The Role of Sovereign Credit Ratings in the Transnationalization of Finance

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. That hypothesis is tested in this paper with regard to data on sovereign credit ratings and foreign portfolio investment. A rating-related gravity model of finance is derived from the choice-theoretical framework of Okawa and van Wincoop (2012) and estimated in three stages. At the first stage, we find that the introduction and evolution of sovereign ratings and their gradual improvement since the 1970s has increased inward portfolio investment stocks and flows in the host countries. At the second stage, we examine to which extent sovereign ratings help to predict the degree of investors’ home bias, as measured by the share of outward portfolio investment holdings in the home countries’ portfolios. At the third stage, we 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.ZenTra Working Paper Series in Transnational Studies