Political and Fiscal Risk Determinants of Sovereign Spreads in Emerging Markets

Using a panel of 46 emerging market economies from 1997 to 2008,this paper investigates the key determi-nants of country risk premiums as measured by sovereign bond spreads.Unlike previous studies,the resultsindicate that both political and fiscal factors matter for credit risk in emerging markets. Lower levels ofpolitical risk are associated with tighter spreads, particularly during financial turmoil. Efforts at fiscal con-solidation narrow credit spreads,especially in countries with high initial public debt levels.The compositionof fiscal policy also matters as higher public investment lowers spreads as long as the fiscal position remainssustainable and the fiscal deficit does not worsen. 1. Introduction Notwithstanding recent developments, financial markets’ perception of credit risks inemerging economies has sharply improved over the last decade. The spread of thecomposite Emerging Market Bond Index Global (EMBIG) calculated by JP Morgantightened by more than 500 basis points between mid-2002 andAugust 2007 (Baldacci,2007). This downward trend was partially reversed during the 2007–08 subprime-induced financial crisis (IMF, 2008), particularly as spillovers spread from majorfinancial centers to emerging markets during the last quarter of 2008. However,EMBIG spreads have recently fallen back to pre-crisis levels (e.g.prior to the collapseof Lehman Brothers in September 2008) as financial markets rebounded following theactions taken by the major economies to repair their banks’ balance sheets and helpspur demand. Overall, the downward trend in bond spreads suggests that a lowerpremium is required to protect investors in emerging market economies againstcountry-specific and asset-class-wide risks than earlier in the decade.Also, the cost ofbuying protection against defaults of sovereign emerging market debt instruments, asmeasured by the spreads of credit default swap (CDS) derivative instruments, felldrastically over the last five years despite the recent cyclical uptick.The literature has attributed the long-term tightening of emerging market spreads tothree factors: (i) sound macroeconomic policies that brought inflation under control(including through more independent monetary authorities),reduced output volatility,and significant reductions in public and external debt (Ciarlone et al.,2007);(ii) highercommodity prices and favorable liquidity conditions that lowered risks and resulted inlarge capital flows to these countries (Hartelius et al., 2008); and (iii) development of