Fiscal Fundamentals and Sovereign Risk: Signal from a time-varying parameter

This paper explores the impact of fiscal sustainability on sovereign risk via a two-step procedure. Firstly, the concept of cointegration between government revenues and expenditure as a measure of fiscal sustainability is exploited. We construct a time-varying parameter of the cointegration slope using a simple recursive Kalman filter in a state space representation. We argue that this parameter measures the degree of fiscal (deficit) sustainability if cointegration holds. Furthermore, we estimate the impact of this time-varying fiscal sustainability parameter on the sovereign yield spread for selected Euro area countries in a panel data regression framework. Our findings reveal that the fiscal sustainability parameter has a negative impact on sovereign spreads, indicating that a stronger fiscal policy stance conveys a positive signal of sustainability to the sovereign debt market, hence a low default risk, which is evidenced by a reduction in sovereign spreads. This study supports the argument that effective and prudent management of a country’s public finances contributes positively to reducing public financial risk as this is reflected in the pricing of risk in the sovereign debt market. JEL: H63, H62, C32, C33