Sovereign Risk Premia: The Link Between Fiscal Rules and Stability Culture

The credibility crisis regarding the sustainability of public debt has transformed the markets for government bonds in the Euro area. A new sensitivity of creditors for the risk of sovereign default has pushed up financing costs of several euro member countries or has even cut them off from market access. Currently, policy makers try to enhance their fiscal reputation through the establishment of better European and national fiscal rules, particular in form of the debt brakes prescribed by the European Fiscal Compact. The hope is that, independent from the current budgetary performance, new fiscal rules send out credible signals to the markets and cut short the way towards lowering the risk spread.

In our paper we study the determinants of sovereign risk premia in the EU countries between 1992 and 2008. Our contribution addresses two interrelated questions: First, do fiscal rules impact on sovereign risk premia in Europe? And second, is any such observable link really causal or rather the consequence of different national "stability cultures", which arise from differing historical institutions or fiscal preferences?

In our empirical analysis, we try to shed light on this issue by employing several types of stability preference related proxies. These proxies are related to a country's past stability performance, government characteristics and survey results related to general trust. We find evidence that these indicators have an influence on risk premia. Moreover, they dampen the measurable impact of fiscal rules on risk premia. The estimated positive effect of fiscal rules on market confidence in the early years of EMU can thus mainly be explained by the fact that mainly high-stability countries introduced such constraints. Our results indicate that these stability-oriented countries would not have had a significantly lower financial market reputation if they had not established fiscal rules. Thus, for these countries strict fiscal rules may be rather interpreted as a confirmation of the underlying fiscal preferences of the voters and their political representatives. Still, even if this is true, it does not preclude the possibility that the new establishment of strict rules - such as intended by the Fiscal Compact - is relevant for fiscal reputation in countries with a lack of historical stability orientation. Our results rather point to the fact that fiscal rules have the largest potential for countries with particularly poor stability culture in the past: for these countries, the effect of rules on risk premia is significantly stronger than for highstability countries. It seems that these countries could benefit from the establishment of debt brakes which is intended by the Fiscal Compact.

Heinemann, Friedrich, Steffen Osterloh and Alexander Kalb (2013), Sovereign Risk Premia: The Link Between Fiscal Rules and Stability Culture, ZEW Discussion Paper No. 13-016, Mannheim.