Do institutional settings condition the effect of macroprudential policies on sovereign default risk? Cross-country evidence

The European sovereign debt crisis highlights the need to understand the factors driving sovereign credit markets. Post-COVID-19, rising sovereign debt and defaults emphasize the urgency of reviewing macro-level governance and regulatory frameworks. Therefore, this study empirically examines the role of institutional quality (IQ) in conditioning the effectiveness of macroprudential policies (MPPs) in mitigating sovereign default risk (SDR) across 44 advanced economies (AEs) and emerging market economies (EMEs) from 2009 to 2021. The two-step system generalized method of moments (GMM) is employed to investigate the relationship, and the three-stage least squares (3SLS) method is used to test the robustness of the results. The major findings confirm that IQ and MPPs are critical in mitigating SDR. IQ enhances the effectiveness of MPPs in both AEs and EMEs. However, poor IQ in EMEs limits the effectiveness of MPPs. In AEs, governance significantly reduces SDR and complements MPPs, and specific borrower- and institution-targeted instruments are also effective. Conversely, in EMEs, governance has a limited impact, with only selected institution-targeted measures, such as loan restriction, limits to credit growth, limits to loan-to-deposit, and limits on foreign currency, showing effectiveness. These findings emphasize the necessity of improving governance structures in EMEs to enhance the effectiveness of MPPs. Further, standalone MPPs, especially institution-targeted, should be focused in the short-run while governance reforms are pursued to enhance long-run effectiveness of MPPs and IQ in EMEs.