Financial and real effects of fiscal risk
Summary
Focus
We examine what happens when investors question fiscal sustainability and demand higher sovereign bond yields as compensation for higher risk. We call these episodes fiscal risk shocks. Such shocks can arise, for example, from a government announcing new spending or tax cuts, or from news that worsens its budget outlook. We develop a new method to identify these shocks from daily movements in bond yields. When fiscal concerns intensify, investors retreat from government bonds and shift towards the safest corporate bonds, resulting in negative co-movement in the yields of these bonds. Exploiting this relationship, we extract fiscal risk shocks for 12 economies. We then trace how these shocks propagate through exchange rates, equity markets, inflation and output.
Contribution
Economists have long maintained that fiscal imbalances or changes in perceptions of fiscal sustainability can affect inflation. Yet they seldom demonstrate how these effects unfold through financial markets. We document how fiscal risks transmit from bond markets to the broader economy and show that their impact depends on two conditions: the stance of monetary policy and the fragility of a country's fiscal position. Our findings offer a market-based account of a process that the literature typically treats in abstract terms.
Findings
We find that fiscal risk shocks, on average, lead to higher borrowing costs, currency depreciation and lower equity valuations. Prices of goods and services also rise on impact and stay elevated for about one year, with inflation expectations moving alongside them. Output enjoys a temporary boost, but this dissipates quickly and is followed by a persistent contraction induced by tighter financial conditions. The effects of fiscal risk intensify when central banks keep policy accommodative and allow real interest rates to remain negative. The effects are also more pronounced when sovereign risk is perceived to be already elevated.
Abstract
This paper estimates the macroeconomic and financial effects of fiscal risk shocks using a novel identification from bond yields. We first recover country-specific fiscal risk shocks from a daily Bayesian VAR model in sovereign and safe corporate bond yields, identified via contemporaneous sign restrictions that capture portfolio rebalancing away from government debt toward private safe assets. We then estimate the effects of these shocks using a local-projections framework applied to a monthly panel of twelve economies. Fiscal risk shocks generate stagflationary dynamics. Inflation and inflation expectations rise on impact, while industrial production increases only temporarily before declining persistently. Sovereign yield curves steepen, exchange rates depreciate and equity prices fall. These effects are significantly stronger when monetary policy remains accommodative– leading to persistently negative real interest rates– and when sovereign risk premia are already elevated.
JEL classification: E31, E52, E62, G12, H63
Keywords: fiscal risk, sovereign yields, safe assets, Bayesian VAR, local projections, monetary–fiscal interactions
