The Impact of Fiscal Variables on Risk Premiums in Central and Eastern European Countries

Theory suggests that as long as a country runs a balanced budget regime, there is no linkage between fiscal variables and the interest rates. In the case of fiscal expansion that is not sufficiently covered by government revenues, however, the government has two options to finance its deficit: printing money or additional borrowing. Both options lead to an increase in the risk premia on government bonds. One strand of literature focuses on a currency crisis that emerges as a necessary outcome in light of contradictions between fixed exchange rate, and fiscal and financial fundamentals. If government bonds are denominated in domestic currency, the government can reduce their real value by higher inflation or by devaluation of the national currency. In order to bear this risk foreign investors require a currency risk premium. Governments can eliminate the risk of currency devaluation by issuing bonds denominated in foreign currencies, but the default risk remains and it depends on public finances. Another strand of the literature looks at the relation between fiscal variables and government bond yields in the framework of portfolio balance model.