Political and Fiscal Risk Determinants of Sovereign Spreads in Emerging Markets Emanuele Baldacci, Sanjeev Gupta, and Amine Mati* Abstract Using a panel of 46 emerging market economies from 1997 to 2008, this paper investigates the key determi- nants of country risk premiums as measured by sovereign bond spreads. Unlike previous studies, the results indicate that both political and fiscal factors matter for credit risk in emerging markets. Lower levels of political risk are associated with tighter spreads, particularly during financial turmoil. Efforts at fiscal con- solidation narrow credit spreads, especially in countries with high initial public debt levels.The composition of fiscal policy also matters as higher public investment lowers spreads as long as the fiscal position remains sustainable and the fiscal deficit does not worsen. 1. Introduction Notwithstanding recent developments, financial markets’ perception of credit risks in emerging economies has sharply improved over the last decade. The spread of the composite Emerging Market Bond Index Global (EMBIG) calculated by JP Morgan tightened by more than 500 basis points between mid-2002 and August 2007 (Baldacci, 2007). This downward trend was partially reversed during the 2007–08 subprime- induced financial crisis (IMF, 2008), particularly as spillovers spread from major financial centers to emerging markets during the last quarter of 2008. However, EMBIG spreads have recently fallen back to pre-crisis levels (e.g. prior to the collapse of Lehman Brothers in September 2008) as financial markets rebounded following the actions taken by the major economies to repair their banks’ balance sheets and help spur demand. Overall, the downward trend in bond spreads suggests that a lower premium is required to protect investors in emerging market economies against country-specific and asset-class-wide risks than earlier in the decade. Also, the cost of buying protection against defaults of sovereign emerging market debt instruments, as measured by the spreads of credit default swap (CDS) derivative instruments, fell drastically over the last five years despite the recent cyclical uptick. The literature has attributed the long-term tightening of emerging market spreads to three factors: (i) sound macroeconomic policies that brought inflation under control (including through more independent monetary authorities), reduced output volatility, and significant reductions in public and external debt (Ciarlone et al., 2007); (ii) higher commodity prices and favorable liquidity conditions that lowered risks and resulted in large capital flows to these countries (Hartelius et al., 2008); and (iii) development of * Baldacci: International Monetary Fund, 700 19th Street, N.W.,Washington, DC 2043, USA.Tel: +1-202-623- 6116; Fax: +1-202-589-6116; E-mail: ebaldacci@imf.org. Gupta: International Monetary Fund, 700 19th Street, N.W.,Washington, DC 2043, USA.Tel: +1-202-623-8872; Fax: +1-202-589-8872; E-mail: sgupta@imf.org. Mati: International Monetary Fund, 700 19th Street, N.W.,Washington, DC 2043, USA.Tel: +1-202-623-7797; Fax: +1-202-589-7797; E-mail: amati@imf.org.We would like to thank Julio Escolano, Manmohan Kumar,Ashoka Mody, Jari Stehn, and two anonymous referees for helpful comments and suggestions on an earlier version, and Annette Kyobe and Sukhmani Bedi for research assistance.The usual disclaimer applies. Review of Development Economics, 15(2), 251–263, 2011 DOI:10.1111/j.1467-9361.2011.00606.x © 2011 Blackwell Publishing Ltd