Fiscal Rules and Financial Systems: Complements or Substitutes?
| DOI | http://doi.org/10.1111/obes.12279 |
| Author | Juan Gabriel Fernández,Francisco Parro |
| Date | 01 June 2019 |
| Published date | 01 June 2019 |
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©2018 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd.
OXFORD BULLETIN OF ECONOMICSAND STATISTICS, 81, 3 (2019) 0305–9049
doi: 10.1111/obes.12279
Fiscal Rules and Financial Systems: Complements or
Substitutes?
Juan Gabriel Fern´
andez,† and Francisco Parro‡
†ESE Business School, Universidad de Los Andes, Av. Plaza 1905, Santiago, Chile (e-mail
jgfernandez.ese@uandes.cl)
‡School of Business, Universidad Adolfo Ib´a˜nez, Diagonal Las Torres 2700, Santiago, Chile
(e-mail francisco.parro@uai.cl)
Abstract
We study the effect of fiscal rules on a country’s credit rating and their interaction with
financial development.We build a rich set of panel data, which includes a novelindex for the
strength of fiscal rules. Wefind a positive and significant effect of fiscal rules on sovereign
ratings. We also find that this effect is attenuated in economies with a more developed
domestic financial system. Therefore, financial markets act as a substitute for fiscal rules
in lowering the default risk assessed by credit rating agencies. This substitution effect
between fiscal rules and financial development is mostly triggered through the monitoring
and enforcement dimension of fiscal rules.
I. Introduction
Fiscal rules refer to the imposition of a long-lasting constraint on fiscal policy through
placing numerical limits on budgetary aggregates. Fiscal rules have been evaluated across
several dimensions.1However, the interaction between fiscal rules, financial development,
and a country’s credit rating has received less attention. In this paper, we empiricallystudy
the effect of fiscal rules on sovereign ratings and whether this effect is exacerbated or
attenuated by a more developed domestic financial system.
We assemble a data set covering the period 1994–2014 for a sample of 57 developed
and developing countries. Our dependent variable is based on the credit rating information
provided by Standard and Poor’s, Fitch, and Moody’s. To measure the strength of the
fiscal rule framework of each country, we build an index that categorizes each rule along
four dimensions: legal basis, flexibility, monitoring and enforcement, and institutions and
procedures. Financial development is proxied by the domestic credit to the private sector
by banks relative to GDP. We control for time fixed effects, macroeconomic conditions,
JEL Classification numbers: E4; E6; H3; H6.
1For instance, von Hagen (1991), Alesina and Bayoumi (1996), Bohn and Inman (1996), Debrun et al. (2008),
Larra´
in and Parro (2008), Ayuso-i-Casalset al. (2009), de Haan, Jong-A-Pin and Mierau (2012), Frankel, Vegh and
Vuletin (2013), Nerlich and Reuter (2013), among others.
Fiscal rules and sovereign credit ratings 589
policy responses of the authority, the exposure of the economy to external shocks, and
political variables. Our empirical strategy relies on pooled OLS regressions, fixed effects
panel regressions, and GMM dynamic panel models.
We find a positive and significant effect of fiscal rules on a country’s credit rating;
that is, a stronger fiscal rule contributes to improved sovereign ratings. More importantly,
we also find that this positive effect is significantly smaller in economies with a more
developed financial market. Concretely, when comparing countries with low and high
financial development (in the 20th and the 80th percentiles of the private credit to GDP
ratio), a one standard deviation increase in our fiscal rule strength index is associated with
an improvement equivalent to 0.8 notches in the average credit rating in economies with
less developed domestic financial systems but is associated with an improvement of only
0.04 notches in economies with more developed systems.
Our results are robust to different specifications, including a model that includes fis-
cal aggregates as additional control variables. The latter result is consistent with fiscal
rules working not only through the primary fiscal balance, but also through introducing
credibility regarding the future path of the fiscal policy.
To explain our main finding, we conjecture that countries that rely on their financial
markets to allocate resources between sectors increase the political cost to the fiscal autho-
rity of behaving irresponsibly, which makes fiscal rules less necessary in the eyes of the
credit rating agencies (CRAs).2Our disaggregated analysis, which considers separately
each fiscal rule’s dimensions, provides partial support to this conjecture: the substitution
between fiscal rules and financial development is mostly triggered through the monitoring
and enforcement dimension of the fiscal rules.
This paper complements the evidence provided by the literature that assesses the per-
formance of different fiscal schemes. Empirical evidence shows that fiscal rules promote
a more solvent public finance (von Hagen, 1991; Alesina and Bayoumi, 1996; Bohn and
Inman, 1996; Debrun et al., 2008; Ayuso-i-Casals et al., 2009; de Haan et al., 2012; Nerlich
and Reuter, 2013), contribute to reducing output volatility (Alesina and Bayoumi, 1996;
Larra´
in and Parro, 2008), limit the use of short-sighted and pro-cyclical budgetary policies
(Debrun and Kumar, 2007; Debrun et al., 2008; Frankel et al., 2013), and reduce sovereign
spreads (Bayoumi and Eichengreen, 1995; Iara and Wolff, 2011).3We contribute to this lit-
erature by studying how the performance of a fiscal rule interacts with the financial system;
specifically, how the impact of fiscal r ules on sovereign ratings is mitigated or intensified
by financial development.
A second strand of literature related to our paper assesses the determinants of the
sovereign credit ratings issued by the CRAs (Cantor and Packer, 1996; Afonso, 2003;
Block and Vaaler, 2004; Mellios and Paget-Blanc, 2006; Archer, Biglaiser and DeRouen,
2007; Afonso, Gomes and Rother, 2011; Duygun, Ozturk and Shaban, 2016). These arti-
cles, however, do not study the effect of formal fiscal rule schemes on credit ratings and
how this effect is shaped by the level of development of the domestic financial market.
Ratings may contain significant information for the market (Cantor and Packer, 1996;
2We further elaborate on this issue in Section IV.
3Hatchondo, Martinez and Roch (2015) even propose the use of a sovereign-premiumlimit instead of a debt limit
as a potential fiscal rule target.
©2018 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd
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