FOOL THE MARKETS? CREATIVE ACCOUNTING, FISCAL TRANSPARENCY AND SOVEREIGN RISK PREMIA
| Date | 01 September 2008 |
| Author | Guntram B. Wolff,Kerstin Bernoth |
| DOI | http://doi.org/10.1111/j.1467-9485.2008.00462.x |
| Published date | 01 September 2008 |
FOOL THE MARKETS?
CREATIVE ACCOUNTING,
FISCAL TRANSPARENCY AND
SOVEREIGN RISK PREMIA
Kerstin Bernoth
n
and Guntram B. Wolff
nn
Abstract
We investigate the effects of official fiscal data and creative accounting signals on
interest rate spreads between bond yields in the European Union. We find that two
different measures of creative accounting indeed both increase the spread. The
increase of the risk premium is stronger, if financial markets are unsure about the
true extent of creative accounting. Moreover, fiscal transparency reduces risk
premia. Instrumental variable regressions confirm these results by addressing
potential reverse causality problems and measurement bias.
I Intro ductio n
The effect of fiscal variables on bond markets is hotly debated. A topic of
particular importance concerns the question, whether and to what extent bond
markets price in the possibility of (partial) sovereign default by demanding
higher interest rates. If a worsening in the fiscal position of an issuer country
increases the default probability, it should also be reflected in an increase of the
default risk premium contained in bond yields, measurable by an increase in the
interest rate spread towards a low risk benchmark country.
In the previous literature, fiscal determinants of sovereign default risk are
quantified by the official fiscal position of a country, usually the official debt and
deficit figures. The general empirical finding is that bond yields depend positively
on the debt and deficit level (Capeci 1991, 1994; Alesina et al., 1992; Bayoumi
et al., 1995; Copeland and Jones, 2001; Codogno et al., 2003; Bernoth et al., 2004;
Hallerberg and Wolff, 2008; Heppke-Falk and Wolff, 2008). No empirical study so
far investigates, whether financial markets are ‘fooled’ by governments if these
misreport on their true state of fiscal policy.
1
This is the main purpose of our paper.
Official reported fiscal variables might not give an accurate picture of the true
fiscal position of a country for many reasons. Politicians might want to hide
n
De Nederlandsche Bank (DNB), Westeinde 1, Nl-1000AB Amsterdam
nn
Deutsche Bundesbank, Wilhelm-Epstein-Str. 14, D-60431 Frankfurt
1
As argued by Koen and van den Noord (2005), governments may wish to put the best
possible gloss on the accounts presented to the outside world.
Scottish Journal of Political Economy, Vol. 55, No. 4, September 2008
r2008 The Authors
Journal compilation r2008 Scottish Economic Society. Published by Blackwell Publishing Ltd,
9600 Garsington Road, Oxford, OX4 2DQ, UK and 350 Main St, Malden, MA, 02148, USA
465
deficits if voters dislike them.
2
Governments might also want to engage in
additional spending without having parliamentary approval. Parliamentary
control can be reduced by fiscal misreporting.
3
Moreover, fiscal rules such as
constitutional deficit limits and international rules such as the stability and
growth pact (SGP) constitute limits on official fiscal data and therefore on fiscal
behavior. This might increase the incentive of governments to hide away deficits
by reverting to window-dressing or shifting fiscal expenditures off the budget
(Milesi-Ferretti, 2003). We label these activities ‘creative accounting’. Especially
the use of creative accounting to ‘comply’ with the European fiscal rules, namely
the excessive deficit procedure (EDP) and the SGP, has recently become an
important policy concern in Europe (see e.g. European Commission, 2003).
Numerous studies investigate the effect of fiscal rules on budget outcomes for
US states and cities (Bunch, 1991; von Hagen, 1991; Kiewiet and Szakaly, 1996;
Bohn and Inman, 1996). The general conclusion from this literature is that binding
restraints induce fiscal actors to use other instruments such as creative accounting
to dampen the effect of the rule. Relatively few studies investigate the use of
‘creative’ accounting in the EU.
4
Von Hagen and Wolff (2006) are the first to
analyze accounting tricks in order to comply with the rules of the SGP. They focus
on stock-flow adjustments (SFA), which are defined as the difference between the
reported annual change in debtlevels and the reported deficits. PositiveSFA imply
that the debt level increases faster than the deficit data suggest. In particular, they
find evidence that SFA was systematically used to reduce the official deficit figures.
Koen and van den Noord (2005) collect information on single one-off measures
(fiscal gimmickry) and show that the probability to obser ve such measures
increases with the budget deficit. The empirical evidence thus confirms the view
that fiscal policy figures are sometimes purposely changed to officially comply with
fiscal rules. Significant use of one-off measures can be detected in Europe.
The reaction of financial markets to this creative accounting is an important
policy topic. If financial markets do not price in the de facto deterioration of the
fiscal position due to creative accounting, while punishing official deficit data,
risk premia could be lowered by shifting deficits to creative accounting. The
lower interest rate in turn would provide an incentive to governments to beautify
their fiscal data. To our knowledge, no study so far analyzes whether financial
markets take note of fiscal window-dressing when pricing government bonds.
This is the purpose of our study. In particular, we study whether spreads react,
besides official fiscal data, to stock-flow adjustments or to an alternative
measure of creative accounting by Koen and van den Noord (2005).
2
Alt and Lassen (2006) provide evidence that electoral cycles depend on fiscal transparency.
They are less pronounced, the more fiscally transparent a country is. Von Hagen and Wolff
(2006) show that creative accounting moves with the business cycle.
3
This is the idea behind the sub-index on fiscal transparency developed in von Hagen (1992).
4
Dafflon and Rossi (1999) survey the accounting tricks used in the run-up to the Euro. They
find that numerous countries have used tricks to qualify for EMU membership. Similarly,
Milesi-Ferretti and Moriyama (2004) find that during the period leading up to 1997
governments reduced the public debt ratio by decumulating government assets in order to
qualify for EU membership.
K. BERNOTH AND G. B. WOLFF466
r2008 The Authors
Journal compilation r2008 Scottish Economic Society
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