Abstract
This study examines the proposition that political business cycle theory is relevant to private foreign lenders to developing countries. We find that: credit rating agencies downgrade developing country ratings more often in election years, and do so by approximately one rating level; bond spreads are higher in the 60 days before an election compared to spreads in the 60 days after an election; spreads trend significantly downward in the 60 days before an election, but then flatten out in the 60 days after an election. Agencies and bondholders view elections negatively, increasing the cost of capital to developing democracies.
Highlights
This empirical study examines links between the possibility of political business cycles in developing countries and the behavior of actors involved in allocating and pricing credit for investment and economic development
Across different model specifications and sub-sample analyses, we consistently find that election years are significantly correlated with lower sovereign risk ratings from the agencies
Spreads increase significantly after elections compared to the pre-election trend, this finding is significant at the p < .10 level and this finding is sensitive to the length of the pre- and post-election period used
Summary
This empirical study examines links between the possibility of political business cycles in developing countries and the behavior of actors involved in allocating and pricing credit for investment and economic development. Evidence of PBCs in industrialized countries is mixed, but a more recent stream of empirical work focusing on nonindustrialized countries suggests that the onset and aftermath of elections is correlated with fiscal, monetary and or related policies consistent with incumbent aims of retaining office even if such policies are contrary to concurrent economic reform programs and potentially prejudicial to post-election economic growth and development This mounting evidence may have important implications for foreign investment and lending, and the private, often foreign-based actors facilitating such transactions. The fundamental proposition of our study is that the incumbent behaviors predicted by PBC theory during election periods matter to domestic constituencies and to foreign actors including agencies and investors Both are assessing the creditworthiness of developing countries in and around elections. The paper concludes with suggestions for future research extending PBC theory to other relationships linking developing country political factors to the broader international financial system
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