The rewards of fiscal consolidations: Sovereign spreads and confidence effects

This paper investigates the effects of fiscal consolidation announcements on sovereign spreads using high frequency data for a panel of 21 emerging market economies during 2000–18. We construct a novel dataset using a global news database to identify the precise announcement date of fiscal consolidation actions. Our results show that sovereign spreads barely decline after fiscal announcements from the executive branch. Nonetheless, spreads decline significantly following news that austerity measures have been approved by the legislature (congress or parliament), particularly in economies with high sovereign spreads, debt levels, and low credit-risk ratings. These effects are even larger in the presence of an IMF program. In addition, we find that consolidation announcements are less contractionary when sovereign spreads decline. The reduction in output is a third of the counterfactual case in which spreads do not respond to announcements. These results show that confidence effects, in the form of lower sovereign spreads, are an important transmission channel of fiscal policy actions. We also find that the role of confidence effects increases with the level of spreads, such that countries with high spread levels stand to benefit the most from putting in place credible austerity packages.