The focus of the book
Towards a political economy approach to sovereign risk perceptions
In the academic literature, sovereign risk perceptions have been analysed from numerous different perspectives and within the context of different disciplines, including economics, finance, international political economy and international relations. Equivalent concepts are sometimes given different names according to the branch of literature concerned, but in reality they represent essentially the same issue approached from different angles. Thus, in the international political economy literature, we find an important group of authors concerned with the analysis of the constraints imposed on sovereign borrowers and their policies by internationally mobile global capital. In another branch of the international political economy and economic history literature, we find authors looking at the "credibility" of sovereign borrowers in financial markets. In the economics and European political economy literature, we find authors studying financial markets' "disciplining" role towards government borrowers. Finally, the finance literature refers more directly to the market pricing of bond spreads and the various components driving these. This book is explicitly designed to reflect the breadth of these approaches and denominations, drawing from each of them as necessary to add value to the analysis, rather than being constrained by the "silos" created by the separation of academic disciplines. The unfolding of the Eurozone sovereign debt crisis, and, broadly, the re-emergence of sovereign risk as an issue for the region's economies, provided the empirical inspiration for this study. Moreover, a review of the literature on sovereign risk perceptions reinforced the motivation for choosing to focus on developed democracies rather than on emerging markets. The existing studies were highly concentrated on emerging markets, while sovereign risk perceptions in developed democracies, and Eurozone countries in particular, had been much less investigated. The finance literature produced quantitative and technical studies of the determinants of bond yields in advanced economies, but these were generally concerned with factors other than credit risk (interest rate risk, liquidity risk, international risk aversion). A few studies looking at the evolution of Eurozone government bond yields before and after the creation of the monetary union had engaged with issues of credit risk, but these left many questions open, partly because of the young and evolving nature of the monetary union. Meanwhile, the economics and political economy literature had generally analysed sovereign risk perceptions within the context of emerging markets. Overall, sovereign risk perceptions in developed democracies in general, and in the Eurozone in particular, emerged both as an insufficiently studied phenomenon and as a highly relevant theme for both positive and normative purposes.
Sovereign risk and sovereign debt crisis are very complex phenomena, spanning economic, financial, political and behavioural domains. In this context, we need to consider the essential nature of sovereign risk itself and ask ourselves: What is it that specifically identifies sovereign risk and differentiates it from other forms of credit risk? We can find the answer in the seminal paper on the study of sovereign debt itself, in the international economics field, by Eaton et al. (1986). Eminent economists here highlight its political nature as the defining feature of sovereign debt. In contrast to private debtors, sovereign borrowers cannot be coerced to make good on their commitments, due to the lack of enforcement mechanisms. So, they argue, for a sovereign borrower, "willingness to pay" can determine default decisions long before its "ability to pay" becomes binding. Reinhart and Rogoff also find that "most country defaults happen long before a nation literally runs out of resources" (2009, p. 51). Thus, sovereign default is essentially a political decision rather than a purely economic determination, implying that government creditworthiness, or sovereign risk, needs to be assessed on political at least as much as on economic grounds. However, there is a disconnect between the theoretically recognised importance of political factors in the determination of sovereign creditworthiness and the relatively limited room afforded to political factors by the empirical literature on sovereign risk. Caouette, Altman and Narayanan (2001) argue that the lack of inclusion of political and political economy variables in traditional approaches to sovereign risk analysis is due to the greater difficulty of measuring these. Moreover, we found that the vast majority of studies looking at the role of political factors in driving sovereign risk perceptions are focused on emerging markets, a finding consistent with the greater focus on emerging markets in sovereign risk analysis overall. A branch of the literature focuses on the role of political institutions in early modern Europe. However, only limited analysis has been applied to contemporary developed democracies, either within or outside the Eurozone. The existing literature relating political factors to financial market performance focuses on political processes, such as elections, referenda and cabinet formation, rather than on institutional and societal factors (see, for example, Bernhard and Leblang, 2006b). Mosley (2003), the key reference in this area in international political economy, provides a comprehensive empirical analysis of interest rates on government bonds across the world, relying on a strong distinction between developed democracies and emerging markets. In her study of bond markets between 1981 and 1997, she finds that, while investors in emerging markets consider a broad set of variables, including political factors, when pricing sovereign debt, investors in developed democracies focus on a limited number of macro-shortcuts to inform their country choices, with minor interest in the direct observation of political factors.19 Mosley's arguments are based on time-dependent empirical evidence gathered in a specific historical period. Thus, her findings do not rule out the possibility that political and political economy factors may indeed be found to matter in investor choices in developed democracies in different institutional and historical circumstances, and particularly in episodes of fiscal stress.