Policy Research Working Paper10741The Sovereign Spread Compressing Effect of Fiscal Rules during Global CrisesErgys IslamajAgustin Samano PenalozaScott SommersDevelopment Economics Development Research GroupMarch 2024 A verified reproducibility package for this paper is available at http://reproducibility.worldbank.org, click here for direct access. Public Disclosure AuthorizedPublic Disclosure AuthorizedPublic Disclosure AuthorizedPublic Disclosure Authorized Produced by the Research Support TeamAbstractThe Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent.Policy Research Working Paper 10741Do fiscal rules help suppress sovereign spreads during periods of global financial stress? Yes! This paper exam-ines whether fiscal rules contribute to mitigating sovereign spreads in emerging markets and developing economies during periods of heightened financial and economic vol-atility worldwide. It finds that the presence of fiscal rules is statistically significantly associated with lower sover-eign spreads during the COVID-19 crisis—about 350 basis points lower on average. Interestingly, this correla-tion persists even when nations deviate from these rules, indicating an expectation of post-crisis compliance. The study shows that deviations from fiscal rules are typically short-lived, with fiscal balance rules reinstated within 3.5 years. Robustness checks, including controls for institu-tional quality, fiscal rule strength, and global and regional factors confirm these results. Overall, the findings suggest that fiscal rules can help emerging markets and developing economies signal fiscal responsibility during episodes of global financial stress, reducing borrowing costs relative to countries without fiscal rules.This paper is a product of the Development Research Group, Development Economics. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://www.worldbank.org/prwp. The authors may be contacted at eislamaj@worldbank.org; asamanopenaloza@worldbank.org; and somme450@umn.edu. A verified reproducibility package for this paper is available at http://reproducibility.worldbank.org, click here for direct access. POLICY RESEARCH WORKING PAPERSTRANSPARENTANALYSIS The Sovereign Spread Compressing Effect of Fiscal Rules during Global Crises Ergys Islamaj* Agustin Samano Penaloza† Scott Sommers‡Keywords: fiscal rules, sovereign spreads, Covid-19 crisis JEL classification: F34, F41 _____________________________ The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the World Bank Group, its Executive Directors, or the governments they represent. We are particularly thankful to Aaditya Mattoo for all his support. For helpful comments, we thank Roman Acosta, Francisco Bullano, Carlos Esquivel, Sergio L. Schmukler, Kurt See, as well as conference participants at the Workshop of the Australasian Macroeconomics Society, Kuala Lumpur, Malaysia for helpful comments and discussions. Any remaining errors are our own. * The World Bank Development Prospects Group, East Asia and Pacific Chief Economist Office, Washington, D.C.; Email: eislamaj@worldbank.org† The World Bank Research Department, East Asia and Pacific Chief Economist Research Center, Kuala Lumpur, Malaysia; Email: asamanopenaloza@worldbank.org; Web: http://www.agustinsamano.com/‡ Department of Economics, University of Minnesota. Email: somme450@umn.edu; Web:http://sites.google.com/view/scottsommers/ 2 1.IntroductionSovereign spreads rose rapidly in emerging markets and developing economies (EMDEs) at the onset of the Covid-19 pandemic, a period during which governments faced rising borrowing costs and fiscal expansion needs, albeit at varying degree across countries. We empirically investigate whether the existence of a fiscal rule was associated with lower or higher sovereign spreads in EMDEs during the recent Covid-19 pandemic shock.1 In theory, the relation between the existence of a fiscal rule and sovereign spreads during economic downturns is ambiguous. On the one hand, fiscal r