Institutions, Partisanship and Credibility in Global Financial Markets

Hye Jee Cho

• Publisher: Routledge
• Year: 2017
• ISBN:
  9781315445021
• Edition: 1
• Topic: Politik & Internationale Beziehungen
• Subtopic: Globalisierung

Increasingly integrated global financial markets have been shaken by a series of severe shocks in recent decades, from Mexico's Tequila crisis to the upheavals in the Eurozone. These crises have demonstrated that signs of uncertain local economic and political conditions can result in market fluctuations which in turn cause economic, social, and political instability. Such instability is particularly severe for developing countries that rely heavily on international financial markets for their financial needs. Building credibility in these markets is therefore important for national governments who wish to prevent market panic and capital flight and, ultimately, to achieve stable economic growth.

Earlier studies have argued that institutional arrangements that constrain governments and commit them to protecting private property rights and market-friendly policies can send a strong positive signal to the markets about a given country's sovereign credibility. This book argues, however, that the market perception of such credibility-building institutions is significantly contingent on which party governs the country. Formal institutions confer significant credibility-building effects on left-wing governments, whereas less or no significant effects are enjoyed by right-wing governments. And beyond that, any significant changes in a country's institutional landscape—such as a breakdown of democracy or joining an international organization that can influence domestic politics—have particularly strong impact on the credibility of left-wing governments. This argument is supported by a quantitative analysis of sovereign credit ratings data collected from around 90 developing countries from 1980 to 2007, by case studies from South Asia, Eastern Europe and Latin America, and by face-to-face interviews with 24 financial market experts based in Hong Kong, Seoul, and Paris.

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Institutions, partisanship and market perceptions

What are the consequences for a country that loses the confidence of international credit markets? A series of severe shocks – from Mexico’s Tequila Crisis to the recent Eurozone upheavals that have shaken markets around the world – have demonstrated that confidence lies at the very heart of international financial relations. Market confidence builds on policy credibility and predictability. Policy certainty is of critical importance in assuring investors. Increasingly, international investment has drastically diversified investors’ country allocations so that local market fluctuations can now affect many countries at once, creating larger-scale market instability. Signs of economic or political uncertainty may result in massive asset sell-offs and financial market fluctuations, which in turn can cause economic, social, and political instability. The costs of market instability are particularly high for developing countries that rely heavily on international finance. Building credibility in international markets is thus an important task for national governments wishing to discourage capital flight and, ultimately, to achieve stable economic growth.

A key question for many cash-strapped developing countries is how to improve their creditworthiness in international financial markets. The extant literature has argued that political institutions that constrain governments, and thus work as a commitment mechanism, encourage investment. However, two important issues have been largely neglected in the literature. First, the markets’ perception of the effectiveness of such institutions in fact depends crucially on the important domestic political environment – that is, which party governs the country. Furthermore, any significant changes in a country’s institutional landscape – such as a breakdown of democracy or joining an international organization that influences domestic politics – are likely to have a significant impact on investor perceptions.

In this book, I address these important yet largely neglected questions by focusing on sovereign credibility – that is, a country’s perceived ability and willingness to repay its sovereign debt. I argue that embracing institutional constraints has strong positive credibility-building effects for left-leaning governments while such effects are not likely to be significant for right-leaning governments.¹ Moreover, any significant changes in a country’s institutional arrangements are likely to have greater impact on the credibility of left-wing governments.

This book specifically examines the “brand name” effect of government partisanship on market perceptions – that is, how a party’s label affects markets’ perception of the party when other important economic and political conditions are taken into consideration. The discussion will focus on perception, as investor confidence essentially builds on perceived risks and credibility. Perception is critical in international financial markets because it is an important determinant of market behavior and a major cause of contagion, whereby shocks propagate internationally, transcending their fundamental commonalities driven and exacerbated by investors’ herding behavior (Obsfelt 1996; Pericoli and Sbracia 2003; Radelet and Sachs 1998).

Investors’ perceptions of governments they regard as left-oriented are typically not favorable. Investors tend to associate them with higher inflation rates and larger public sectors, more expropriation risk, and less respect for debt obligations. They thus see such governments as less credible when it comes to prudent macroeconomic policies (Broz 2013; Broz and Weymouth 2013; Garrett 1998; Leblang 2002; Mosley 2003; Vaaler et al. 2005, 2006). This perception is largely due to the historical association between leftist governments and anti-market policies. Even today, the World Bank reports that the governments in the developing world that are classified as left-wing do indeed tend to expropriate private assets more often (MIGA 2013: 48). Extreme measures such as expropriation may have become less frequent over the years, but the policy risk that a government may suddenly change rules, regulations, and investment contracts still remains significant in many countries (Henisz and Zelner 2010; Sobel 2002).

The consequence of such negative market perceptions of left-wing governments is that even when political and economic conditions are controlled for, left-wing governments suffer stigma or a brand name effect whereby they receive a biased reaction in the markets, regardless of their stated intentions and actual policies. Although left-wing parties are not always market-averse or committed to expansionary policies, investors fear that they may behave opportunistically for political purposes.² As a result, investors are typically guarded and suspect left-wing parties of being less market-friendly than those farther to the right. It is indeed common to hear news reports that the election of a left-wing political leader has led to a drop in market indicators. Such concerns are particularly acute for investors in developing countries due to the greater policy uncertainty they face, the history of sovereign default and expropriations in such economies, and greater macroeconomic volatility overall (Bergoeing et al. 2004; Brooks and Mosley 2007; Broz 2013; Caballero and Krishnamurthy 2005; Gavin and Perotti 1997; Kaminsky et al. 2004; Lane 2003; Loayza et al. 2007; Mendoza 1991).

Holding such reservations about left-wing governments is rational for investors, who will tend to respond to information asymmetry and high information acquisition costs by using partisanship as an important shortcut for assessing the political environment (Broz and Weymouth 2013; Leblang 2002; Mosley 2003). Bankers and institutional investors may make more educated guesses about government policy than the general public, but it is still costly and time-consuming for them to unravel all of the aspects of the complex public policy issues facing the various governments in their portfolios (Brooks and Mosley 2007; Tomz 2007). Furthermore, investors are increasingly diversifying their portfolios to minimize risk, and have thus lost the incentive to gather costly information on individual countries (Calvo and Mendoza 2000: 102; Santiso 2003: 19). Political parties serve as labels that foreign investors use to anticipate the future course of government policy, and left-wing governments have to make extra efforts to establish their credibility in global markets.

In this context, the presence of domestic political and international institutions that constrain a country’s political leadership from making arbitrary policy changes, and that make the future direction of policy more predictable, can send a strong positive signal to markets about the policy contents and future course of policy at the most fundamental level. I argue that such institutional constraints are likely to work as a contingent signal, so that they have a lesser effect on right-wing governments. Such governments are perceived as supportive of the business owners and capitalists who are their core supporters. They are perceived to oppose inflation and high taxes, and be more business- and market-friendly overall (Broz and Weymouth 2013; Hibbs 1977; MacRae 1977; Nordhaus 1975). They are not likely to be as threatening to investors as left-wing governments when other things are equal, as there is an expectation that property rights are more likely to be protected under right-wing governments than under left-wing governments (Broz and Weymouth 2013). Institutional constraints are therefore not as likely to be considered important with a right-wing government. Similarly, any significant changes in a country’s institutional arrangements should have greater signaling effects on the credibility of left-wing governments than on their right-wing counterparts.

The argument that left-wing governments benefit more from constraining institutions is in accordance with the idea of “Nixon goes to China.” This phrase, originally from the visit to China by a hardline anticommunist US President Nixon, has been used in the political science literature to describe a situation in which the policy proposals of a politician gain greater support when there is a greater perceived mismatch between the ideological position of the politician and the proposed policy (Cowen and Sutter 1998; Cukierman and Tommasi 1998). Because markets tend to perceive left-wing governments in the developing world to be more prone to expropriation, inflation, and populism³ that often circumvents democratic rules, governments that are labeled as leftist can earn greater credibility by submitting themselves to institutional constraints designed to restrain unpredictable behaviors and protect private property rights.

The idea of Nixon-going-to-China in the political science literature has been confined to the domestic political settings rather than the international political economic context. The core of the idea, however, lies in perception, which is essential for understanding the behavior of international financial markets. The interactions between governments and investors are not much different in nature than those between governments and the general public, because investors also face significant information asymmetry and follow ideological clues in making decisions. Investors face significant difficulties in ascertaining governments’ policy directions and preferences, particularly in developing countries (Mosley 2003; Santiso 2003; Tomz 2007). The domestic public may in fact have more local knowledge concerning their governments than foreign investors.

The international political economy literature, however, mainly focuses on the formal and informal institutions that structure collective choices, and surprisingly little attention has been paid to the question of how market perceptions of sovereign credibility are contingent on the dynamics between institutions, institutional change, and government partisanship, which is an important aspect of any domestic political environment.⁴ This is probably inappropriate, as political parties are ubiquitous in real-world politics and have obvious influence over national and international policy choices. Moreover, previous studies that consider political parties in the literature focus on how institutions influence or shape their policies and behaviors to result in different economic outcomes.⁵ These studies therefore neglect to address the dynamics of institutions and government partisanship in influencing market perception when other factors are taken into consideration.

Party labels serve as a powerful signal and information shortcut for the markets. Furthermore, investors tend to exhibit a negativity bias – that is, they tend to react more sharply to what they consider to be a negative event than to a positive one (Akhtar et al. 2011; Baumeister et al. 2001; Peeters and Czapinski 1990). The markets’ perceptions of a political party, combined with such a bias, have a substantial and significant effect on market behavior, which has become an important consideration in current international market environment. Highly diversified and very complex financial markets discourage costly information gathering by investors and force them to rely considerably on risk perceptions based on information shortcuts and other investors’ decisions (Bikhchandani and Sharma 2000; Gray 2013; Jegadeesh and Kim 2010). This reliance on perception has significant consequences, as it affects asset prices and may contribute to increased market volatility or even disruption.

The findings in this book suggest that credibility-enhancing institutions indeed send contingent signals to the markets so that they improve the sovereign credibility of left-leaning governments, whereas no such effects are found for right-leaning governments. Any negative development in institutional arrangements tends to have greater adverse effects on the credibility of left-wing governments than that of right-leaning governments. In the context that markets behave rationally to minimize costs given policy uncertainty, the brand name effects of a political party can be very influential. Brand name effects persist even when other important economic and political conditions are taken into consideration. The financial market experts interviewed for this study consistently noted that a political leader’s party identity is very important for predicting the policy directions of a country and therefore developing investment strategies.

This book focuses primarily on formal institutions and their utility as an important signal in international financial markets. Recently, much attention has been paid to informal institutions such as norms, unwritten rules, and relational contracting practices as important influences on economic outcomes (Helmke and Levitsky 2004). It has been suggested that they shape political and economic outcomes by complementing or even substituting formal institutions (Helmke and Levitsky 2004). Some scholars even contend that so-called “best-practice” formal institutions, such as the court system and the rule of law that are designed to protect contractual and private property rights, incur high costs to build and maintain in developing countries (Dixit 2004; Rodrik 2008). Therefore, they argue, best-practice institutions can actually prevent developing countries from achieving reform and economic development, or at least require higher costs and efforts.

The findings in this book suggest, however, that formal institutions in fact play an important role by sending signals to the markets about sovereign credibility. Although informal institutions may complement or substitute for formal institutions, they cannot replace formal institutions as a fundamental solution (Helmke and Levitsky 2004: 731). More importantly, they cannot signal strongly and effectively because they are often not sufficiently visible to outsiders. The signaling effect of informal institutions has received little scholarly attention, probably because measuring their quality and international comparisons are difficult. Foreign investors cannot reliably assess the credibility of a government through its informal institutions. They may strengthen or complement formal institutions, but they cannot send a strong signal to the markets. It is also unclear how informal institutions affect sovereign credibility through their interactions with government partisanship. Brand name effects influence market behavior when future policy is unclear, and formal institutions ultimately work as a more effective commitment device to build credibility.

This book uses the idea of the Nixon hypothesis to explain the market behaviors. Previous findings on the relationship between institutions and financial markets are mixed, possibly because they do not consider that institutions’ credibility-building effects are significantly contingent on the important domestic political condition of who governs.

Market perceptions of the left in developing countries: a lesson from Lula

Sovereign credibility reflects a country’s perceived ability and willingness to repay its sovereign debt, and left-wing governments are often regarded as lacking in both areas. Of course, a party that is labeled left-wing will not necessarily always adhere to expansionary or market-averse policies. Furthermore, the left-wing emphasis on welfare measures, redistribution, and employment may help to address economic inequality and social problems caused by international market integration, which in turn may promote market stability. Regardless of what policies a left-wing party actually pursues, however, a leftist label tends to signal risk to investors, as they suspect that even if a left-wing political leader promises to implement business-friendly policies, he or she may later not hesitate to reverse direction in response to political needs. Leftist political parties therefore bear the burden of being perceived as a greater threat to investment than those further to the right.

Examples of such brand name effects are commonplace, but the case of the former Brazilian president Luiz Inácio Lula da Silva, or Lula, is particularly illuminating. As a founding member of the Workers Party of Brazil, he held and fought for strong left-wing beliefs, but once he became president, he adopted market-friendly policies. To many people, he is a stellar example of a successful left-wing politician who prudently managed the economy to win market confidence. Lula tried to reassure both foreign investors and local businesspeople that he was no radical and that he had in fact moved irrevocably to the center (Institutional Investor, December 2002). He focused on balancing budgets, giving the central bank independence, and promoting trade liberalization – tactics traditionally associated with more conservative, neoliberal politicians.

However, despite his proclamations and the largely market-friendly policy outcomes, there was constant suspicion of his true policy directions throughout his presidency. When Lula was first elected, analysts expected that the incoming administration would initially resist the temptation to boost government spending to stimulate growth, but that in the later years it would probably try to make good on some of the promises that had helped Lula to victory (Institutional Investor, December 2002). Then, with Brazil’s economy lagging behind and growing only around 2 percent a year since Lula was elected, far below the expected growth rate of 6.5 percent for emerging markets, his administration eased spending controls as the new election approached (Financial Times, April 4, 2006). Lula pursued his expansionary policies thanks to high commodity prices and a buoyant international economic environment, but investors again suspected that he was likely to backtrack on the reforms he was pursuing and revert to a labor-friendly “populist” agenda to gain support (Newsweek, August 8, 2005).

Lula’s landslide reelection reignited fears that he might attempt to pursue more populist and interventionist policies at the expense of fiscal austerity, as some powerful members of his Workers Party were urging him to increase government spending dramatically (Globe and Mail, October 31, 2006). For example, when the fiscally orthodox finance minister Antonio Palocci resigned amid a scandal, the Brazilian real fell 2 percent in a day and stocks on the Bovespa exchange fell almost 1 percent out of fear that expansionary policies might follow. The shock persisted for over a month as the total return of J.P. Morgan’s Emerging Market Bond Index (EMBI) declined steadily for the following three months. Such a decline in response to political news is rare (Associated Press, March 28, 2006). The decline was a reaction to possible risks, as commentators doubted the true priorities of Lula’s administration when the government granted a generous pay rise to public employees and increased the minimum wage by an amount significantly above the inflation rate (Financial Times, February 21, 2007). Analysts warned investors of a populist turn in Brazil, suggesting that Lula had in fact not betrayed the poor but rather the promise of growth (Financial Times, April 5, 2006). The market-friendly policies he pursued during his first term could not fully assure investors ...

Table of contents

• Cover
• Title
• Copyright
• Dedication
• Contents
• Acknowledgements
• 1 Institutions, partisanship and market perceptions
• 2 Sovereign credibility in global financial markets
• 3 Leftist party government and perceived creditworthiness
• 4 Democracy and sovereign creditworthiness
• 5 Political constraints and sovereign creditworthiness
• 6 The IMF and sovereign creditworthiness
• 7 Conclusion: partisan politics and credibility in global financial markets
• Appendix 1: Interviews with financial market experts
• Appendix 2.1: Data sources and summary statistics
• Appendix 2.2: Countries in the sample
• Appendix 3: Supplements to Chapter 3
• Appendix 4: Supplements to Chapter 4
• Appendix 5: Supplements to Chapter 5
• Appendix 6: Supplements to Chapter 6
• References
• Index