Do fiscal rules reduce government borrowing costs in developing countries?

• Author: John Thornton,Chrysovalantis Vasilakis
• DOI: http://doi.org/10.1002/ijfe.1771
• Published date: 01 October 2020
• Date: 01 October 2020

RESEARCH ARTICLE

Do fiscal rules reduce government borrowing costs in

developing countries?

John Thornton

1

| Chrysovalantis Vasilakis

2

1

Norwich Business School, University of

East Anglia, Norwich Research Park,

Norwich, NR4 7TJ, United Kingdom and

US Department of the Treasury, Office of

Technical Assistance, Washington DC

20006, USA

2

The Business School, Bangor University,

Bangor, Gwynedd, United Kingdom

Correspondence

John Thornton, Norwich Business School,

University of East Anglia, Norwich

Research Park, Norwich, NR4 7TJ, United

Kingdom.

Email: john.thornton@otatreas.us

Abstract

We examine whether adopting a numerical fiscal rule framework to guide fis-

cal policy helped reduce the cost of borrowing by governments in a sample of

61 low- and middle-income countries for 1985–2017, 24 of which adopted such

rules. We address the self-selection problem of policy adoption by applying a

variety of propensity score matching methods and show that the average treat-

ment effect of fiscal rules on government borrowing costs is quantitatively

quite large and statistically significant in rule adopting countries. We also find

that the presence of institutional arrangements to strengthen fiscal rules

results in a larger reduction in borrowing costs than is the case without these

arrangements, which is consistent with strong rules adding to the credibility of

the fiscal policy framework.

KEYWORDS

credibility, developing countries, fiscal rules, government borrowing costs, propensity score matching

JEL CLASSIFICATION

E43; G12; H60

1|INTRODUCTION

Although numerical fiscal rules have been a popular

addition to fiscal frameworks since the early 1990s, their

effectiveness in lowering government borrowing costs

remains controversial.

1

A theoretical basis for adopting

fiscal rules to reduce borrowing costs is provided by

Hatchondo and Martinez (2009) who present a model in

which governments issuing bonds with duration like the

average for emerging market countries face an interest

rate that is substantially higher and more volatile com-

pared to when only short-term debt is issued. Hatchondo,

Martinez, and Padilla (2011) demonstrate the importance

of debt dilution in accounting for the level and volatility

of the interest rate spread paid by sovereigns; and

Hatchondo, Martinez, and Roch (2015) show how intro-

ducing a fiscal rule lowers sovereign risk and generates

welfare gains because the rule limits debt dilution.

2

With

the fiscal rule, lenders expect lower future government

debt levels, which accounts for the decline in interest

rates at which the government can borrow. Thus, for a

given level of indebtedness, the government is able to

borrow, paying at a lower interest rate.

The empirical evidence on the impact of fiscal rules

on borrowing costs is mixed and relates mainly to the

experience of US states and some European economies.

For the US, this evidence includes: Eichengreen and

Bayoumi (1994) and Bayoumi, Goldstein, and Woglom

(1995), who report that constitutional restraints to bor-

rowing reduce the costs of borrowing by US states;

Poterba and Rueben (1999a,b), who find that rules on US

states' expenditure, deficits, and debt reduce their bor-

rowing costs except when a state also imposes limitations

on the ability to raise taxes; Poterba and Rueben (2001),

who find that a sudden increase in the fiscal deficit raises

state financing costs, but that the rise is smaller if the

Received: 2 September 2015 Revised: 18 October 2018 Accepted: 13 September 2019

DOI: 10.1002/ijfe.1771

Int J Fin Econ. 2020;25:499–510. wileyonlinelibrary.com/journal/ijfe © 2019 John Wiley & Sons, Ltd. 499