Ethnic politics and sovereign credit risk

Abstract

How does domestic politics affect sovereign credit risk? To date, scholars have largely focused on how economic interests along class-cleavages influence sovereign default risk and borrowing costs. Ethnic dynamics are another important political factor that explains governments’ creditworthiness, yet are understudied. We investigate how ethnic politics shape governments’ credit access and argue that the fiscal incentives generated by ethnic coalitions influence credit risk differently than those created by class cleavages. Because ethnic coalitions are usually smaller than class coalitions, left governments with ethnic support can commit to lower spending and receive more favorable risk assessments. Right governments that rely on ethnic support, however, will have greater spending demands because of their need to satisfy ethnic groups. We test our argument using a new indicator of government ethnic support and four indicators of sovereign credit risk. We find that, in emerging markets, the borrowing costs of right governments increase as they become more dependent on ethnic groups for political support. Our findings suggest that financial markets are attuned to multiple dimensions of domestic politics and demonstrate that ethnic divisions can have strong implications for governments’ access to credit.