# **1. Introduction**

Sovereign spreads rose rapidly in emerging markets and developing economies (EMDEs) at the onset of the Covid19 pandemic, a period during which governments faced rising borrowing costs and fiscal expansion needs, albeit at varying degree across countries. We empirically investigate whether the existence of a fiscal rule was associated with lower or higher sovereign spreads in EMDEs during the recent Covid-19 pandemic shock.<sup>1</sup> In theory, the relation between the existence of a fiscal rule and sovereign spreads during economic downturns is ambiguous. On the one hand, fiscal rules could signal fiscal responsibility and serve as a commitment device to reassure financial markets’ confidence, lowering sovereign spreads. On the other hand, fiscal rules might exacerbate the negative shock by constraining the government’s flexibility to conduct countercyclical fiscal policy, rising even more sovereign spreads.<sup>2</sup> We first document trends in fiscal rule adoption prior to and throughout the recent pandemic using the IMF Fiscal Rule Dataset (IMF, 2022). We then empirically investigate whether fiscal rules are associated with lower spreads and whether this relationship held through the pandemic. Next, we distinguish between rules that were continually enforced throughout the pandemic, rules that were temporarily abandoned due to escape clause usage, and rules that were suspended due to discretionary fiscal policy. In each of the empirical analyses described above, we use daily data of sovereign spreads from countries included in the J.P. Morgan Emerging Markets Bond Index Global (EMBI Global). Our baseline sample includes 58 EMDEs and spans the period between January 2019 through the first five months of 2022.<sup>3</sup> Our tests include controls such as global, regional, and corporate factors, country-specific proxies of economic activity, and various policy-related variables.

We document three novel findings regarding the relationship between fiscal rules and sovereign spreads. First, we show that countries with fiscal rules in place faced lower sovereign spreads relative to countries without rules before and after the onset of the COVID-19 pandemic.<sup>4</sup> Specifically, our estimates imply that through the pandemic, the presence of fiscal rules is associated with 350 basis point lower sovereign spreads, on average. Second, we illustrate that the difference in sovereign spreads for countries with and without rules widened in the

> 1 We consider budget balance rules, debt rules, expenditure rules, and revenue rules in our empirical analysis.

> 2 An important strand of the literature has theoretically studied the fiscal rules’ tradeoff between commitment and flexibility. See for example, Angeletos et al. (2006); Halac and Yared (2014); Halac and Yared (2018); and Halac and Yared (2022).

> 3 In a robustness test, we investigate the spread-compressing effect of fiscal rules during the global financial crisis (GFC) of 2008-09. The sample covering the GFC timeframe includes 26 countries and uses data covering January 2007 through December 2009.

> 4 Importantly, we show that the spread-compressing effect of fiscal rules is robust to the GFC of 2008-09.

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