metadata: authors: 0: author: Islamaj,Ergys
1: author: Samano Penaloza,Agustin
2: author: Sommers,Scott James
count: World
docna: 0: docna: The Sovereign Spread Compressing Effect of
            Fiscal Rules during Global Crises
docty: Policy Research Working Paper
abstracts: cdata!: Do fiscal rules help suppress sovereign
            spreads during periods of global financial stress? Yes! This
            paper examines whether fiscal rules contribute to mitigating
            sovereign spreads in emerging markets and developing
            economies during periods of heightened financial and
            economic volatility worldwide. It finds that the presence of
            fiscal rules is statistically significantly associated with
            lower sovereign spreads during the COVID-19 crisis
            &#x2014; about 350 basis points lower on average.
            Interestingly, this correlation persists even when nations
            deviate from these rules, indicating an expectation of
            post-crisis compliance. The study shows that deviations from
            fiscal rules are typically short-lived, with fiscal balance
            rules reinstated within 3.5 years. Robustness checks,
            including controls for institutional quality, fiscal rule
            strength, and global and regional factors confirm these
            results. Overall, the findings suggest that fiscal rules can
            help emerging markets and developing economies signal fiscal
            responsibility during episodes of global financial stress,
            reducing borrowing costs relative to countries without
            fiscal rules.
display_title: The Sovereign Spread Compressing
            Effect of Fiscal Rules during Global Crises
listing_relative_url: /research/2024/03/34289887/sovereign-spread-compressing-effect-fiscal-rules-during-global-crises
topicv3: Fiscal Rules m1584062 4486,Coronavirus (COVID-19) m1939478 4828
publishtoextweb_dt: 2024-03-28T00:00:00Z
dois: 10.1596/1813-9450-10741
no_of_pages: 40
author_keys: 0: author_key: 906068
1: author_key: 2046387
2: author_key: 2177446
model_extractions: Policy Research Working Paper 10741 The Sovereign Spread Compressing Effect of Fiscal Rules during Global Crises _Ergys Islamaj Agustin Samano Penaloza Scott Sommers_ Development Economics Development Research Group March 2024 A verified reproducibility package for this paper is available at http://reproducibility.worldbank.org, click **here** for direct access.
Policy Research Working Paper 10741

# **Abstract**

Do fiscal rules help suppress sovereign spreads during periods of global financial stress? Yes! This paper examines whether fiscal rules contribute to mitigating sovereign spreads in emerging markets and developing economies during periods of heightened financial and economic volatility worldwide. It finds that the presence of fiscal rules is statistically significantly associated with lower sovereign spreads during the COVID-19 crisis—about 350 basis points lower on average. Interestingly, this correlation persists even when nations deviate from these rules, indicating an expectation of post-crisis compliance. The study shows that deviations from fiscal rules are typically short-lived, with fiscal balance rules reinstated within 3.5 years. Robustness checks, including controls for institutional quality, fiscal rule strength, and global and regional factors confirm these results. Overall, the findings suggest that fiscal rules can help emerging markets and developing economies signal fiscal responsibility during episodes of global financial stress, reducing borrowing costs relative to countries without fiscal rules.

This paper is a product of the Development Research Group, Development Economics. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://www.worldbank.org/prwp. The authors may be contacted at eislamaj@worldbank.org; asamanopenaloza@worldbank.org; and somme450@umn.edu. A verified reproducibility package for this paper is available at http://reproducibility.worldbank.org, click **here** for direct access.

<!-- Start of picture text --> TRANSPARENT<br>ANALYSIS<br>G<br>R E<br>N<br>S<br>I P<br>Y E<br>K A<br>C A<br>R P<br>LI R<br>O E<br>O C<br>W R<br>H<br>S<br>P<br><!-- End of picture text --> _The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# **The Sovereign Spread Compressing Effect of Fiscal Rules during Global Crises**

## **Ergys Islamaj***

**Agustin Samano Penaloza**<sup>**†**</sup>

**Scott Sommers**<sup>**‡**</sup>

### **_Keywords:_** fiscal rules, sovereign spreads, Covid-19 crisis

### **_JEL classification:_** F34, F41

### **_____________________________**

The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the World Bank Group, its Executive Directors, or the governments they represent. We are particularly thankful to Aaditya Mattoo for all his support. For helpful comments, we thank Roman Acosta, Francisco Bullano, Carlos Esquivel, Sergio L. Schmukler, Kurt See, as well as conference participants at the Workshop of the Australasian Macroeconomics Society, Kuala Lumpur, Malaysia for helpful comments and discussions. Any remaining errors are our own.

* The World Bank Development Prospects Group, East Asia and Pacific Chief Economist Office, Washington, D.C.; Email:

<u>eislamaj@worldbank.org</u>

> **†** The World Bank Research Department, East Asia and Pacific Chief Economist Research Center, Kuala Lumpur, Malaysia; Email: asamanopenaloza@worldbank.org; Web: http://www.agustinsamano.com/

‡ Department of Economics, University of Minnesota. Email: somme450@umn.edu; Web: <u>http://sites.google.com/view/scottsommers/</u>
# **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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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).

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shocks. We view our findings as complementary to Zheng (2023), as we highlight the mechanism through which fiscal rules lead to the ex-ante creation of fiscal space. Specifically, we show that fiscal rules lower borrowing costs for sovereign governments, and that the signal of fiscal responsibility provided to credit markets persists through a crisis period, regardless of the extent to which rules are followed during the crisis.<sup>7</sup> Davoodi et al. (2022b) investigate the relationship between fiscal rule compliance and 5y CDS spreads for a panel of 90 countries during the 1990-2021 period. The authors find that after exceeding a budget balance rule, a country is expected to have higher spreads than countries who adhere to the rule, for around 3-4 years after the initial breach. Our framework presents a comprehensive analysis of the determinants of spreads, as we follow the existing literature by including controls such as a global factor, regional factor, corporate factor, country-specific measurements of economic activity, and various policy-related variables.<sup>8</sup> In this sense, our framework allows for a comparison of sovereign spreads between countries with a fiscal rule and those without a rule, and allows us to control for the degree of compliance of each rule. Further, our analysis focuses on periods of global crisis, during which EMDEs are more likely to experience shocks of a global nature.

Arellano et al. (2023) study debt relief programs and finds a compelling case for their implementation as a policy option to provide EMDEs with fiscal space during global crises. Havlik et al. (2022) compare the impact of monetary versus fiscal policy announcements on euro area government bond spreads in the unfolding COVID-19 pandemic, finding larger effects for monetary than for fiscal announcements. The study also finds that the relaxation of European fiscal rules through the activation of the emergency-escape clause under the Stability and Growth Pact is associated with rising spreads. Other studies that have empirically examined the impact of fiscal rules on spreads include Iara and Wolff (2010) and Kalan et al. (2018). To date, however, the existing literature is mostly limited to studies exploring the effect of fiscal rules across countries within the European Union, or the effect of fiscal rules at the sub-national level.<sup>9</sup> Our paper complements this strand of the literature by exploring the signaling effect of

> 7 Our study also considers a broader set of fiscal rules, as Zheng (2023) only considers national rules that are determined to be credible following a specified set of criteria, and the rules flagged are only up to date as of 2015.  Therefore, this study is not able to consider rule suspensions or escape clause activations through the pandemic, as our study does.

> 8 Daehler et al. (2020) test a similar specification in a study of the determinants of changes in sovereign CDS spreads of 30 emerging market economies through the first six months of 2020. The authors do not, however, consider the spread compressing effect of fiscal rules.

> 9 Iara and Wolff (2010) study the impact of national fiscal rules on sovereign spreads within the euro area, finding stronger fiscal rules in member states to have a compressing effect. Kalan et al. (2018) study the impact of noncompliance with fiscal rules on sovereign spreads within the European Union from 1999-2016, finding spreads for countries that have been placed under an Excessive Deficit Procedure (EDP) to be on average 50-150bp higher than spreads for those that have not. Feld et al. (2017) studies the effects of sub-national fiscal rules on the risk premia of sub-national government bonds in Switzerland.

4
fiscal rules on sovereign spreads across a broader group of EMDEs, beyond the European Union, which typically face relatively higher spreads during periods of global financial stress.

This paper is also related to the literature on rules versus discretion. At the core of these papers is a tradeoff between the benefit of committing the government to not overspend against the benefit of granting it flexibility to react against negative shocks. For example, Angeletos et al. (2006) study the trade-off between commitment and flexibility in a consumption savings model with taste shocks privately observed by agents. They derive conditions under which minimum-savings policies, reminiscent to fiscal rules, characterize the solution to the principal-agent problem. Halac and Yared (2014), Halac and Yared (2018), and Halac and Yared (2022) study fiscal rules under similar environments. Fiscal rules emerge as an efficient mechanism through which citizens provide incentives to the government to behave according to their best interest. Our paper complements this strand of the literature by showing empirically that, during global crises, fiscal rules can signal future commitment (i.e., fiscal responsibility) without sacrificing flexibility to react against exogeneous shocks.

Our study also ties more broadly into the literature pertaining to the functioning and effectiveness of fiscal rules in influencing fiscal outcomes. The mechanism through which we hypothesize that fiscal rules dampen sovereign spreads is the signaling effect to credit markets of fiscal responsibility and long-term debt solvency. Crucial to this signal is the belief that fiscal rules are effective in achieving their intended use. An extensive theoretical literature has found the impact of a fiscal rule to vary based on the specific type of rule in place. Azzimonti et al., (2016), for example, theoretically and quantitatively evaluate the impact of a budget balance rule under which legislators cannot run any deficit whatsoever, finding that such a rule leads to a gradual reduction in public debt. Bianchi et al. (2023) study optimal policy response to a recession in the presence of sovereign risk, showing theoretically that in the midst of a recession, a rule that promises lower government spending in the future can help reduce current spreads and make stimulus more desirable. Hatchondo et al. (2022) introduce fiscal rules into a sovereign default model featuring long-term debt, showing that welfare gains can be achieved from the introduction of debt-brake and spread-brake rules, and that a common spread brake generates larger welfare gains for a union of heterogeneous countries. More recently, Esquivel and Samano (2023) show theoretically and quantitatively in a sovereign debt model with capital accumulation that a debt limit rule could increase investment due to lower sovereign risk, generating an economic expansion in the long run and relatively larger welfare gains.

The remainder of the paper is structured as follows: Section 2 details trends in fiscal rule adoption, and outlines the data employed in our empirical analysis as well as our empirical methodology. Section 3 presents our empirical 5
results and discusses the policy implications that follow. Section 4 concludes. In the Appendix we report additional figures relating to movements in sovereign spreads through the GFC and COVID-19 pandemic, as well as the results for our robustness checks.

# **2.        Data and Empirical Framework**

# **2.1      Fiscal Rules**

In the thirty years preceding the pandemic, fiscal rules, which are numerical limits on budgetary aggregates, had surged in popularity as policies implemented by sovereign governments to achieve fiscal discipline. Fiscal rules commonly take the form of budget balance rules, debt rules, expenditure rules, and revenue rules.<sup>10</sup> Across all income levels, the number of countries with at least one fiscal rule in place has increased from 26 countries in 1997 to 103 countries in 2021.<sup>11</sup> As can be seen in Figure 1a, whereas high-income economies were early adopters of fiscal rules, recent growth in fiscal rule adoption has been dominated by low- and middle-income economies. As recently as 1997, low- and middle-income economies accounted for only 12% of all countries adhering to a fiscal rule, but by 2021 this share had risen to 58%. Among low- and middle-income countries, fiscal rule adoption has been widespread geographically. Regarding the types of rules adopted, budget balance rules and debt rules are by far the most adopted rules (see Figure 1b).

The widespread adoption of fiscal rules by low- and middle-income countries in recent years has been associated with enhanced fiscal discipline for sovereign governments adopting rules. As discussed in Section 1, a large literature exists documenting the disciplinary effect of fiscal rules on sovereign governments. Our descriptive statistics provide yet further evidence of the correlation that exists between fiscal rule adoption and fiscal discipline. Table 1 shows that during the 15-year period spanning 2007-2021, the average structural deficit-toGDP ratio of countries adhering to any type of fiscal rule was 0.63 percentage points lower than the structural deficit of countries without a fiscal rule, and a one-sided t-test for the difference in means shows this difference to be statistically significant. The two years that stand out, however, are 2020 and 2021, as in these two years the trend reverses as countries with fiscal rules have slightly larger structural deficit-to-GDP ratios (4.59%), on average, than those without (4.35%).<sup>12</sup> Contrary to popular belief, this fact illustrates that fiscal rules do not constraint the government’s capacity to respond to negative shocks. Moreover, as we will show in Section 3, the

> 10 See for example, Davoodi et al., (2022a). 11 Ibid.

> 12 This finding is consistent with Zheng (2023), which shows that fiscal rules enhance sovereign borrowing capacity.

6
unprecedented spike in rule suspensions and escape clause usage that occurred through the COVID-19 pandemic did not dampen the effect of fiscal rules on spreads for countries temporarily abandoning their rules. Instead, our empirical results imply that fiscal rules still provide a spread-compressing effect even if abandoned. We interpret these results to reflect the expectation that rule abandonment will be temporary, and that countries will return to fiscal rule compliance after a short duration of time.

**Figure 1. Trends in Fiscal Rule Adoption**

<!-- Start of picture text --> Number of countries<br>120<br>100<br>80<br>60<br>40<br>20<br>0<br>1986 1991 1996 2001 2006 2011 2016 2021<br>High Income Low- and Middle-Income<br>a. Adoption of fiscal rules, by income group<br><!-- End of picture text --> <!-- Start of picture text --> Number of countries<br>70<br>60<br>50<br>40<br>30<br>20<br>10<br>0<br>1986 1991 1996 2001 2006 2011 2016 2021<br>Debt rule Balanced budget rule Any rule<br>b. Fiscal rules in low- and middle-income countries, by<br>type<br><!-- End of picture text --> Source: Davoodi et al. (2022a)

**Table 1. Average Structural Deficit (% GDP) for Countries with and without Fiscal Rules (2007-2021)**

||**Average **|**Standard Deviation**|
|---|---|---|
|**Countries With Fiscal Rule**|2.78%|1.01%|
|**Countries Without Fiscal Rule**|3.41%|0.81%|

Source: Davoodi et al. (2022a) and World Economic Outlook Database (April 2022 Vintage) Note(s): Sample size of 41 middle and low-income countries.

Perhaps the most notable development in fiscal rule usage recently has been the unprecedented spike in escape clause usage and fiscal rule suspension witnessed during the COVID-19 pandemic. In 2020 and 2021, 39% and 36% of low- and middle-income countries with fiscal rules, respectively, either temporarily suspended a rule or used an escape clause.<sup>13</sup> The previous peak occurred in 2010, when suspensions and escape clause usage stood at a 7% rate, as only three countries abandoned their fiscal rules (see Figure 2). With the growing importance and relevance of fiscal rules in the years leading up to the pandemic, such a sudden breakdown in fiscal discipline raises the question of how long it will take for fiscal balances to return to their pre-pandemic trend, thus allowing

> 13 See Appendix Table A1 for a list of all low- and middle-income countries that either enacted an escape clause or temporarily suspended a fiscal rule during 2020-2021.

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countries to return to fiscal rule compliance. We address this question in Section 3 using the IMF Fiscal Rule Dataset (IMF 2022), which provides us with a sample including every instance in which a budget balance rule was either suspended, revised upward, and/or an escape clause was used over the period 2000-2019.

A potential contributing factor to the increase in escape clause usage and temporary rule suspensions during the pandemic was the development of a “second-generation” of fiscal rules in the decade preceding the COVID-19 pandemic. As noted by Eyraud et al. (2018), in the years following GFC 2008-09, a “second-generation” of fiscal rules emerged which sought to construct rules in such a way that allows for an appropriate degree of short-run flexibility when necessary while still promoting long-term fiscal responsibility. In this context, many reforms made post-GFC introduced new escape clauses covering a larger set of contingencies during crisis periods in which unexpectedly large fiscal expansion is necessary, while providing guidance on the path back to compliance. The trend shown in Figure 2 highlights the fact that these enhancements allowed for a high degree of flexibility in fiscal rule enforcement through COVID-19 pandemic. Our empirical results reported in Section 3 provide evidence that with this added flexibility, fiscal rules continued to serve as a signal of fiscal responsibility during the pandemic, even for countries that enacted escape clauses and used discretion to suspend rules. Interestingly, we show that the existence of fiscal rules compressed sovereign spreads through the pandemic regardless of whether enforcement continued during the COVID-19 period.

**Figure 2. Suspensions or Activations of Escape Clause by Year**

<!-- Start of picture text --> Number of countries<br>30<br>25<br>20<br>15<br>10<br>5<br>0<br>1986 1991 1996 2001 2006 2011 2016 2021<br>Suspension Escape clause<br><!-- End of picture text --> Source: Davoodi et al. (2022a) Note: Figure includes all middle- and low-Income countries with fiscal rules

# **2.2       Sovereign Spreads**

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<!-- Start of picture text --> 2,000<br>1,800<br>1,600<br>21,400<br>2<br>mo<br>o<br>2 1,200<br>Qa<br>”n<br>ez<br>5 1,000<br>a<br>5<br>¢ 800<br>c<br>o<br>3<br>(C) 600<br>400<br>200<br>Oo (ac SSS fs SS<br>2019 2020 2021 2022<br>om P33-P66 — Countries Without Fiscal Rule (P50) —- Countries With Fiscal Rule (P50)<br><!-- End of picture text -->
In our baseline analysis, we employ daily data of emerging market sovereign spreads over Treasuries on U.S. dollar-denominated debt for 58 countries included in the J.P. Morgan Emerging Markets Bond Index Global (EMBI Global). Table A2 presents our sample of countries, and the sample period covered is January 2, 2019 through May 27, 2022. The global factor used in our analysis is the EMBI Global index. Corporate spreads are captured by the J.P Morgan CEMBI IG+ index. To construct the regional factor, we adopt an approach similar to that used by Daehler et al. (2021). First, countries are grouped into geographic buckets according to the seven regional classifications defined by the World Bank’s World Development Indicators database.<sup>14</sup> The regional factor for a given country is then calculated as the daily average logged spread for the country’s regional grouping, excluding the country itself.

The country-specific economic indicators used as controls include the total external debt stock, primary balance (% of GDP), GDP per capita growth, and annual changes in consumer prices, all lagged by one year. Data for the external debt stock and primary balance is sourced from the spring 2022 vintage of the cross-country database of fiscal space created by Kose et al. (2022). GDP per capita growth is sourced from the IMF WEO database, and annual inflation data comes from the IMF as well.

Our policy-related variables are included to control for the influence of monetary policy decisions and pandemicinduced lockdowns and restrictions. These controls include dummy variables indicating dates of Federal Reserve and ECB announcements through the pandemic timeframe, and daily log changes in the Oxford COVID-19 Government Response Tracker Stringency Index. The Stringency Index, ranging from 0 to 100 (with 100 indicating the strictest response), is a composite of nine metrics measuring the stringency of school and workplace closures, stay-at-home requirements, and other government-mandated restrictions. Use of the Stringency Index serves as a control for variation in governments’ responses to the pandemic.<sup>15</sup> The Federal Reserve and ECB actions that we flag include interest rate cuts and any other monetary policy-related measures taken to reassure markets through the early stages of the pandemic. A priori, it is ambiguous whether Federal Reserve or ECB action would increase or decrease spreads during a crisis period. On one hand, by easing global risk aversion, action taken could lower spreads by encouraging capital flows into emerging markets. On the other hand, if Fed or ECB action fails to soothe

> 15 Our methodology using the Oxford COVID-19 Government Response Tracker Stringency Index follows Daehler et al., (2021), who investigated factors influencing credit default swap (CDS) spreads through the COVID-19 pandemic.

10
spread;, = By + B,FiscalRule;, + B,GE;, + P3;CEMBI, + B,EMBI, + B;Region;, +7'X;. 0” + @’xpeney +e 4¥; + Eig spread;, = bo + 6, FiscalRule;, + b2GE,, + n'X; orem +¥p + Vi + Et
# **3.  Empirical Results**

# **3.1     The Sovereign Spread-Compressing Effect of Fiscal Rules**

Table 2 shows the results from the specification outlined in Equation (1). The full set of estimates for all covariates are reported in Table A4, in the appendix. Column (1) displays the estimates when the fiscal rule flag, global factor, regional factor, corporate factor, variable controlling for government effectiveness, country fixed effects, and month fixed effects are included as regressors. Column (2) includes all the variables mentioned above, in addition to our regressors relating to fiscal space. Column (3) includes the variables in Column (1), in addition to inflation and GDP per capita growth. Column (4) incorporates all the variables included in the first three tests. Column (5) includes all these as well as our policy variables. Notably, the existence of a fiscal rule is negatively associated with spreads across all tests, and the relationship is always statistically significant at the 1 percent level, with coefficient estimates ranging from -.775 to -1.029. In other words, the existence of a fiscal rule is associated with 54%-64% lower sovereign spreads. Given that the median spread throughout the entire sample period for countries without a fiscal rule was 590 basis points, our estimates imply that the average spread-reducing effect of a fiscal rule is 319 to 378 basis points. As expected, March 2020 is the month associated with the highest spreads.

We also estimate a negative and statistically significant relationship between government effectiveness and spreads. Turning to the regressors related to fiscal space, GDP growth, external debt, and inflation, the signs of most coefficient estimates are in line with our expectations.<sup>17</sup> Higher inflation and external debt are found to be associated with higher spreads, GDP per capita growth is found to be associated with lower spreads, and these coefficients are estimated with statistical significance at the 5 percent level across all tests. A stronger primary balance is estimated to compress spreads across all tests, although these coefficients are not always estimated with a high degree of statistical significance. Regarding policy-related regressors, we find statistically insignificant announcement effects for both the Fed and ECB policy variables. Likewise, we find statistically insignificant policy stringency effects.

Similarly, the results for the GFC era shown in Table A5 in the appendix indicate that a statistically significant spread-compressing effect of fiscal rules existed during 2007-2009, albeit one of a smaller magnitude. The coefficient estimates for β1 range from -.101 to -.195, implying that an average spread-reducing effect of 36 to 67 basis points, given that the median spread for countries without a fiscal rule during the sample period is 378 basis

> 17 See Table A4 in the appendix.

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|||Dep<br>Log|endent Variable<br> Spread (Daily)|||
|---|---|---|---|---|---|
||(1)|(2)|(3)|(4)|(5)|
|Fiscal Rule|-1.029***<br>|-0.867***<br>|-0,8357**<br>|-0,775"**<br>|-0,775***<br>|
||(-38.99)|(-34.36)|(-32.24)|(-29.21)|(-29.21)|
|Global/Regional/Corporate Factors|Yes|Yes|Yes|Yes|Yes|
|Policy-Related Controls|No|No|No|No|Yes|
|Total External Debt Stocks|No|Yes|No|Yes|Yes|
|Primary Balance|No|Yes|No|Yes|Yes|
|GDP Per Capita Growth|No|No|Yes|Yes|Yes|
|Inflation|No|No|Yes|Yes|Yes|
|Government Effectiveness|Yes|Yes|Yes|Yes|Yes|
|Country Fixed Effects|Yes|Yes|Yes|Yes|Yes|
|Month Fixed Effects|Yes|Yes|Yes|Yes|Yes|
|Observations|48956|46675|45887|44320|44320|
|Re|0.9184|0.9264|0.9107|0.9135|0.9135|

t statistics in parentheses * p<0.10, ** p<0.05, *** p<0.010 <!-- Start of picture text --> spread;, = By + B,FiscalRule;, B,FiscalRule;, + B2PostCrisis, B2PostCrisis, + B3FiscalRule;, * PostCrisis, + ByGE,, ByGE,, + BsCEMBI, BsCEMBI, + BpEMBI, BpEMBI, + b7Region;,<br>+n’ xpeonomy + @’ xpeonomy + @’ + @’ @’ xPoticy tu; + + Cit<br><!-- End of picture text --> spread;, = By + B,FiscalRule;, B,FiscalRule;, + B2PostCrisis, B2PostCrisis, + B3FiscalRule;, * PostCrisis, + ByGE,, ByGE,, + BsCEMBI, BsCEMBI, + BpEMBI, BpEMBI, + b7Region;, +n’ xpeonomy + @’ xpeonomy + @’ + @’ @’ xPoticy tu; + + Cit
|||Dep<br>Log|endent Variable<br> Spread (Daily)|||
|---|---|---|---|---|---|
||(1)|(2)|(3)|(4)|(5)|
|Fiscal Rule|-0.745***<br>|-0.626***<br>|-0.711***<br>|-0.709***<br>|-0.709***<br>|
||(-29.01)|(-25.22)|(-28.31)|(-27.26)|(-27.27)|
|Post Covid|0.337***<br>|0.238***<br>|0.261***<br>|0.253***<br>|0.254***<br>|
||(61.88)|(42.20)|(48.16)|(44.68)|(44.72)|
|Fiscal Rule#Post Covid|-0,.228***|-0,174***|-0.176***|-0.174***|-0.174***|
||(-42.38)|(-33.32)|(-35.33)|(-34.31)|(-34.30)|
|Global/Regional/Corporate Factors|Yes|Yes|Yes|Yes|Yes|
|Policy-Related Controls|No|No|No|No|Yes|
|Total External DebtStocks|No|Yes|No|Yes|Yes|
|Primary Balance|No|Yes|No|Yes|Yes|
|GDP Per Capita Growth|No|No|Yes|Yes|Yes|
|Inflation|No|No|Yes|Yes|Yes|
|Government Effectiveness|Yes|Yes|Yes|Yes|Yes|
|Country Fixed Effects|Yes|Yes|Yes|Yes|Yes|
|Month Fixed Effects|No|No|No|No|No|
|Observations|48956|46675|45887|44320|44320|
|R?|0.9195|0.9252|0.9115|0.9136|0.9136|

t statistics in parentheses

* n<0.10, ** p<0.05, *** p<0.010
spread;; = Bo + #,FiscalRule;, + B2(FiscalRule;: * ¥z) + BzGEi2 + BaCEMBI, + B[5EMBI, + BgRegion;: +nXCCOMMY 4 OTXPOUY ty 4 ys + €:4
<!-- Start of picture text --> 0.8<br>0.6<br>wo<br>©<br>€ 0.4<br>oa)<br>Wn<br>Cob)<br>ec<br>@ 0.2 y<br>‘oO<br>fa<br>3 ~V\<br>O 0 RTs\f —Week fixed effect<br>—Week fixed effect + Fiscal rule<br>-0.2<br>FOSE> CS WOH SYFOE E> CS WOH SYEOS ES CS MOY FOF OS E><br>SSIES B= 235 SABLE CE 35 246 SABLE CE 3> 235 SARLS ZS<br>2019 2020 2021 2022<br><!-- End of picture text -->
<!-- Start of picture text --> spread; = Bo + B,FiscalRule;, B,FiscalRule;, + B,EscapeClause;, + B3Suspension;, + ByGE;, + B; CEMBI, + B,EscapeClause;, + B3Suspension;, + ByGE;, + B; CEMBI, + + B3Suspension;, + ByGE;, + B; CEMBI, + B3Suspension;, + ByGE;, + B; CEMBI, + + ByGE;, + B; CEMBI, + ByGE;, + B; CEMBI, + + B; CEMBI, + B; CEMBI, + CEMBI, + + Bj EMBI, + B;Region;, B;Region;,<br>+4 X0rTM 4 XPOMY ty ty t ep XPOMY ty ty t ep ty ty t ep ty t ep t ep ep<br><!-- End of picture text --> spread; = Bo + B,FiscalRule;, B,FiscalRule;, + B,EscapeClause;, + B3Suspension;, + ByGE;, + B; CEMBI, + B,EscapeClause;, + B3Suspension;, + ByGE;, + B; CEMBI, + + B3Suspension;, + ByGE;, + B; CEMBI, + B3Suspension;, + ByGE;, + B; CEMBI, + + ByGE;, + B; CEMBI, + ByGE;, + B; CEMBI, + + B; CEMBI, + B; CEMBI, + CEMBI, + + Bj<sup>EMBI,+ B;Region;, B;Region;,</sup> +4 X0rTM 4 XPOMY ty ty t ep XPOMY ty ty t ep ty ty t ep ty t ep t ep ep
|||Dep<br>Log|endent Variable<br> Spread (Daily)|||
|---|---|---|---|---|---|
||(1)|(2)|(3)|(4)|(5)|
|FiscalRule<br> <br>||||||
|— NoSuspensionor Escape<br>Clause|-1.022***<br>(-39.05)|-0.867***<br>(-34.57)|-0.845***<br>(-32.91)|-0.802***<br>(-30.49)|-0.802***<br>(-30.48)|
|Escape Clause|-1,021***<br>|-0,886***<br>|-0,841***<br>|-0,.822***<br>|-0,822***<br>|
||(-36.68)|(-33.26)|(-31.03)|(-29.43)|(-29.42)|
|Suspension|-1.232***<br>|-1.041***<br>|-1.043***<br>|-1.004***<br>|-1.004***<br>|
||(-45.30)|(-39.94)|(-39.12)|(-36.57)|(-36.57)|
|Global/Regional/Corporate Factors|Yes|Yes|Yes|Yes|Yes|
|Policy-Related Controls|No|No|No|No|Yes|
|Total External Debt Stocks|No|Yes|No|Yes|Yes|
|Primary Balance|No|Yes|No|Yes|Yes|
|GDP Per Capita Growth|No|No|Yes|Yes|Yes|
|Inflation|No|No|Yes|Yes|Yes|
|Government Effectiveness|Yes|Yes|Yes|Yes|Yes|
|Country Fixed Effects|Yes|Yes|Yes|Yes|Yes|
|Month Fixed Effects|Yes|Yes|Yes|Yes|Yes|
|Observations|48956|46675|45887|44320|44320|
|Re|0.9197|0.9274|0.9125|0.9152|0.9152|

t statistics in parentheses * p<0.10, ** p<0.05, *** p<0.010
2021. Limiting the sample timeframe to 2000-2019, we identify fourteen instances of such events in the dataset, which we refer to as budget balance rule modification events and are reported out in the appendix, in Table A14. Following Davoodi et al. (2022b), we measure a country’s fiscal balance using the country’s specified budget balance target, which can differ across countries. For example, Chile’s budget balance rule pertains to its structural balance, whereas Israel’s budget balance rule pertains to its overall balance, and Uruguay’s rule pertains to its primary balance. Each of these variables are identifiable in the IMF’s Fiscal Rules and World Economic Outlook (WEO) datasets. A country’s baseline (pre-suspension/revision) fiscal balance is calculated as the three-year average target balance prior to the suspension or revision of a fiscal rule. Our summary statistics (reported in Table A15) show that following a budget balance rule modification event, the median duration for a country to return to its baseline fiscal balance is 3.5 years. The median deviation of a country’s fiscal balance from its baseline following a modification is 4.4% of GDP. In the sample analyzed, two countries, Argentina and Russia, which both suspended their budget balance rules in 2009 as a result of the global financial crisis, never returned to their presuspension baseline in the years following the suspensions, and ultimately abolished their rules.<sup>20</sup> While the sample of countries that have previously suspended, revised, and/or enacted an escape clause for budget balance rules is not large, we employ an event study analysis as an initial step to empirically answer the question of how long a country should be expected to take to return to compliance. After controlling for year and country fixed effects, our estimates indicate that following a budget balance rule modification, a country is expected to take approximately three years to return to its baseline fiscal balance. This implies that for a country that suspended its budget balance rule in 2020, its target balance would be expected to return to its 2017-2019 average by the year 2023. Further, our estimates find the deterioration of the fiscal balance to reach its peak one year following the initial modification, with the deficit in this year estimated to be almost 4% of GDP higher than the three-year average preceding the modification. As mentioned at the beginning of this section, we believe that the short time duration for which it has historically taken for sovereign governments to return to compliance after abandoning fiscal rules is a key driver underlying the results reported out in Section 3.3. The full results of our analysis can be seen in Figure 5.

# **Figure 5. Fiscal Balance Path Following Suspension/Revision of Budget Balance Rule or Escape Clause Usage**

> 20 In the case of Argentina, the budget balance rule was suspended between 2009 and 2017, and then abolished thereafter. For Russia, its short-lived budget balance rule (targeting the non-oil balance) became effective in 2008, was suspended in April 2009, and was formally abolished in 2012.

19
<!-- Start of picture text --> o<br>we<br>bhB<br>=<br>‘op St<br>I<br>4<br>5<br>c=<br>a)<br>8<br>Rs<br>QJ<br>ZO<br>2<br>Hwo<br>g<br>a<br>ay<br>-3 -2 -1 0 1 2 3 4 5<br>Years Since Adjustment or Suspension to Budget Balance Rule is Made<br><!-- End of picture text -->
existence of a fiscal rule, our constructed index has a mean of .362 and standard deviation of .258 during our sample timeframe of 2019-2022.

Use of our constructed index allows us to assess the notion that not all rules are created equal, and that the strength of a country’s rules may influence the spread-compressing effect afforded by the rules. Indeed, the literature has found rule strength to matter in some contexts, such as their disciplinary effect. For example, Caselli and Reynaud (2020) estimate the causal effect of fiscal rules on fiscal balances using a panel of 142 countries from 1985-2015, finding well-designed rules to have a statistically significant impact on fiscal balances, after correcting for selection bias. Given that rule strength influences the disciplinary effect of fiscal rules, and this disciplinary effect in turn influences a country’s degree of fiscal responsibility as perceived by credit markets, it is plausible that the strength of rules may influence their ability to compress spreads as well.

We begin by testing our initial specification outlined in Equation (1), replacing the binary fiscal rule variable with our constructed index, lagged by one year. We lag the index due to the fact that it is constructed on an annual basis, and in practice the individual components of fiscal rules from which our index is measured may change at different points during the calendar year for different countries. The lagged index value therefore represents the strength of a country’s fiscal rules at the onset of the current year. The results of this test, which are reported out in Appendix Table A10, indicate that a similar spread-compressing effect is estimated when our index of rule strength is used as a regressor, the difference being that the magnitude of spread reduction associated with the existence of fiscal rules is now increasing in rule strength. For example, for a country whose fiscal rule index takes on the mean value of .362, the magnitude of spread reduction relative to a country with no fiscal rules is estimated to be range from 118 to 156 basis points. Meanwhile, a country whose fiscal rule index takes on the maximum possible value of 1, as Lithuania does throughout the entire sample timeframe, the magnitude of spread reduction is estimated to range from 272 to 338 basis points. It is worth noting that our estimated spread reduction associated with fiscal rules is lower when rule strength is controlled for, compared to our baseline analysis. We therefore interpret the range of estimates reported out in Section 3.1 to be an upper bound for the reduction in spreads associated with the existence of fiscal rules.

Next, we test our second specification for the COVID-19 timeframe outlined in Equation (3) using the fiscal rule index in place of the binary fiscal rule variable and estimate a similar spread-compressing effect as in Section 3.2 now with the magnitude increasing in rule strength. The full set of coefficient estimates for this test can be seen in Appendix Table A11. The standalone fiscal rule index coefficient estimate again represents the spread reduction 21
associated with fiscal rules prior to the onset of the pandemic. This coefficient ranges from -.444 to -.542, implying a 88 to 105 basis point reduction in spreads for a country with rules of mean strength. The spread reduction associated with fiscal rules through the pandemic is then given by the sum of the coefficient estimates for the standalone fiscal rule index and interaction between fiscal rule index and post-pandemic indicator variable. This sum ranges from -.884 to -.958, implying a spread reduction of 186 to 199 basis points through the pandemic.

Similarly, we retest the specification shown in Equation (5) which distinguishes between countries that temporarily suspended their fiscal rules, countries that enacted an escape clause, and those that maintained their rules through the pandemic, using the lagged fiscal rule index in place of binary measurements. As was the case in the initial test outlined in Section 3.3, the results of this test imply a similar spread compression for all countries with fiscal rules, regardless of the degree of enforcement through the pandemic. The results from this test can be seen in Appendix Table A12. Finally, the results of our three main tests outlined in Sections 3.1-3.3 remain robust to tests in which outlier countries are excluded. See the Appendix for a description of the methodology used for these tests and see Table A13 for the full set of coefficient estimates for our baseline estimation with outliers removed.

# **4 Conclusion**

This paper provides empirical evidence that the adoption of fiscal rules can help suppress borrowing costs for emerging markets and developing economies during periods of global financial stress. Using the COVID-19 timeframe as our baseline sample period, we find that the existence of a fiscal rule is associated with lower sovereign spreads, with estimates of the average spread-compressing effect ranging from 319 to 378 basis points. The result is robust after controlling for institutional quality, and to the extent to which enforcement of the rule occurred during the global crisis. Our robustness tests also indicate that the spread-compressing effect is increasing in rule strength, and we therefore interpret the spread-compressing effect estimated in our baseline test as an upper bound. Further, we show that the spread-compressing effect of fiscal rules is robust to other global crisis periods such as the GFC of 2008-09. The spread-compressing effect is estimated to be stronger during the COVID-19 pandemic than during the GFC, a result which we interpret to reflect the gradual improvement of fiscal rules and generation of “second-generation” rules in the decade preceding the pandemic.

Regarding the finding that fiscal rules compressed spreads through the pandemic regardless of the degree of enforcement, we also provide suggestive evidence for the mechanism driving this result by performing an event study empirically estimating the time it takes to return to compliance following an abandonment of a budget 22
balance rule. Together, our results suggest that during global crises, credit markets internalize the fact that temporary rule abandonments generally do not lead to long-term debt insolvency. Thus, our results provide evidence that credit markets functioned properly through the pandemic in the sense that sovereign governments possessing a reputation of fiscal responsibility faced borrowing costs which facilitated meeting rising short-term needs. Our results have strong implications for policymakers in EMDEs who seek policies that signal fiscal responsibility and compress borrowing costs, especially during global crises such as the COVID-19 pandemic. The results not only suggest that a spread-compressing effect of fiscal rules exists, but that complex rules attempting to achieve flexibility through the inclusion of complicated contingencies can be greatly simplified given that credit markets do not perceive any difference between suspensions and escape clause usage during global crises.

There are several interesting issues concerning the spread-compressing effect and the fiscal responsibility channel of fiscal rules that future work can focus on. For instance, does the spread-compressing effect of fiscal rules hold during idiosyncratic, country-specific crises? If so, do markets internalize temporarily rule abandonments during idiosyncratic negative shocks the same way they do during periods of global crisis? Which type of fiscal rule is most effective in simultaneously signaling fiscal responsibility and enforcing fiscal discipline - simple debt rules, spread break rules as in Hatchondo et al. (2022), or a rule promising low government spending in the future as in Bianchi et al. (2023)? What would constitute an adequate escape clause for this fiscal rule, if any? Our analysis suggests that the spread-compressing effect of fiscal rules is worth consideration, and, thus, we view the questions posed as promising avenues for future research. Specifically, extending our empirical framework to countryspecific crises and enhancing sovereign debt models with strategic enforcement of fiscal rules to explore the issues raised above are interesting areas for future research.

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