Sovereign Debt Ratings Research Articles

The Sovereign Debt Crisis in Sri Lanka: Anatomy and Policy Options

Abstract During the COVID-19 pandemic, there was a dramatic increase in national debt levels across the world, with reported cases of downgrading sovereign debt ratings and difficulty of fulfilling debt obligations (“debt distress”), heavily concentrated in low- and middle-income countries. In this context, the unfolding sovereign debt crisis in Sri Lanka has attracted worldwide attention as the canary in the coal mine for what could become a global “development” crisis. This paper examines the Sri Lankan crisis encompassing both the sources of vulnerability to the COVD-19 shock, and stabilization and structural adjustment reforms after the debt default, with emphasis on the systemic “solvency” challenge of dealing with the massive debt overhang evolved over the previous two decades. The prime focus of the Extended Fund Facility (EFF) program that Sri Lanka signed with the IMF in March 2023 is on economic stabilization through fiscal consolidation. This paper makes a strong case for combining economic stabilization with coherent structural adjustment policies to redress the long-standing antitradable bias in the incentive structure that underpinned vulnerability of the economy to external shocks.

Revisiting the determinants of sovereign debt ratings in Europe through artificial intelligence techniques

ABSTRACT In papers using artificial intelligence (AI) techniques, little attention has been paid to the determinants of sovereign debt ratings. We propose a reduced set of variables regarding the economic performance of a country that are consistent with the idea of debt sustainability. The robustness of this set is supported by the results obtained with different well-known AI techniques using data from EU-15 countries during the 2002–2017 period as the experimental setting. The variables are publicly available, allowing a quick and reliable assessment of the creditworthiness of a sovereign and providing useful information for decision-makers and investors.

Do financial markets reward government spending efficiency?

We provide a novel set of government spending efficiency scores for the OECD countries and then assess to what extent capital markets perceive government efficiency increases (decreases) as part of the determinants of sovereign rating decisions. Public efficiency scores are computed via data envelopment analysis. Then, we rely notably on ordered response models to estimate the response of sovereign ratings to changes in efficiency scores. Covering 35 OECD countries over the period 2007–2020, we find that increased public spending efficiency is rewarded by financial markets via higher sovereign debt ratings. In addition, higher inflation and government indebtedness lead to sovereign rating downgrades, while higher foreign reserves contribute to rating upgrades.

External Debts and Economic Growth when Debt Rating Matters

The paper investigates the dependence pattern of economic growth on external debt supply by accounting for the safety of debts, measured by the sovereign debt rating. The method of cross-section regression is based on a sample of 145 advanced and developing economies with averaged data over the 1990–2019 period. The pattern of economic growth follows a U-shaped curve, for which the growth rate is first decreasing and then increasing on the external debt supply. A possible explanation can rely on the sovereign debt rating. For low supply of external debts, more supply of debts reduces the debt rating, which, in turn, lowers the economic growth rate. But for high enough supply of debts, more debts raise their rating, improving the growth rate. These results are robust on controlling for various determinants of economic growth and on the fixed effect panel regression.

Reconstruction Rating Model of Sovereign Debt by Logical Analysis of Data

Sovereign debt ratings provided by rating agencies measure the solvency of a country, as gauged by a lender or an investor. It is an indication of the risk involved in investment and should be determined correctly and in a well-timed manner. The current system is lacking transparency of rating criteria and mechanism. The present study reconstructs sovereign debt ratings through logical analysis of data (LAD), which is based on the theory of Boolean functions. It organizes groups of countries according to 20 World Bank-defined variables for the period 2012–2015. The Fitch Rating Agency, one of the three big global rating agencies, is used as a case study. An approximate algorithm was crucial in exploring the rating method, in correcting the agency’s errors, and in determining the estimated rating of otherwise unrated countries. The outcome was a decision tree for each year. Each country was assigned a rating. On average, the algorithm reached almost 98% matched ratings in the training set and was verified by 84% in the test set.

Sovereign debt ratings and the country composition of cross-border holdings of euro area sovereign debt

This paper documents how sovereign debt ratings shape the country composition of euro area cross-border holdings of euro area sovereign debt, using granular sectoral security holdings statistics for the period 2009Q4 until 2016Q1. Credit risk is the main risk for bond investors when investing in bonds that are issued in the same currency as the currency of the investor’s home country. Sovereign debt ratings provided by rating agencies give investors key information on the creditworthiness of governments. The results in this paper show that investors respond differently to credit ratings. In particular, we find that investors from core euro area countries respond more to credit ratings than investors from peripheral euro area countries. The results show that banks and insurance companies in core countries hold significantly more sovereign bonds of countries with higher credit ratings. In peripheral countries we do not find a positive relationship between ratings and sovereign bond holdings.

Determinants of sovereign debt ratings in clusters of European countries – effects of the crisis

PurposeThis paper aims to study the determinants of the sovereign debt ratings provided by the 3 main rating agencies for 32 European countries. It verifies the clusters of countries existing for each of the agencies, considering regional bias, and then analyzes whether the determinants were different before and after the global financial crisis. It also aims to explain how the determinants are taken into account for rich and developing countries, using a sample for the period between 2001 and 2008 and the period between 2009 and 2016.Design/methodology/approachTo this purpose, this paper performs panel data estimation using an ordered Probit approach.FindingsThis method shows that for developing countries after the crisis, the relevant explanatory variables are the unemployment rate and the presence in the Eurozone. For rich countries, the inflation rate is pivotal after the crisis period.Originality/valueThis paper is the first to use a clustering methodology within sovereign debt rating literature, grouping the countries into cohesive clusters according to their sovereign debt ratings along with the proposed time frame. Moreover, it explains, which countries belong to strong or weak groups, according to the rating agencies under discussion; and, in these groups, it identifies the sovereign rating determinants.

Prema-chandra Athukorala Comment on Rethinking “Economic Fundamentals” in an Era of Global Physical Shocks: Insights from the Philippines Experience with COVID-19

Prema-chandra Athukorala Comment on Rethinking “Economic Fundamentals” in an Era of Global Physical Shocks: Insights from the Philippines Experience with COVID-19

Can fiscal rules improve financial market access for developing countries?

A number of countries have introduced fiscal rules to deter fiscal profligacy, enhance the credibility of fiscal policy, and reduce borrowing costs. In this paper, we examine the outcome of fiscal rules in terms of improving financial market access for developing countries. We use entropy balancing and various propensity score matching. We find that the adoption of fiscal rules reduces sovereign bond spreads and increases sovereign debt ratings for a sample of 36 developing countries, which are part of the JP Morgan Emerging Markets Bond Index Global (EMBIG), for the period 1993-2014. We explain this finding by the effect of fiscal rules on the credibility of a country's fiscal policy: more credible governments are rewarded in the international financial markets by low sovereign bond spreads and high sovereign debt ratings. These results are robust to a wide set of alternative specifications. We also show that this favorable effect is sensitive to several country structural characteristics. Our findings confirm that the adoption and sound implementation of fiscal rules is an instrument for policy makers to improve developing countries’ financial market access.

The Dilemma of International Diversification: Evidence from the European Sovereign Debt Crisis

AbstractThis paper tests how capital markets value the international diversification of banks in good and in bad economic times by investigating changes in domestic and foreign sovereign debt ratings before and during the European sovereign debt crisis. Tracing 320 European banks in 29 countries and 226 credit rating announcements for European sovereigns between 1 January 2001 and 15 August 2012, we show that the market values banks with access to foreign funds. Despite occasional adverse effects immediately following negative news regarding sovereign credit rating changes, international diversification was found to be beneficial to European banks, especially during periods of distress.

Modelling sovereign debt ratings for sub-national governments: the case of Spain before and after the crisis

Since 2007, Europe has been living through one of its deepest crises in recent history. What began as financial turmoil has quickly become a public-debt crunch. In Spain, public debt rose from less than 40% of GDP in 2008 to nearly 100% of GDP in 2013. This shock has resulted in a deterioration of public-debt ratings. In Spain, as in many other countries, public debt is composed not only of the central government’s debt but also of debt issued by sub-national entities. Although the evolution of national ratings has received broad attention in the literature, few articles have dealt with sub-national entities. The purpose of this article is to shed new light on the structure and evolution of the public-debt ratings of Spain’s regional governments. Our main contribution rests on an analysis of recent changes in the main variables, before and after the crisis, and specifically of the sustainability of the 2012 debt reform and the structure of Spain’s public debt.

Comparing Sovereign Debt Rating consistency with Sovereign AML Rating Accuracy

Many stakeholders in the global anti-money laundering (AML) space, including correspondent banks, rely upon explicit or de facto AML sovereign rating services. This reliance is similar to that reposed by fixed income investors in sovereign debt ratings. In this paper we demonstrate that sovereign debt rating agencies provide highly consistent and reasonably accurate ratings. Sovereign AML ratings, by contrast, are usually inconsistent and lack any empirical basis to judge their accuracy. Users of sovereign AML ratings are therefore cautioned that, whatever value they place upon these ratings, they are unreliable measures of the actual incidence of money laundering in any given jurisdiction.

Sovereign risk evaluation for European Union countries

This study investigates the short run and the long run relationship between government bond yields and their associated credit default swaps (CDS), using co-integration and Granger causality techniques, for eight major European Union countries, over three different periods, considering the global financial and the resultant European debt crises. Moreover, this study tries to explore the interactions between changes in sovereign debt ratings and the corresponding credit premiums as an effort to examine the role of top credit rating agencies in defining CDS prices and as an attempt to illuminate the importance of the announcement date based on an event study.

Sovereign rating announcements and the integration of African banking markets

PurposeThe purpose of this paper is to examine the information spillover of sovereign rating changes on the market valuation of bank stocks in Africa.Design methodologyFirst, the authors apply event study methodology to evaluate the stock market reaction of African bank stocks on the announcement of sovereign rating changes. Second, the cross sections of the abnormal returns are examined by multivariate regression analyses. Third, the findings are proved for robustness.FindingsThe authors investigate how 37 African banks react to 203 African sovereign rating announcements from the three leading credit rating agencies over the period 2010-2016 and find that negative announcements trigger the significant positive stock reactions of African banks, especially contributed by banks in the non-reviewed African countries. These unusual reactions can be explained by the low integration and the severe information asymmetry of African capital markets. The authors further locate the influencing factors of banks’ reactions and show that rating downgrades magnify the abnormal effects while the membership of the African Free Trade Zone mildens the stock market reactions.Research limitations/implicationsLimitations are given by the limited sample size. There are only limited numbers of publicly listed African banks with sufficient trading data.Practical implicationsThe paper argues for a critical dependency of African bank equity valuation in the case of sovereign debt rating changes in neighbor countries. This observation is important for the risk assessment of African banking assets.Originality/valueThe paper is the first to examine stock market reactions on sovereign rating announcements for the evaluation of capital market integration in Africa. It thereby underlines the usefulness of this simply to apply approach as an instrument for ongoing examining the progress in capital market development in emerging countries.

The Impact of Sovereign Debt Ratings on Euro Area Cross-Border Holdings of Euro Area Sovereign Debt

This paper documents how sovereign debt ratings shape euro area cross-border holdings of euro area sovereign debt, using granular sectoral security holdings statistics for the period 2009Q4 until 2016Q1. Credit risk is the main risk for bond investors when investing in bonds that are issued in the same currency as the currency of the investor’s home country. Sovereign debt ratings provided by rating agencies give investors key information on the creditworthiness of governments. The results in this paper show that investors respond differently to credit ratings. In particular, we find that investors from core euro area countries respond more to credit ratings than investors from peripheral euro area countries. The results show that banks, insurance companies, pension funds and investment funds in core countries all significantly increase their bond holdings when credit ratings improve. In peripheral countries we document only a positive effect for pension funds and find no relationship between ratings and bond holdings for the other investor sectors. Finally, we find non-linearities in the relationship between bond holdings and credit ratings.

Sovereign debt: election concerns and the democratic disadvantage

We re-examine the concept of 'democratic advantage' in sovereign debt ratings when optimal repayment policies are time-inconsistent. If democratically elected politicians are unable to make credible commitments then default rates are inefficiently high, so democracy potentially confers a credit market disadvantage. Institutions that are shielded from political pressure may ameliorate the disadvantage by adopting a more farsighted perspective. Using a numerical measure of institutional farsightedness obtained from the Global Insight Business Risk and Conditions database, we find that the observed relationship between credit-ratings and democratic status is strongly conditional on farsightedness. With myopic institutions, democracy is associated with worsened credit ratings on average by about 3 investment grades. With farsighted institutions there is, if anything, a democratic advantage.

Rating Agencies, Self-Fulfilling Prophecy and Multiple Equilibria? An Empirical Model of the European Sovereign Debt Crisis 2009-2011

We explore whether governments may have faced scenarios of self-fulfilling prophecy and multiple equilibria during Europe’s sovereign debt crisis. To this end, we estimate the effect of interest rates and other macroeconomic variables on sovereign debt ratings, and of ratings on interest rates. We detect a nonlinear effect of ratings on interest rates which is strong enough to permit multiple equilibria. The good equilibrium is stable, ratings are excellent and interest rates are low. A second unstable equilibrium marks a threshold beyond which the country slides towards an insolvency trap. Coefficient estimates suggest that countries should stay well within the A segment of the rating scale in order to remain safe from being driven towards default.

Sovereign Debt Ratings and Stock Liquidity around the World

Sovereign Debt Ratings and Stock Liquidity around the World

Do cultures influence abnormal market reactions before official sovereign debt rating downgrade announcements?

We investigate whether cultural norms influence the way market information is incorporated into overall market prices. We examine whether cultures influence abnormal market reactions before official sovereign debt rating downgrade announcements across 46 countries. Michaelides et al. (2015) find that institutional quality is significantly associated with less negative abnormal market reactions prior to downgrades. Hofstede’s six cultural dimensions (Hofstede and Bond, 1988) are used to measure cultural differences. We show that high masculinity and high individualism are significantly associated with less negative abnormal market reactions. Masculinity remains significant when the model includes institutional quality and other key variables.

Sovereign debt risk in emerging market economies: Does inflation targeting adoption make any difference?

Based on a sample of 38 emerging economies, we find that inflation targeting (IT) adoption improves sovereign debt risk. Next, we show that this favorable effect is sensitive to several structural characteristics, and to the considered time span. Finally, the measure of sovereign risk (sovereign debt ratings or government bond yield spreads) and the IT form (full-fledged or partial) equally influence the effect of IT adoption on sovereign debt risk. Thus, our paper provides valuable insights regarding IT implementation as a device for improving emerging market economies' access to international financial markets.