Sovereign credit ratings and central banks: Why do analysts pay attention to institutions?

Abstract

This paper studies the effect of the governance of modern central banks on the ratings assigned by the credit rating agencies Standard and Poor's and Moody's. Until recently, the rating process was not public. Even still, the factors or precise methodologies used by the agencies remain uncertain and analyst judgment remains important. We argue that, given uncertainty over the future paths of countries, the quality of the central bank governance serves as a useful heuristic for a stable and favorable country trajectory. In particular, the central bank's independence signals that the government is committed to general macroeconomic stability, including debt repayment. Additionally, central bank transparency clarifies who is the principal of the bank and provides information about how the central bank understands the economy and monetary policy. Finally, tensions between the central bank and the government, as reflected by irregular turnover of central bank governors, raise doubts about countries' future prospects. Empirically, we use a variety of models, including mediation analysis, to ensure that the effect we identify stems from the central bank governance itself, as a heuristic for the future paths of countries, and not the central bank's direct contribution to the macroeconomy, as reflected in the available data.

IMF conditionality and central bank independence

“…After the government announced constitutional changes threatening CBI in December 2011, international rating agencies downgraded Hungarian government bonds to junk status. As a result, premia on government bonds increased by almost a 100 basis points, effectively preventing the issuance of new sovereign debt tranches and driving the Orbán administration to the verge of default (Bodea and Hicks, 2018). 5 In addition, enhancing CBI can produce political benefits for a sitting government.…”

“…Furthermore, the IMF has been an active advocate for CBI and even threatens to withdraw from loan commitments to block governments' attempts of undermining CBI (e.g., Johnson, 2016). For example, in 2011, the IMF threatened the Hungarian government to withdraw from its Stand-by Loan Agreement if policymakers were enacting and implementing new central bank legislation aimed at removing CBI (Bodea and Hicks, 2018).…”

“…In fact, there are several practical/pragmatic reasons why the IMF attaches CBI conditions to its loans. First, CBI is a strong signaling device for investors concerning the soundness of future macroeconomic policies (Maxfield, 1997;Polillo and Guillén, 2005;Bodea and Hicks, 2018). Thus, requiring governments to enhance CBI, the IMF envisions to boost confidence among international investors to relief pressure from a country's balance of payments.…”

Biased politicians and independent agencies

“…See https://www.wsj.com/livecoverage/jerome-powell-federal-reserve-senate-confirmation-2017/card/1511884907 and https://money.cnn.com/2017/07/12/news/economy/ yellen-posey-audit-the-fed/index.html 5. The punishment from voters could be reinforced by reduced investment or sovereign credit ratings (Bodea and Hicks, 2018). 6.…”

It's (Almost) Always the Economy: Economic Performance and Political Realignments in Argentina in 2019

“…This resulted in the resignation of central bank's governor, Federico Sturzenegger, who argued that the government's interference in monetary policy was undermining the bank's credibility (Infobae 2018). Tensions between the government and the central bank not only are associated with higher inflation (Beckerman 1995;Binder 2018;Garriga and Rodriguez 2020), but are a bad signal for international markets (Maxfield 1997;Bodea and Hicks 2015b), which normally translates into poor credit rating scores (Bodea and Hicks 2018) and capital flight (Bodea and Hicks 2015a).…”