Abstract
Abstract It is a matter of debate in how far credit ratings contribute to allocative efficiency or to excessive volatility of asset prices and cross-border capital flows. Yet it is generally taken for granted that ratings play a significant role in the transnationalization of financial relations. This paper tests that hypothesis with data on sovereign credit ratings and foreign portfolio investment. A rating-related gravity model of finance is derived from the choicetheoretical framework of Okawa and van Wincoop (Gravity in International Finance, 2012) and estimated in three stages. At the first stage, the authors find that the introduction and evolution of sovereign ratings since the 1970s has affected inward portfolio investment in host countries. At the second stage, they examine to which extent sovereign ratings help to predict the degree of investors’ home bias, and whether they can account for the divergent dynamics before and after the global financial crisis. At the third stage, the authors look at the explanatory content of ratings for the determination of the size of bilateral portfolio investment. Evidence for a significant role of sovereign ratings is found at all three stages.
Highlights
We look at different categories of rating quality as a set of explanatory factors for the direction and size of foreign portfolio investment: Hypothesis 3, “Size-‐making”: Rating quality serves as a determinant of the size of bilateral portfolio holdings
In the gravity model of finance, we proxy “financial distance” by various indicators derived from sovereign credit ratings, which are described in the results section
Even if conceding to critics that rating signals set by the Credit rating agencies (CRAs) have, to some degree, been misleading, mistimed or otherwise inefficient, it is hardly contested that they contribute to reducing information asymmetries between domestic and foreign financial investors
Summary
The purpose of this paper is to analyse the co-‐evolution of cross-‐border capital flows and credit ratings. At the stage of home bias cutting, we aim to identify the influence of ratings on foreign portfolio holdings
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