Sovereign credit ratings, emerging market risk and financial market volatility

Abstract

Standard-Nutzungsbedingungen:Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden.Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen.Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in IntroductionCredit rating agencies were conspicuous among the many who failed to predict Mexico's economic 1994-95 crisis. While the December 20 devaluation of the peso rocked the world financial markets, until December 22 Standard and Poor's had Mexico's sovereign debt only one step below an investment grade rating with a "positive outlook". TheMexican crisis has thus produced the sentiment that rating agencies react to events rather than anticipating them and raised questions about how seriously investors should take sovereign ratings on developing countries.Our paper aims at broader empirical content for judging whether the two leading rating agencies lead or lag market events with respect to sovereign risk. The evidence will be based on announced as well as implemented ratings of sovereign bonds from the two major rating agencies for up to 49 OECD and non-OECD countries and their impact on yield spreads relative to US treasury bonds and on stock market returns. We go beyond an earlier study (Larrain, Reisen, von Maltzan,1997) by investigating whether credit ratings add to or dampen bond market and emerging stock market volatility.The next section will present a discussion on the potential of the rating industry to attenuate boom-bust cycles with overborrowing in the international capital markets.Section 2 will describe the country sample, the data and the methodology. Section 3 will present the econometric evidence on the interaction of sovereign yield spreads and changes in country ratings. We take three approaches: first, we perform Granger causality tests based on an unbalanced panel data set with yearly observations for the period 1988-95; second, we perform an event study to examine the daily reaction of sovereign yield spreads on rating change announcements and implemented rating changes between 1987 and 1996. For the third approach -also an event study -we use the historical volatility of sovereign bond yield spreads in order to measure country risk perception. Taking into account the strong sensitivity of stock markets towards news, we run the event study likewise for the historical volatility of stock market returns.Section 4 concludes. Sovereign Emerging-Market Risk and the Rating IndustryThe Asian crisis of 1997 and the Mexican crisis of 1994-95 have again demonstrated the vulnerability of emerging-market economies to financial crises associated with the reversal of excessive private capital inflows. The boom-bu...

Politics, Early Warning Systems, and Credit Rating Agencies

“…Second, and complementing the notion that political context is germane to forecasting default or currency crises, is the finding that CRAs have emerged as key intermediaries between investors and recipients of foreign capital (Block and Vaaler 2004, 918). In contrast to previous work that argues CRAs do not adequately signal a crisis but instead only react after the crisis has happened (Larraín, Reisen, and von Maltzan 1997; Reisen and von Maltzan 1998; Reinhart 2002; Reisen 2003; Sy 2003), our findings offer support for the recommendation of the Bank for International Settlements (1999) that CRAs provide a useful regulatory role in assessing the health of sovereign bond markets and ultimately merit inclusion in a global EWS. The inclusion of CRAs is not to suggest that ratings agencies always accurately predict crises.…”

“…While there have been recommendations to use CRAs as a part of EWS, some have questioned not only their effectiveness but also the transparency and accountability of CRAs arguing that they lag the market at best and are dangerous unregulated actors at worst (Larraín et al. 1997; Reisen and von Maltzan 1998; Fight 2001; Reinhart 2002; Reisen 2003; Sy 2003). Our research indicates that CRAs could be helpful in signaling crises and defaults.…”

Global Factors and Emerging Market Spreads*

“…Interestingly, while they note that upgrades occur when markets are rallying and (more visibly) downgrades are affected when they are collapsing, they conclude that ratings are a cause of instability during crises times, acting as a signal that coordinates investors towards a bad equilibrium. Similarly, while Reisen and von Maltzan (1998) find evidence of a two‐way Granger causality for a sample of developed and emerging countries over the 1988–95 period, they conclude, using event studies, that negative rating news elicit a significant impact on spreads.…”

Sovereign credit ratings: Guilty beyond reasonable doubt?

“…Larrain et al (1997) and Reisen and von Maltzan (1998) find that negative announcements significantly raise sovereign bond yield spreads as well as bond and stock market volatility, especially for emerging markets. They also test Granger causality and find a bi-directional causality.…”