The Moderating Effect of Bureaucratic Quality on the Pricing of Policy Instability

Abstract

We examine how policy instability is priced in interest rates. Policy instability refers to the likelihood that the current policy will be changed in the future in the absence of political power shifts. Chinese government’s experimental policymaking approach provides an ideal set of frequent policy flip-flops which allows us to identify the effect of policy changes. Conditional on the bureaucratic quality of policymaking, a good-quality policy reversal is related to reductions in interest rate term spread and volatility; a bad-quality policy reversal is related to increases in the spread and volatility. The bureaucratic quality is multi-dimensional and the moderating effect is stronger on interest rates when it is measured more precisely.