Sovereign Bond Market Reactions to Fiscal Rules and No-Bailout Clauses – The Swiss ExperienceZEW Discussion Paper No. 13-034 // 2013
The budgetary problems of many governments which emerged as a consequence of the economic and financial crisis are on top of the political agenda. Simultaneously to the increasing debt levels, investors demanded much higher compensations for the growing default risk, thus boosting the sovereign bond yields of several nations. The exploding refinancing costs put further pressure on the public budgets and call for measures which are capable of restoring the market participants’ confidence in the sustainability of public finances in the short run. This paper focuses on two different institutional factors which can be hypothesised to work in this direction: strong numerical fiscal rules and a credible no-bailout policy.
Concerning fiscal rules, there is large evidence suggesting that numerical constraints limit debt, deficit, expenditure, and revenue levels of governments. In case of fiscal rules being perceived as binding promises for future responsible fiscal behaviour, their adoption should thus immediately restore market confidence in financial sanity and result in lower risk premia. However, the prerequisites for this effect are both strong and reliable numerical fiscal rules. We empirically test the impact of this institutional measure for bond emissions at the subnational level of Switzerland. The Swiss system serves as a perfect laboratory, since it is characterised by an extensive fiscal federalism with high fiscal autonomy at the cantonal level – especially with regard to constitutional and statutory fiscal restraints. Most Swiss cantons have introduced numerical fiscal rules which seem to be much stronger in comparison to other national fiscal rules.
With respect to a credible no-bailout policy, the literature so far has focused almost exclusively on the benefits of such an implicit guarantee for those issuers who are potentially bailed out, and ignored the costs for those who potentially provide a bailout. In the Swiss context, however, we can exploit a quasi-natural experiment generated by a Swiss court decision in 2003 to investigate the opposite effect. On 3 July 2003, the Swiss Supreme Court decided – against general expectation – that the canton Valais is not obliged to bail out its highly indebted municipality Leukerbad. This decision was a break since it relieved the cantons from backing municipalities in financial distress, thus leading to a fully credible no-bailout regime at the cantonal level. Since most Swiss cantons issue tradable bonds, we make use of unique financial market data on 288 cantonal bonds in the period from 1981 to 2007 to measure the impact of both institutional features on the investors’ confidence in the cantons’ refinancing capacity.
In a nutshell, the results reveal that both the presence and the strength of fiscal rules and a credible no-bailout regime significantly contribute to lower risk premia at the cantonal level. The effects are relevant in qualitative and quantitative terms: The introduction of a strong fiscal rule reduces cantonal risk premia in relation to Swiss federal bonds by 10 basis points on average – even under stable market conditions before the beginning of the financial crisis. Furthermore, we show that risk premia of cantonal bonds were on average 25 basis points higher before the Swiss Supreme Court decided that the cantons are not liable for the obligations of their municipalities. This finding suggests that the implicit liabilities in a non-credible no-bailout regime impose severe sanctions on the possible guarantors. Consequently, both institutional measures, strong numerical fiscal rules and a credible no-bailout policy, can actually contribute to lower refinancing costs and help to restore financial market confidence.
Feld, Lars, Alexander Kalb, Marc-Daniel Moessinger and Steffen Osterloh (2013), Sovereign Bond Market Reactions to Fiscal Rules and No-Bailout Clauses – The Swiss Experience, ZEW Discussion Paper No. 13-034, Mannheim.