Sovereign Risk and Government Change: Elections,Ideology and Experience

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 investors 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 financing 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 performance enables investors to make increasingly precise estimates of political risk. Volatility has implications for the real economy, as well as for governments’ 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.