Inflation Targeting and Country Risk: An Empirical Investigation

Abstract

The sovereign debt crisis in Europe has highlighted the role of country risk premia as a link between countries' fiscal and external balances, financial conditions and monetary policy. The purpose of this paper is to estimate how adoption of inflation targeting (IT) affects spreads. It is hypothesized that country risk premia for IT countries (especially among emerging market economies) may be lower than for other countries owing to greater policy predictability and more stable long-term inflation. The findings suggest that IT reduces the risk premium, both through adoption of the IT regime, and through the observed track record in stabilizing inflation.

Fiscal Rules and Government Borrowing Costs: International Evidence

“…Data on bond spreads are from Fouejieu and Roger (), which we have updated from the International Monetary Fund's (IMF) International Financial Statistics database and Bloomberg, and data on domestic borrowing spreads are from the World Bank's World Development Indicators database . Figures and illustrate borrowing spreads in the international and domestic credit markets, respectively, for countries with and without fiscal rules for the years 1985–2012.…”

“…In the previous section, we noted that past empirical studies of the impact of fiscal rules on borrowing spreads typically searched for fiscal rule effects by incorporating a fiscal rule adoption dummy into a data panel to examine the statistical significance and sign of the coefficient on the dummy variable. We follow this practice with our first set of estimates, which are based on a model that embeds a fiscal rule dummy in a standard model (e.g., Baldacci, Gupta, and Mati ; Bellas, Papaioannou, and Petrova ; Edwards ; Fouejieu and Roger ) of the main determinants of sovereign spreads. The model is specified as: where α i is country i 's country fixed effect on the sovereign risk premium, θ i is the time fixed effects, X it is a vector of variables that effects sovereign risk, and ϵ it is a random error term.…”

“…Data on bond spreads are from Fouejieu and Roger (2013), which we have updated from the International Monetary Fund's (IMF) International Financial Statistics database and Bloomberg, and data on domestic borrowing spreads are from the World Bank's World Development Indicators database. 5 Figures 1 and 2 illustrate borrowing spreads in the international and domestic credit markets, respectively, for countries with and without fiscal rules for the years 1985-2012. International bond spreads moved reasonably closely together for the rule adopting and nonrule adopting countries over the period; in the domestic markets, the spreads for nonrule adopting countries were substantially higher at times but narrowed sharply late in the sample period in line with the spreads for rule adopting countries.…”

A DSGE Model for a SOE with Systematic Interest and Foreign Exchange Policies in Which Policymakers Exploit the Risk Premium for Stabilization Purposes

“…However, although a positive correlation between foreign debt and the risk premium is typically found in empirical research (Bellas et al 2010, Di Cesare et al 2012, a negative correlation between CB reserves and the risk premium is also measured. 25 Fouejieu and Roger (2013), for example, place Gross external debt and Foreign exchange reserves (both as a ratio to GDP) at the top of their potential determinants of country risk and use system GMM estimation with annual data from 40 emerging and high income countries in the 1989 to 2010 period. In their Table 2, they report statistically signi cant (at 1%) effects of both variables, and the positive in uence of foreign debt on country risk is around three times (the abolute value of) the negative in uence of CB international reserves.…”

“…Furthermore, there is an additional multiplicative shock φ that may represent either an exogenous component of the risk function or an international liquidity shock (or both). 5 In an extension of the model, the risk premium function is made to also respond, but negatively, to the CB's international reserves to GDP ratio er=Y (see Fouejieu and Roger (2013) for econometric measurements).…”