Fiscal institutions, fiscal policy and sovereign risk premia in EMU

Abstract

We investigate the effect of fiscal institutions such as the strength of the finance minister in the budget process and deficits on interest rate spreads of Eurozone countries. Deficits significantly increase risk premia measured by relative swap spreads. The effect of deficits is significantly lower under EMU. This effect partly results from neglecting the role of fiscal institutions. After controlling for institutional changes, fiscal policy remains a significant determinant of risk premia in EMU. Better institutions are connected with lower risk premia. Furthermore deficits matter less for risk premia in countries with better institutions. Markets acknowledge that better institutions reduce fiscal difficulties rendering the monitoring of annual developments less important. © 2008 Springer Science+Business Media, LLC.