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Do Financial Markets Value Quality of Fiscal Governance?

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Abstract

We examine the link between the quality of fiscal governance and access to market-based external finance. Stronger fiscal governance is associated with improvements in several indicators of market access, including a higher likelihood of issuing sovereign bonds and having a sovereign credit rating, receiving stronger ratings, and obtaining lower spreads. Using the more granular information on quality of fiscal governance from Public Expenditure and Financial Accountability (PEFA) assessments for 89 emerging and developing economies, we find that similar indicators of market access are correlated with sound public financial management practices, especially those that improve budget transparency and reporting, debt management, and fiscal strategy.

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Notes

  1. Many credit agencies include governance measures such as the World Bank’s Worlwide Governance Indicators (WGI) in their publicly-available credit rating methodologies.

  2. Existing research highlights factors explaining the probability that a country issue external debt, the amounts borrowed, and the yields and spreads on these debts in both primary markets [e.g.,] (Kamin and Von Kleist 1999) and secondary markets (Bellas et al. 2010; Rocha and Moreira 2010; Baldacci et al. 2011; Siklos 2011; Comelli 2012; Kennedy and Palerm 2014; Csontó 2014; Guscina et al. 2014). Other papers examine idiosyncratic differences that are region-specific or arise because of first-time bond issuances (Olabisi and Stein 2015; Gueye and Sy 2014). These factors can all be interpreted as increasing or mitigating risk and hence impacting the required return of investors.

  3. This result also holds during crises (Comelli 2012) and periods of higher volatility (Csontó 2014).

  4. Kennedy and Palerm (2014) argues that virtually all of the run-up in emerging market spreads during the 2008-09 financial crisis was due to a large increase in the measure of risk aversion.

  5. The IMF has also undertaken a renewed engagement on governance issues more broadly, including fiscal governance. See, for example, IMF (2018b) and IMF (2019a).

  6. Glennerster and Shin (2008) exploit random variation in the timing of introduction of improved IMF country reports, ROSC assessments and Special Data Dissemination Standard (SDDS) data releases across countries. They find that an improvement in fiscal transparency linked to these reforms lowered average sovereign bond yields across 23 emerging market economies.

  7. Arndt and Oman (2006), Knack (2006), Kurtz and Schrank (2007) and Thomas (2010) question the usefulness of the WGI for making comparisons of governance over time and across countries since they are normalized within every year. These authors also call out possible biases in the inputs underlying the aggregate governance indicators, including the lack of independence of some of the assessments. Kaufmann et al. (2010) argue that these concerns are not specific to the WGI and are likely to arise in the context of any effort to measure governance.

  8. The other WGI indicators are voice and accountability; political stability; regulatory quality; rule of law; and control of corruption.

  9. Since the inputs to the WGI are sometimes subjective or prone to measurement error, Charron et al. (2010) suggest that countries should be clustered with respect to their relative quality of governance. The binned scatterplots achieve this by computing the average outcome within deciles of the Government Effectiveness score. In the appendix, we also show that the results are robust to using alternative measures of fiscal governance, such as the WGI Rule of Law or Control of Corruption scores (See Figs. 6 and 7)

  10. Many of these countries may be rated by export credit agencies, insurance agencies, and international banks, but these ratings are often confidential or for internal use only.

  11. Ratha et al. (2011) examine the role of macroeconomic, fiscal and governance variables as predictors of sovereign credit ratings. However, they focus on rule of law, rather than government effectiveness.

  12. The impact of fiscal governance on market access may be different in countries with large fiscal deficits or public debt. For example, a large fiscal deficit may be less of a concern in a country with a strong record of fiscal transparency. To account for these nonlinearities, we also considered controlling for interactions between fiscal governance and fiscal deficits and debt ratios. The results are similar, and are available upon request.

  13. Since the regression of average ratings on the WGI score is conditional on having a credit rating, we have also considered two-step estimators as in Heckman (1979), which considers the possible selection bias of excluding unrated countries. The results are similar and are available upon request.

  14. https://pefa.org/

  15. As Fig. 3 in the appendix shows, PEFA scores are strongly correlated with the WGI Government Effectiveness score.

  16. See PEFA (2016). This format reflects the 2016 PEFA framework. The previous 2005 and 2011 PEFA frameworks had slightly different questions and structure, which we map into the 2016 framework to ensure consistent scores across assessments.

  17. One important limitation of our analysis is the potential for spatial dependence in financial market access. Access to markets and financial market conditions tend to cluster by geographic region, and it is common to observe financial market shocks in one country (e.g., to sovereign spreads) spill over to neighboring countries. Even when spatial dependence does not impact the unbiasedness and consistency of the pooled OLS estimator, it can still impact the estimated standard errors [e.g.,] (Wooldridge 2002),.

  18. No countries in our sample achieved an A score in the budget execution and external audit categories, so those coefficients could not be estimated and were dropped from the analysis.

  19. As in the previous section, the impact on the average credit rating is estimated conditional on having a credit rating. Results from a two-step estimator that controls for possible selection bias of excluding unrated countries are qualitatively similar, and available upon request.

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Author information

Authors and Affiliations

  1. University of Orléans, Orléans, France

    Kady Keita

  2. Caribbean Development Bank, Caribbean, USA

    Gene Leon

  3. International Monetary Fund, Washington, USA

    Frederico Lima

Authors
  1. Kady Keita
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  2. Gene Leon
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  3. Frederico Lima
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Correspondence to Kady Keita.

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We thank Philip Barrett, Racheeda Boukezia, Sophia Chen, Jason Harris, Ashraf Khan, Jason Lakin, Paolo de Renzio, two anonymous reviewers and seminar participants at the IMF and World Bank for helpful comments and discussions. The views expressed herein are those of the author(s) and should not be attributed to the IMF, its Executive Board, or its management.

Appendices

Other Figures

Fig. 2
figure 3

PEFA assessment main categories

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Fig. 3
figure 4

PEFA and WGI score

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Fig. 5
figure 5

Government Effectiveness and Share of External Public Debt that is Market-Based. Noted: The left panel examines the relation between the share of public external debt that was market-based in 2010 (e.g., sovereign bond issuances or syndicated loans) and the WGI Government Effectiveness score. The right panel shows the impact of PEFA score improvements on the same indicator. In both cases, the sample is restricted to emerging and developing economies

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Fig. 6
figure 6

Rule of Law and Market Access. Note: These binned scatterplots display the nonparametric relation between fiscal governance, measured by the WGI Rule of Law score (horizontal axes), and different indicators of access to market-based external finance (vertical axes). Fitted quadratic regression lines are shown in red. The top left panel shows whether a country was rated by any of the three major rating agencies in 2010, while the top right panel looks at the average sovereign rating in 2010, for countries that did have a rating (the vertical axis follows the Standard & Poor’s rating scale). The bottom left panel examines whether a country issued at least one external sovereign bond between 1996 and 2016, focusing only on developing and emerging economies, while the bottom right panel plots the (option-adjusted) spread for countries that issued sovereign bonds

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Fig. 7
figure 7

Control of Corruption and Market Access. Note: These binned scatterplots display the nonparametric relation between fiscal governance, measured by the WGI Control of Corruption score (horizontal axes), and different indicators of access to market-based external finance (vertical axes). Fitted quadratic regression lines are shown in red. The top left panel shows whether a country was rated by any of the three major rating agencies in 2010, while the top right panel looks at the average sovereign rating in 2010, for countries that did have a rating (the vertical axis follows the Standard & Poor’s rating scale). The bottom left panel examines whether a country issued at least one external sovereign bond between 1996 and 2016, focusing only on developing and emerging economies, while the bottom right panel plots the (option-adjusted) spread for countries that issued sovereign bonds

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Other Tables

Table 1 Conversion of Sovereign Credit Ratings to Numerical Scale
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Table 2 Summary Statistics
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Keita, K., Leon, G. & Lima, F. Do Financial Markets Value Quality of Fiscal Governance?. Open Econ Rev 32, 907–931 (2021). https://doi.org/10.1007/s11079-021-09652-4

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