Credit Ratings and Firm Innovation: Evidence from Sovereign Downgrades

Abstract

This study investigates how credit ratings affect firm innovation. By exploiting sovereign downgrades as an exogenous shock to corporate credit ratings, we show that a sovereign downgrade leads to significant reductions in innovation among firms that have a rating at the sovereign bound ex ante. The effect is concentrated in firms with high external finance dependence. Also, we identify the shift in debt choice towards bank loans and the increase in creditor control as potential channels of the causal relation. Further evidence suggests that firms are more likely to acquire innovative targets to mitigate the decline in innovativeness following downgrades.