Sovereign Risk and Government Change: Elections, Ideology and Experience

• Author: Sarah M. Brooks,Raphael Cunha,Layna Mosley
• Published date: 01 August 2022
• Date: 01 August 2022
• DOI: http://doi.org/10.1177/00104140211047407
• Subject Matter: Articles

Article

Comparative Political Studies

2022, Vol. 55(9) 1501–1538

© The Author(s) 2022

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DOI: 10.1177/00104140211047407

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Sovereign Risk and

Government Change:

Elections, Ideology and

Experience

Sarah M. Brooks

1

, Raphael Cunha

2

, and

Layna Mosley

3

Abstract

Global capital markets can react dramatically to elections in developing

countries, affecting governments’access to f‌inance and sometimes setting off

broader crises. We argue, contrary to some conventional wisdom, that in-

vestors do not systematically react to the election of left-leaning parties and

candidates. Government ideology is often an imprecise heuristic, given the

diversity in policies among parties, especially those on the left. We therefore

expect that neither elections generally, nor elections that produce specif‌ic

partisan outcomes, are associated with signif‌icant changes in sovereign f‌i-

nancing costs. Yet we also predict that the election of left-leaning parties will

generate volatility in sovereign bond markets, ref‌lecting investors’uncertainty

over future policy outcomes. This volatility is especially pronounced when

new governments take off‌ice; over time, however, government policy per-

formance enables investors to make increasingly precise estimates of political

risk. Volatility has implications for the real economy, as well as for gov-

ernments’ability to manage their debt. We test, and f‌ind support for, our core

expectations using monthly data on sovereign bond spreads and credit default

swap prices for 74 developing countries from 1994–2015.

1

Ohio State University, Columbus, OH, USA

2

Florida State University, Tallahassee, FL, USA

3

Princeton University, Princeton, NJ, USA

Corresponding Author:

Sarah M. Brooks, Department of Political Science, Ohio State University, 2140 Derby Hall,

Columbus, OH 43210, USA.

Email: brooks.317@osu.edu

Keywords

political economy, presidents and executive politics, political parties,

globalization, sovereign debt

In an era of f‌inancial globalization, market responses to elections can dra-

matically affect governments’f‌inancing capabilities, as well as the cost of

capital throughout the economy. Elections may generate uncertainty not only

about who will win, but also about which coalition will govern and which

policies the new government will adopt. In developing and advanced in-

dustrial nations alike, elections have generated foreign exchange speculation

(Bernhard and Leblang, 2006;Eichengreen et al., 1995;Leblang, 2002);

declines in sovereign credit ratings (Block and Vaaler, 2004;Vaaler et al.,

2006); increased spreads on sovereign debt (Mart´

ınez and Santiso, 2003;

Block and Vaaler, 2004;Vaaler et al., 2005); and stock market volatility

(Jensen and Schmith, 2005;Leblang and Mukherjee, 2005). Like broader

macroeconomic volatility and capital f‌light, volatility in government f‌inancing

costs can impose signif‌icant welfare costs on developing countries as gov-

ernment investment and spending are curbed, threatening growth as con-

sumption shocks reverberate through the economy (Loayza et al., 2007;

Pastor, 1990). Market reactions can be particularly notable when elections

result in partisan switches, perhaps implying signif‌icant policy changes

(Sattler, 2013). Left-leaning governments are more likely to defend their

currencies from speculative attacks, while right-leaning governments are

associated with looser bank regulation (Broz, 2013;Walter, 2009). Investors

in government bonds may worry that left governments will raise taxes, inf‌late

the economy or even default on sovereign debt. If these expectations generate

negative market reactions, newly elected governments may be tempted to

reverse their policies, sometimes dramatically.

Yet, even when elections result in partisan switches or victories for left-

leaning governments, they do not always generate negative market reactions.

Indeed, as we demonstrate below, most national elections in developing

countries are not associated with abnormal bond market returns. We therefore

offer a more nuanced assessment of the causal channels through which

elections affect investors’risk assessments. We theorize that government

partisanship is not a consistently useful information shortcut for investors.

Rather, the partisan signal is noisy: there is signif‌icant macroeconomic policy

heterogeneity among left-leaning political parties. As a result, left-leaning

governments will not pay systematically higher borrowing costs than their

right-leaning counterparts.

At the same time, elections and partisan shifts do increase investors’

uncertainty regarding future government policy, especially for newly elected

1502 Comparative Political Studies 55(9)

left-leaning governments. Uncertainty among investors regarding the course

of future policy generates greater volatility in sovereign bond pricing for

newly elected left governments. Volatility can have important consequences

for government debt management, as well as for broader economic outcomes.

As government time in off‌ice increases, investors are better able to form

expectations regarding future policies, and volatility decreases. We test our

claims using data from 74 emerging market countries between 1994 and 2015.

Our analyses, which support our core empirical predictions, further our

understanding of the precise linkages between domestic politics and inter-

national f‌inancial markets.

Markets, Elections and Political Risk

Investors in sovereign debt are closely attuned to default, as well as inf‌lation

and currency, risk (Eaton and Gersovitz, 1981;Eichengreen and Hausmann,

2005;Tomz and Wright, 2013). Although developing countries’access to

capital markets is driven partly by global and regional factors (Brooks et al.,

2015;Gray, 2013;Longstaff et al., 2011;Ballard-Rosa et al., 2021), country-

specif‌ic factors play a central role. When evaluating sovereign risk, investors

consider governments’ability, as well as their willingness, to pay. Ability to

pay typically is associated with macroeconomic fundamentals, including

public debt, current account position, and reserve holdings, as well as with

monetary and f‌iscal institutions (Bodea and Hicks, 2015,Mosley, 2003).

Investors also may reward f‌inancial and economic transparency (Copelovitch

et al., 2018). Willingness to pay, on the other,hand, usual ly is associated with

domestic political institutions. For instance, democratic regime structures may

encourage respect for loan contracts; constrain executive f‌iscal authority,

impose greater audience costs for default, and facilitate greater economic

transparency (e.g., Archer et al., 2007;Beaulieu et al., 2012;Biglaiser and

Staats, 2012;Cox and Saiegh, 2018;Hollyer et al., 2011;North and Weingast,

1989;Stasavage, 2003;Schultz and Weingast, 2003;Tomz and Wright,

2013).

2

Although democratic institutions may assuage investors’concerns re-

garding governments’willingness to pay, elections also affect sovereign risk

assessments. When election outcomes are easy to predict, differences between

candidates generate concerns about future government policies, especially if

they portend partisan switches (Tomz, 2007;McGillivray and Smith, 2008).

This is especially likely when partisan shifts are signif‌icant (Bernhard and

Leblang, 2006;Vaaler et al., 2006); when a country has recently undergone

regime change (Frye, 2010); or when elected off‌icials face few institutional

2. But also see Ballard-Rosa (2016);Ballard-Rosa et al. (2021).

Brooks et al. 1503