Democracy's positive impact on developing countries and their sovereign bonds


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By Marshall L. Stocker, Ph.D., CFADirector of Country Research and Portfolio Manager, Eaton Vance Management

London - Economic policy has an empirically documented relationship to asset prices. For example, sovereign bonds of economically "free" countries typically have higher credit ratings and much tighter yield spreads than those of countries where economic policy is much less liberal.1

So what are the determinants, the precedent conditions, to economic policy change? To find out, we researched the relationship between a country's political institutions and its future economic policy changes. This entailed regressing various political institution variables against data from the Fraser Institute's Economic Freedom of the World (EFW) Index, which ranks more than 150 countries on a standardised economic freedom measure, ranging from 0 (least free, i.e. very illiberal economic policy) to 10 (most free, i.e., "ideal" economic policy). These scores can be understood as the ability, in a particular country, to produce, trade and consume any goods and services acquired without the use of force, fraud or theft.

We found that a country's political institutions do explain how likely a country is to increase its level of economic freedom or to reverse an already high level of economic freedom. Specifically, we found that:

  • Prior to the turn of the 21st century, high levels of democracy correlated to increases in economic freedom across all countries.
  • Since then (2000-2017), democracy has continued to play a positive role in low economic freedom countries such as emerging markets, correlating to future increases in economic freedom.
  • However, in the period 2000-2017, in countries that have already achieved a high level of economic freedom, the role of democracy is either indifferent or antagonistic (e.g., democracy facilitating illiberal economic policy).
  • Civil liberties (freedom for the individual) appear to be consistently related to improvements in economic freedom among both higher and lower economic freedom countries.

In our view, it may be the case that economic freedom, a liberty for the individual, eventually conflicts with democracy, the rule of the simple majority, while civil liberty applies to every individual. Further research that describes democracy as distinct from individual liberty may provide insights.

Bottom line: Democracy typically helps poorer economies improve their economic institutions, which in turn, fosters beneficial socio-economic changes and (all else equal) asset price gains. However, among countries that already have relatively sound economic institutions, democracy can facilitate the loss of economic liberalism; intensifying the redistribution of resources and extracting economic rents from various groups.

1 Stocker, M. "Emerging markets debt: Determinants of sovereign bond quality and returns", September 2019. This paper published findings of a regression model showing a strong correlation between the orientation of economic policy, as measured by the Fraser Institute's Economic Freedom of the World Index dataset, and Moody's ratings. It found economic freedom to be the most important determinant of sovereign bond quality and yield spreads.