiscal Balance/GDP (selected rows)
  - WAEMU: -1.6 -2.1 -1.7 -2.4 -2.7 6.9 -2.2 -1.9 -3.5 -3.1 -4.0 -3.9
  - Benin: -4.8 -5.1 -1.7 -1.2 -2.3 -0.3 0.2 -1.7 -4.3 -1.6 -1.8 -0.7
  - Burkina Faso: -3.9 -4.9 -3.0 -4.5 -5.0 16.6 -5.7 -4.4 -4.8 -4.5 -2.5 -3.6
  - Côte d’Ivoire: 0.9 -1.1 -2.1 -1.7 -1.7 -1.8 -0.8 -0.6 -1.6 -2.3 -4.3 -4.3
  - Guinea-Bissau: -5.4 -3.6 -1.0 -4.6 -4.9 -2.3 -2.7 1.7 2.7 -2.5 -2.8 -1.9
  - Mali: -3.2 -3.8 -1.3 -2.6 -3.1 31.3 -3.2 -2.2 -4.2 -2.7 -4.1 -2.1
  - Niger: -3.5 -3.0 -2.8 -3.6 -2.0 40.3 -1.0 1.5 -5.4 -2.5 -2.8 -3.9
  - Senegal: -2.4 0.0 -1.3 -3.1 -3.0 -5.7 -3.7 -4.6 -4.8 -5.2 -6.7 -5.9
  - Togo: -0.1 -0.4 2.4 1.0 -2.4 -2.8 -1.9 -0.9 -2.8 -1.6 -2.9 -6.3
  - Source: Country authorities and IMF staff estimations.

- Table 4. Countries Receiving Debt Relief (Year of the Debt Relief)
  - Benin 2006
  - Burkina Faso 2006
  - Côte d’Ivoire 2012
  - Guinea-Bissau 2010
  - Mali 2006
  - Niger 2006
  - Senegal 2006
  - Togo 2010

- Table 5. Descriptive Statistics (Variable, Number of Observations, Mean, Standard Deviation, Min., Max.)
  - Average annual interest rate: 65, 4.89, 1.11, 1.77, 6.85
  - Overall fiscal balance to GDP: 65, -2.71, 1.79, -6.49, 1.50
  - Inflation (average): 65, 2.83, 3.04, -4.8, 10.7
  - U.S. policy interest rate: 65, 2.29, 2.00, 0.1, 6.24
  - Political risk indicator: 58, 55.5, 56.5, 43.9, 66.83
  - External debt to GDP: 65, 58.97, 50.02, 11.57, 189.69
  - General gov’t debt to GDP: 65, 43.13, 40.01, 1.8, 227.34
  - WAEMU excess reserves to GDP: 10, 0.55, 1.35, 0.55, 2.12

- Table 6. Alternative Specification: Basic Fiscal Balance — Selected coefficient estimates (columns labeled (1) Int Rate, (2) Int Rate, (3) Int Rate, (4) Int Rate)
  - Basic fiscal balance to GDP: 0.107 (0.105); 0.0972 (0.169); -0.190*** (0.000); -0.0690 (0.276)
  - Domestic debt to GDP: -0.0448 (0.320); -0.0556 (0.247); 0.139*** (0.000); 0.120*** (0.001)
  - Inflation: -0.0213 (0.551); -0.0174 (0.651); -0.0581* (0.056); -0.0420 (0.161)
  - Excess reserves to GDP: -1.734*** (0.000); -1.755*** (0.000); -0.802*** (0.000); -1.225*** (0.000)
  - WAEMU basic fiscal balance to GDP: 1.009*** (0.000); 0.973*** (0.000); -0.561*** (0.000); -0.0488 (0.777)
  - Political risk rating: -0.00769 (0.859); 0.0538*** (0.000)
  - Lagged interest rate: 0.847*** (0.000); 0.550*** (0.000)
  - Constant: 9.062*** (0.000); 9.481*** (0.000)
  - Observations: 57 52 52 47
  - R2: 0.7039 0.7093
  - p-values in parentheses; * p<0.10, ** p<0.05, *** p<0.01

- Figures noted (titles only as in source)
  - Figure 3. External Debt-to-GNP Ratio and Debt Relief
  - Figure 4. Ratio of Multilateral Debt to Total External Debt
  - Figure 5. Share of External Debt to Total Debt in WAEMU

### Appendix B — Theoretical model (summary of framework)
- Model framework and purpose
  - Uses framework of Eaton and Gersovitz [1981] to investigate the impact of market-based fiscal discipline on interest rate spreads in WAEMU government bond markets.
  - Governments default when the value of defaulting exceeds the value of repaying; default probabilities are determined by current debt holdings and governments’ income processes.

- Key theoretical relationships and notation
  - Default probability: θ(b′, y, λ) where b′ is current debt level holdings to be repaid next period, y is current income, and λ is lenders’ belief about the government being a reputable agent.
  - Bond price equation:
    - q(b′, y, λ) = (1 − θ(b′, y, λ)) / (1 + r)
  - Interpretation:
    - Left-hand side q(b′, y, λ) is the price of a bond.
    - θ(b′, y, λ) is the probability of default.
    - r is the risk free interest rate.
    - An increase in repayment probability raises the bond price and shrinks the spread.

- Empirical linkage
  - Empirical proxies are needed to gauge market information used to determine default probabilities.
  - Details of the empirical model are explained in Section II (of the source document).

*Source: _wp13216 - REFERENCES (IMF staff and country authorities content as presented in the provided PDF).*

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