Why institutional constraints matter for sovereign risk

It is a commonplace nowadays that economic institutions – the rules and norms that govern economic relations among different people, firms and governments – matter for key macroeconomic outcomes. Institutions significantly determine the long-term economic growth and prosperity of societies (Acemoglu et al., 2001). Beyond long-term impacts, there are immediate consequences, as is reflected in the practices of credit rating agencies. In some form or other, many of them incorporate measures of institutional development and in particular corruption in their sovereign risk assessments (Panizza, 2017). But why exactly should institutional constraints on politicians and elite members shape macroeconomic stability?

The first channel through which institutions might affect business cycle dynamics is by establishing mechanisms to resolve conflicts among different political groups. A clear separation of powers might help prevent violent disputes and improve contract enforcement. In principle, this could lead to more sustainable policymaking, more predictable private contracting and more efficient investment practices. This mechanism is empirically supported by cross-country evidence: poorer institutional frameworks are associated with more frequent and severe macroeconomic crises (Acemoglu et al., 2003).

The second channel is the accountability of politicians and public authorities. There is a stark difference between developed and emerging economies in the dynamics of government spending and debt. The former group, including countries such as the US and Japan, on average borrow more, default less and demonstrate countercyclical government spending. The latter, including countries such as Argentina and Russia, have lower levels of sovereign debt yet they default more frequently and spend relatively more during economic booms. Novel research argues that loose constraints on politicians in power create incentives to overborrow in order to buy political support (Azzimonti & Mitra, 2026). This mechanism is so strong that it can account for the bulk of the difference in government finance dynamics between the two country groups.

Finally, property rights institutions – those that protect citizens against expropriation by powerful elite members – not only enhance a country’s investment climate but also improve its fiscal capacity. My recent research, based on high-frequency financial market data from Russia in 2008-2011, shows that failures of legal systems to protect minority shareholders triggered an increase in sovereign spreads, reflecting the changing perceptions of sovereign risk by foreign creditors (Kiselev, 2026). A key message is that grand corruption in emerging markets not only raises eyebrows among foreign creditors but also increases the cost of issuing new government debt.

To sum up, the idea that international investors prefer to invest in countries with the rule of law rather than the law of rulers is not only appealing on ethical grounds but is also economically sound. Increasingly, financial market participants pay attention to the integrity of those in power and checks on them when making their investment decisions.

References:

Acemoglu, D., Johnson, S. & Robinson, J. A. (2001). The Colonial Origins of Comparative Development: An Empirical Investigation. The American Economic Review, 91(5).

Acemoglu, D., Johnson, S., Robinson, J. & Thaicharoen, Y. (2003). Institutional causes, macroeconomic symptoms: Volatility, crises and growth. Journal of Monetary Economics, 50(1), 49-123. https://doi.org/10.1016/S0304-3932(02)00208-8

Azzimonti, M. & Mitra, N. (2026). Clientelism, Institutions, and Sovereign Default.

Kiselev, A. (2026). Essays on institutions, information, and markets [European University Institute]. https://doi.org/10.2870/0826483

Panizza, U. (2017). The Use of Corruption Indicators in Sovereign Ratings. Inter-American Development Bank. https://doi.org/10.18235/0000849