Sovereign risk: The impact of national numerical fiscal rules

Anna Iara, Guntram Wolff 20 January 2011



The ongoing economic and financial crisis has put public budgets worldwide under extraordinary strain. Large public spending packages designed to support domestic consumption and the financial sector have coincided with sizeable drops of growth and public revenue and resulted in soaring public debt in many countries. In response, the European Commission has come forward with proposals to reform economic governance in the Eurozone and the EU. A legislative proposal to strengthen numerical fiscal rules at the level of the EU member states is an important part of the European Commission proposals of 29 September 2010 and has also been well received in the academic debate (Wyplosz 2010) and several governments in the Eurozone are currently contemplating the introduction of stronger fiscal rules.

Eurozone member states have come under increasing scrutiny from financial markets – as we have seen with increasing government bond yields relative to Germany among Eurozone members recently. Part of the increase in sovereign spreads can be attributed to rising risk aversion, different developments in explicit debt (Schuknecht, von Hagen and Wolswijk 2010), and potential government liabilities related to the banking sector (Gerlach et al. 2010; Ejsing and Lemke 2010). Investors’ expectations regarding the credibility of the commitment of governments to ultimately correct unsustainable fiscal policies could be a further central determinant of sovereign spreads (Hallerberg and Wolff 2008). Moreover, the empirical literature on sovereign bond spreads has established that the price of sovereign risk systematically varies with international credit risk (Favero et al. 1997; Codogno et al. 2003).

New insights from a unique dataset

Going beyond these factors, in our recently published paper (Iara and Wolff 2010), we assess the contribution of rules-based national fiscal governance to containing sovereign bond spreads in the Eurozone. The very role of numerical fiscal rules is to constrain realisations of fiscal outcomes. If effective, they reduce the uncertainty. We argue that this reduction in uncertainty should be particularly relevant when risk aversion is high. We therefore expect fiscal rules to reduce sovereign risk premia in times of high risk aversion specifically.

Our analysis makes use of a unique dataset on rules-based national fiscal governance in EU member states that contains an index measuring the strength of numerical fiscal rules. Information for the dataset is obtained from the EU member states via the Economic Policy Committee attached to the Ecofin Council (the dataset is accessible here). The fiscal rule index summarises information on 5 dimensions describing each fiscal rule in force at the local, sub-national or national level, namely:

  • the statutory base of the rule,
  • room for revising objectives,
  • mechanisms of monitoring compliance with and enforcement of the rule,
  • the existence of pre-defined enforcement mechanisms, and
  • the visibility of the rule in the media.

Figure 1 shows the development of rules-based fiscal governance in the 11 Eurozone members of our sample, as measured by the aggregate fiscal rules index. The strength of the fiscal rules in force in our country of reference, Germany, has been above average and constant at around 7 throughout the period considered. The strength of the numerical fiscal rules in force in the other Eurozone countries ranged between zero (for Greece, that has had no such rule in force) and above 9 for the Netherlands and Spain. Countries with below-average fiscal rule index scores were Ireland, Portugal, and Italy. Remarkable changes for the better occurred in the case of France 2006 and 2008 to 2009, as well as Ireland 2004, while the strength of the fiscal rules deteriorated in Finland after 2007 and in Austria in 2009.

Figure 1. The fiscal rule index in 11 Eurozone members, 1999 to 2009

Source: Iara and Wolff (2010)

The benefits of stricter rules

Our empirical analysis shows that stronger numerical fiscal rules do indeed contribute to lower government bond spreads in periods of higher risk aversion of market participants in particular. Indeed, we find that the benefit of stronger fiscal rules increases with international risk aversion. Figure 2 visualises this relationship. Quantitatively, our results point to significant effects.

Figure 2. Marginal effect of stronger fiscal rules on sovereign bond spreads

Note: The figure shows the marginal effect of fiscal rules on sovereign bond spreads as a function of international risk aversion measured by uscorp. Dotted lines indicate the 95% confidence interval. Source: Iara and Wolff (2010).

In times of high risk aversion, the benefit of stronger national fiscal rules can be sizeable. According to our estimates, if Greece had had a similarly strong set of fiscal rules in place as Germany when risk aversion peaked at a spread of 750 basis points in 2009, risk premia required on Greek bonds would have been 55 basis points lower. For Portugal, yields could have been by up to 50 basis points lower. In contrast, the quality of fiscal rules in Spain contributed to the comparatively low level of sovereign bond yields in Spain in 2009 and might also explain the comparatively good fiscal performance in the years prior to the crisis.

What rules are most important?

Our research also explores the relevance of each of the 5 dimensions measuring the strength of numerical fiscal rules. The strength of the legal base turns out to be the most important dimension for the perceived effectiveness of the rule. The stronger the legal base establishing national fiscal rules (that may vary between mere party coalition agreements and constitutional law), the lower risk premia will be. The enforcement mechanisms of the rules turn out to be important as well, while the nature of the bodies in charge with monitoring compliance with the rules appears to be somewhat less relevant. Our results thus show that rules become more credible to market participants the stronger their binding character is, and the more effectively they can be enforced. Our results point to significant benefits in terms of interest rate cost on public debt.

Overall, our results robustly confirm the significant benefits of stronger national fiscal rules. These rules (and their legal base and enforcement mechanisms specifically) turn out to be highly important for containing sovereign bond spreads in times of elevated market uncertainty in particular. Our results are not impaired by endogeneity concerns; they are robust to the level of aggregation of the data in time, the length of the time period chosen, and the measurement of international risk aversion. Furthermore, they are not flawed by the impact of the financial crisis 2009 and by burdens to public finance resulting from banking liabilities either. Depending on the circumstances, better fiscal rules can reduce sovereign bond spreads between Eurozone member states and Germany by up to 100 basis points according to our estimates.

This article was written by Anna IARA and Guntram B. WOLFF, Directorate-General for Economic and Financial Affairs

© European Union, 2011

The views expressed in this Article are those of the authors and do not necessarily reflect the official position of the European Commission.


Codogno, Lorenzo, Carlo Favero, and Alesssandro Missale (2003), “Yield Spreads on EMU Government Bonds”, Economic Policy, 18(37):503-532.

Ejsing, Jacob, and Wolfgang Lemke (2009), “The Janus-headed salvation: sovereign and bank credit risk premia during 2008-09”, ECB working papers no. 1127.

Favero, Carlo, Francesco Giavazzi, and Luigi Spaventa (1997), “High yields: the spread on German interest rates”, Economic Journal, 107:956-985.

Gerlach, Stefan, Alexander Schulz, and Guntram Wolff (2010), “Banking and sovereign risk in the Eurozone”, CEPR Discussion Paper 7833.

Hallerberg, Mark, and Guntram Wolff (2008), “Fiscal institutions, fiscal policy and sovereign risk premia in EMU”, Public Choice, 136 (3-4):379-396.

Iara, Anna and Guntram Wolff (2010), “Rules and risk in the Eurozone: does rules-based national fiscal governance contain sovereign bond spreads?”, European Commission, European Economy – Economic Papers, 433.

Schuknecht, Ludger, Jürgen von Hagen, and Guido Wolswijk (2010), ”Government bond risk premiums in the EU revisited: the impact of the financial crisis”, ECB working paper 1152.

Wyplosz, Charles (2010), “Eurozone reform: not yet fiscal discipline, but a good start”,, 4 October.



Topics:  EU policies

Tags:  Germany, EU policy, Eurozone crisis

Anna Iara

Economist, D-G Economic and Financial Affairs, European Commission

Guntram Wolff

Director, Bruegel