Sovereign Credit Risk and Government Effectiveness

Abstract

This paper investigates the relation between the effectiveness of a country's government and its creditworthiness. Employing a sample of 75 developed and emerging countries over the 1996-2011 period, we find that more effective government helps reduce sovereign credit risk. This effect strengthens for countries exhibiting severe default risk, high levels of ineffectiveness, and poor economic conditions. We formulate a theoretical explanation for these findings using a structural model of sovereign credit risk in which governments adjust default and debt policies based on their abilities to efficiently collect and use fiscal revenue. The theory posits that countries with more effective governments have less incentive to default and thus benefit from narrower sovereign credit spreads, although they may choose higher levels of indebtedness.