How Do Political Factors Shape the Bank Risk–Sovereign Risk Nexus in Emerging Markets?

• Date: 01 August 2017
• DOI: http://doi.org/10.1111/rode.12274
• Published date: 01 August 2017
• Author: Stefan Eichler

How Do Political Factors Shape the Bank Risk–

Sovereign Risk Nexus in Emerging Markets?

Stefan Eichler*

Abstract

This paper studies the role of political factors for determining the impact of banking sector distress on

sovereign bond yield spreads for a sample of 19 emerging market economies in the period 1994–2013.

Using interaction models, I find that the adverse impact of banking sector distress on sovereign solvency

is less pronounced for countries with a high degree of political stability, a high level of power sharing

within the government coalition, a low level of political constraint within the political system, and for

countries run by powerful and effective governments. The electoral cycle pronounces the bank risk–

sovereign risk transfer.

1. Introduction

Banking crises have frequently contributed to the outbreak of sovereign debt crises

in emerging market economies (Reinhart and Rogoff, 2011a, 2013). By increasing

public debt levels, damaging the real economy and deteriorating sovereign liquidity,

banking sector distress typically increases sovereign default risk. In periods of

banking sector distress, the incumbent government can make political decisions to

reduce the transfer of default risk from the banking sector to the sovereign such as

restructuring and recapitalization of the banking sector, fiscal consolidation

measures, or economic reform packages.

The present paper considers the role of political factors for determining the

impact of banking sector distress on sovereign bond yield spreads. Using annual

panel data on 19 emerging market economies in the period 1994–2013, I find that—

on average—sovereign bond yield spreads significantly increase during periods of

banking sector distress. This sovereign solvency deteriorating effect of banking

sector distress is however heterogeneous across countries with different political

environments. Using interaction models, I identify several political conditions,

which make this sovereign solvency deteriorating effect of banking sector distress

less pronounced or even insignificant.

The results suggest that in countries where the government has a high degree of

political power (i.e. where the government holds a large majority in the parliament

and is constrained by a low number of checks within the political system), banking

sector distress has a less disastrous impact on sovereign solvency. Investors appear

to anticipate that powerful governments are better able to implement unpopular

but potentially necessary decisions such as nationalization of banks or the

implementation of austerity budgets. Moreover, high government effectiveness is

associated with a lower bank risk–sovereign risk transfer suggesting effective crisis

*Eichler (Corresponding author): Leibniz University Hannover, Institute of Money and International

Finance, Hannover, Germany. Tel.: +49-511-7624551; Fax: +49-511-7624796; E-mail: eichler@gif.uni-

hannover.de. Also affiliated to the Department of Financial Markets, Halle Institute for Economic

Research, Halle, Germany.

Review of Development Economics, 21(3), 451–474, 2017

DOI:10.1111/rode.12274

©2016 John Wiley & Sons Ltd

management. Political instability may reduce the government’s credibility and may

therefore lead to more pronounced banking crisis induced increases in sovereign

bond yield spreads. Moreover, I find evidence for an electoral cycle where the bank

risk–sovereign risk transfer is more intense during pre-election and election years.

A large body of literature has examined the determinants of sovereign risk

focusing either on actual sovereign default episodes (Cuadra and Sapriza, 2008;

Hatchondo et al., 2009; Manasse and Roubini, 2009; Saiegh, 2009; Van Rijckeghem

and Weder, 2009; Kohlscheen, 2010; Reinhart and Rogoff, 2011a,b; Jorra, 2012) or

on sovereign bond yield spreads (Edwards, 1986; Cantor and Packer, 1996; Mauro

et al., 2002; Block and Vaaler, 2004; Vaaler et al., 2005; Baldacci et al., 2008;

Dailami et al., 2008; Hilscher and Nosbusch, 2010; Bellas et al., 2011; Faria et al.,

2011; Knedlik and von Schweinitz, 2012; Eichler and Hofmann, 2013; G

omez-Puig

and Sosvilla-Rivero, 2013, 2014; Eichler, 2014; G

omez-Puig et al., 2014). The list of

variables that these studies identify as important drivers of sovereign default risk

includes, for example, high levels of public debt, poor macroeconomic

fundamentals, shortages of foreign exchange reserves and global risk factors.

Some of these papers have focused on the relevance of political factors for

determining sovereign default risk. Van Rijckeghem and Weder (2009) find that, in

democracies, checks and balances and a parliamentary system can reduce the risk of

external sovereign debt defaults if the economic fundamentals a re strong. In non-

democratic systems, the risk of defaults on domestic sovereign debt is low if the political

environment is characterized by a high degree of stability, a low degree of polarization,

or long tenure. Kohlscheen (2010) finds that in parliamentary democracies, where

governments need the support of the legislature to stay in office, the government will

less likely default on external debt than in presidential democracies. Moreover, he finds

that sovereign defaults are less probable for multi-party governments, lower turnover of

the executive, effective checks and balances, and at the end of presidential office terms.

Saiegh (2009) finds that multi-party governments are less likely to default on sovereign

debt than single-party governments. Cuadra and Sapriza (2008) show that higher

degrees of political stability reduces the discount factor of the current government and

the incentive to shift future resources to the present by increasing public debt. In result,

Cuadra and Sapriza (2008) demonstrate political stability reduces sovereign default risk.

Bellas et al. (2011) find that higher levels of political risk increase sovereign bond yield

spreads in the long run, but not in the short run.

Manasse and Roubini (2009) provide evidence of a political business cycle,

finding that the risk of sovereign debt defaults increases prior to presidential

elections, particularly if elections coincide with large amounts of short-term debt

and rigid exchange rate regimes. Block and Vaaler (2004) analyze the impact of the

political business cycle on sovereign yield spreads and ratings. They find that

sovereign credit ratings are downgraded in election years and that sovereign yield

spreads are higher before elections than after elections. Hatchondo et al. (2009)

show that if the incumbent government is perceived to be creditor friendly,

sovereign bond yield spreads may increase prior to elections if investors fear that it

may be replaced by a debtor friendly government that may trigger sovereign

default. Vaaler et al. (2005) investigate the role of ideological differences for

determining sovereign bond yield spreads. They find that investors perceive higher

(lower) sovereign default risk if a right (left) government is more likely to be

elected out of office. Eichler (2014) finds that emerging markets with presidential

regimes (as opposed to parliamentary regimes), high degrees of political stability

and powerful governments suffer less under high sovereign bond spreads. These

452 Stefan Eichler

©2016 John Wiley & Sons Ltd