post-pandemic period (292 basis points prior to the pandemic vs. 398 basis points after the pandemic started), mostly driven by sovereign spreads in countries without rules remaining high even after the global financial stress resided. Third, we find that the coefficient estimates of the fiscal rule dummy variables flagging enforcement throughout the pandemic, escape clause activation, and rule suspension are virtually identical, suggesting that the spread-compressing effect does not depend on the degree of enforcement of the rules through the pandemic.

Our results suggest that, during periods of global crisis, credit markets interpret the mere existence of fiscal rules as a signal of the sovereign government’s fiscal responsibility.<sup>5</sup> Even if a rule is temporarily abandoned during a global crisis, the sovereign is expected to restore fiscal discipline in the aftermath of the crisis. Our results are robust after controlling for government effectiveness, suggesting that the adoption of fiscal rules creates a degree of market confidence beyond that generated by the government’s reputation alone.

We provide suggestive evidence of the mechanism underlying our result that fiscal rules compress spreads even when temporarily abandoned, by performing an event study in which we empirically estimate the time it takes to return to compliance following such an abandonment of a budget balance rule. Using a sample including every instance of a sovereign government either suspending, revising upward, or activating an escape clause for a budget balance rule from 2000-2019, we show that following such a rule modification, a government is expected to return to compliance in approximately 3.5 years. This result, in conjunction with the sovereign spreadcompressing effect, suggests that during global crises, credit markets internalize that temporary rule abandonments generally do not sacrifice long-term debt sustainability, and therefore do not penalize governments for activating an escape clause or suspending a fiscal rule. Thus, our results provide evidence that sovereigns possessing a reputation of fiscal responsibility faced lower borrowing costs through the pandemic.

This paper mainly contributes to the literature on sovereign spreads, in particular the literature exploring the effect of the COVID-19 shock on sovereign spreads and sovereign debt.<sup>6</sup> Zheng (2023), which is closely related to this paper, uses the global natural experiment created by the COVID-19 shock to identify sovereign borrowing capacity in time of need and its determinants. The study shows that countries with fiscal rules in place were able to borrow more through the pandemic and concludes that following fiscal rules and maintaining fiscal discipline during normal times allows sovereign governments to build the capacity to finance policy responses to fiscal

> 5 Our paper complements Halac and Yared (2014), Halac and Yared (2018), and Halac and Yared (2022) by showing empirically that, during the COVID-19 crisis and GFC, fiscal rules help signaling future commitment without sacrificing flexibility in the short run.

> 6 For example, Davoodi et al., (2022b); Havlik et al., (2022); Arellano et al., (2023); and Zheng (2023).

3