The Rewards Of Fiscal Consolidation Sovereign Spreads And Confidence Effects

This paper investigates the effects of fiscal consolidation announcements on sovereign spreads in a panel of 21 emerging market economies during 2000-18. We construct a novel dataset using a global news database to identify the precise announcement date of fiscal consolidation actions. Our results show that sovereign spreads decline significantly following news that austerity measures have been approved by the legislature (congress or parliament), in periods of high sovereign spreads or in countries under an IMF program. In addition, consolidation announcements are less contractionary when sovereign spreads decline, with the reduction in output being half of the counterfactual case in which spreads do not respond to announcements. These results constitute direct evidence that confidence effects, in the form of lower sovereign spreads, are an important transmission channel of fiscal shocks. We also find that the role of confidence effects increases with the level of spreads such that countries with high spread levels stand to benefit the most from putting in place credible austerity packages.

Using a panel of 30 emerging market economies from 1997 to 2007, this paper investigates the determinants of country risk premiums as measured by sovereign bond spreads. Unlike previous studies, the results indicate that both fiscal and political factors matter for credit risk in emerging markets. Lower levels of political risk are associated with tighter spreads, while efforts at fiscal consolidation narrow credit spreads, especially in countries that experienced prior defaults. The composition of fiscal policy matters: spending on public investment contributes to lower spreads as long as the fiscal position remains sustainable and the fiscal deficit does not worsen.

We study gains from introducing a common numerical fiscal rule in a “Union” of model economies facing sovereign default risk. We show that among economies in the Union, there is significant disagreement about the common debt limit the Union should implement: the limit preferred by some economies can generate welfare losses in other economies. In contrast, a common sovereign spread limit results in higher welfare across economies in the Union.

Fiscal Consolidation: Taking Stock of Success Factors, Impact, and Design

The Effects of Fiscal Measures During COVID-19

In this paper, we use quarterly data and a novel database on fiscal policy consolidation announcements, for a sample of advanced economies and emerging markets to quantify the effects of fiscal tightening on inflation expectations. We find that fiscal consolidation announcements reduce inflation expectations over the medium-term (three and five-years ahead), but not in the short-term (one-year ahead). There is also some evidence that consolidation announcements reduce “disagreement” about expected future inflation at longer horizons. The inflation anchoring role of consolidation announcements is enhanced by the strength of a country’s fiscal and monetary frameworks, and when fiscal and monetary policy work in tandem. In addition, we find that initial conditions matter—inflation expectation’s response to consolidation announcements is larger in periods of high contemporaneous inflation. With these results in hand, we show that the effectiveness of fiscal consolidation in controlling realized inflation depends greatly on the response of inflation expectations to consolidation announcements. These results show that fiscal policy is crucial to anchor inflation expectations and a key element of a credible disinflationary process.

Governments face difficult policy trade-offs with record debt levels, tightening monetary policies, and urgent demands, including food and energy crises, the climate agenda, and population aging. Governments need to communicate fiscal plans to reduce debt sustainability risks and promote consistent macroeconomic policies. Many envisage a return to fiscal rules that had been suspended during the pandemic to strengthen credibility. This situation offers an opportunity to rethink fiscal rules and determine how governments can make fiscal policy more agile, including in responding to crises, without undermining fiscal sustainability. A risk-based medium-term fiscal framework that combines standards, rules, and strengthened institutions would strike a better balance between flexibility and credibility.

We study the response of corporate investment in Emerging Markets to unexpected fiscal shocks. We find that, although firm-level investment decreases on impact following unexpected public expenditure adjustments (classical Keynesian multiplier effect), it quickly rises above pre-shock levels. The rebound in investment is facilitated by fiscal space, flexible exchange rates, and more predictable fiscal policy. We also show that the composition of fiscal adjustments matters for investment’s response—compared to public investment adjustments, reductions in public consumption lead to larger private investment contractions on impact, but drive private investment to above pre-shock levels. Finally, we exploit firm-level heterogeneity in several dimensions, including to show that corporate investment’s recovery is stronger in firms in the tradable sector and in larger and less indebted firms, and to show that the long-run benefits to economic activity of the fiscal shock appear to outweigh its short-run costs.