MARKET DISCIPLINING OF THE DEVELOPING COUNTRIES' SOVEREIGN GOVERNMENTS

I. INTRODUCTION Over the last two decades, many developing and emerging economies have experienced an integration of their financial markets with the global market. Both public and private sectors have started using external borrowing for financing their investment and consumption expenditures. The high amount of net external debt that these countries incurred raised the question whether the global markets would have any disciplining effect on the sovereign governments of these countries. This is important because market disciplining is an essential element for an economy to function well. Where market forces are the sole determinant of prices, efficiency and productivity are achieved by punishing the poorly performing actors in the economy. Likewise, we expect that the rational credit suppliers will respond to the bad performance of the sovereign borrowers by charging more to compensate for the default risk of the sovereign borrowers in their external debt. In that context, the so-called market discipline hypothesis (MDH) suggests that the market mechanism works to discipline the poorly performing fiscal authorities by asking higher default-risk premiums from those governments. In turn, sovereign borrowers respond to this by improving their fiscal performance. Assuming that financial markets price the fiscal behaviors effectively, a government with a higher level of public debt will have a higher default risk, which pulls up the premium on government bonds. Thus, a higher default-risk premium on government bonds decreases the borrowing capacity of the sovereign governments. By this feedback mechanism of market disciplining, we expect that governments will improve their fiscal balances in the end, as debt servicing would otherwise become a great burden to economy. This article seeks to analyze the MDH at the sovereign government level and aims to fill the gap in the literature by working with developing countries and by focusing more on the second part of the MDH, which deals with the sovereign governments' reaction to change in financial indicators pertaining to their performance. The most appealing factor of working on developing countries is that the financial markets do not show any mercy toward these countries' sovereign governments. Generally, emerging market governments face stronger and broader market constraints than their counterparts among the governments of developed countries. When it comes to developing countries, credit suppliers consider many more risk factors than they would with the sovereign government of an advanced economy. Many aspects of government policy are, therefore, put under surveillance, which ties up sovereign borrowers in terms of domestic policy targeting. In addition, creditors do not want to share any risk that may arise from the borrower's currency and usually insist on buying bonds issued in foreign currency, mostly in U.S. dollars. However, from the point of view of the borrower, borrowing in a foreign currency only increases their vulnerability to default risk. This increase in risk associated with borrowing in foreign currency stems from nongovernmental effects, such as global shocks, or demand shocks on imported and exported goods, which can devalue the domestic currency against major foreign currencies and therefore increase the cost of borrowing, as the interest payments in these years worsen government fiscal balances. Therefore, it is important to discover if and how much the sovereign borrowers in the developing world are affected by (global) financial market pressures. The rest of the article is constructed as follows: Section II describes the MDH and empirical literature on it. Section III explains the empirical methodology used to test the MDH. The clam and structural budget balance estimations are also presented in this section. In Section IV. we present our estimation results and for robustness, the results are checked for sensitivity to two alternative structural budget balance estimations, one alternative sovereign government default-risk premium and one alternative estimator (the dynamic panel data estimation approach). …