Determinants of government bond spreads in European transition economies and implications for small and medium enterprises

Abstract

Given the need for transition economies to finance some of the investment required for development through borrowing, this paper empirically examines the determinants of government bond spreads, focusing on institutional quality as a contextual dimension. The literature generally assumes that market assessments of sovereign risk - i.e., the probability of default - and hence the cost of sovereign borrowing over the risk-free rate are based on the borrower’s macroeconomic fundamentals, solvency, and liquidity indicators related to fiscal and financial variables, and indicators of external financial market volatility. Using fixed effect estimation, our findings suggest that government bond spreads in European transition economies are sensitive to domestic macroeconomic fundamentals and global financial market volatility. From macroeconomic fundamentals, fiscal deficit levels, inflation rates, and countries’ effective exchange rates emerge as the leading indicators determining bond spreads over the observed period. Moreover, our results suggest that financial markets consider the quality of institutions when assessing default probabilities; hence, the potential risks arising from the quality of institutions are factored into the cost of sovereign borrowing. These results are robust to various extensions and robustness tests.