FISCAL POLICY AND FINANCIAL MARKETS

We examine the effect of fiscal policy on sovereign risk spreads and investigate whether the interaction of fiscal variables with political institutions affect financial markets. Using panel data from emerging market countries, we find that revenue-based adjustment lowers spreads more than spending-based adjustment. Financial markets also react to the composition of spending. Cuts in current spending lower spreads more than cuts in investment. We show that debt-financed spending increases sovereign risk, while tax-financed spending lowers spreads, suggesting that international investors prefer the latter. Further, we find evidence that financial markets' reaction to fiscal policy depends on political institutions.