Sovereign default risk and decentralization: Evidence for emerging markets

We study the impact of decentralization on sovereign default risk. Theory predicts that decentralization deteriorates fiscal discipline since subnational governments undertax/overspend, anticipating that, in the case of overindebtedness, the federal government will bail them out. We analyze whether investors account for this common pool problem by attaching higher sovereign yield spreads to more decentralized countries. Using panel data on up to 30 emerging markets in the period 1993–2008 we confirm this hypothesis. Higher levels of fiscal and political decentralization increase sovereign default risk. Moreover, higher levels of intergovernmental transfers and a larger number of veto players aggravate the common pool problem.