Sovereign Debt Ratings and Stock Liquidity Around the World

Abstract

This paper studies the impact of sovereign debt rating changes on liquidity for stocks from 40 countries for the period 1990-2009. We find that sovereign rating changes significantly affect stock liquidity. The impact is stronger for downgrades than for upgrades, and is nonlinear in event size. The loss of investment grade has a particularly strong negative impact on stock liquidity. In the cross-section, firms with smaller size, higher book-to-market ratio, higher fraction of closely-held shares, lower liability/asset ratio, lower liquidity, lower profitability, less transparency, or no political connection tend to experience more negative liquidity effects from downgrades. We also find that the country legal and macroeconomic environment is important in explaining the differences in the impact of rating changes on liquidity across countries. Specifically, stocks from countries with civil law, poorer minority protection, poorer accounting standard, lower market capitalization, lower credibility of financial disclosure, higher level of earnings management, lower transparency, higher foreign institutional ownership, or lower GDP tend to experience sharper drops in stock liquidity in response to an adverse sovereign credit event.