Fiscal Deficits, Public Debt, and Sovereign Bond Yields

Abstract

The recent sharp increase in fiscal deficits and government debt in many countries raises questions regarding their impact on long-term sovereign bond yields. While economic theory suggests that this impact is likely to be adverse, empirical results have been less clear cut, have generally ignored nonlinear effects of deficits and debt through some other key determinants of yields, and have been mostly confined to advanced economies. This paper reexamines the impact of fiscal deficits and public debt on long-term interest rates during 1980-2008, taking into account a wide range of country-specific factors, for a panel of 31 advanced and emerging market economies. It finds that higher deficits and public debt lead to a significant increase in long-term interest rates, with the precise magnitude dependent on initial fiscal, institutional and other structural conditions, as well as spillovers from global financial markets. Taking into account these factors suggests that large fiscal deficits and public debts are likely to put substantial upward pressures on sovereign bond yields in many advanced economies over the medium term. This Working Paper should not be reported as representing the views of the IMF.

Foreign Investor Flows and Sovereign Bond Yields in Advanced Economies

“…A 1 percent increase in the expected real growth rate leads to a 48-49 basis points decline in bond yields, while a 1 percent increase in expected infl ation leads to an increase of 18-23 basis points in bond yields. The negative impact of growth is consistent with the fi ndings of Baldacci and Kumar (2010) and can be explained by the stronger infl uence of cyclical (relative to structural) factors on growth in the relatively high frequency (quarterly) data used in the analysis. The smaller impact of infl ation could be driven by the fact that, in AEs, infl ation expectations have been fi rmly anchored at a low level, diminishing their importance for long-term investors.…”

Determinants of fiscal rules

“…E.g., in case of a fiscal expansion, higher interest rates are triggered by an increase in total demand and the financing of budget deficits by bonds issuance (Kumar and Baldacci 2010), which induces capital inflows and leads to an appreciation of the domestic currency and thus lower net exports.…”

Extrapolative expectations and capital flows during convergence

“…However, as it becomes apparent in the quantitative results, the stationarity inducing assumption operates over the very long run, and impacts only marginally the dynamics we wish to analyze. 6 Furthermore, while generally used for business cycle analysis, the fact that the country spread should be increasing in the debt to GDP ratio finds support in literature on the long run determinants of country spreads (Kinoshita, 2006;Kumar and Baldacci, 2010). …”