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Boom, bust and sovereign ratings: Lessons for the Eurozone from emerging-market ratings

Credit rating agencies have recently downgraded Greek, Portuguese, and Spanish sovereign debt, causing unrest among Europe’s leaders. This column argues that unless sovereign ratings can be turned into proper early warning systems, they will continue to increase instability and volatility and to undermine the benefits of capital markets. One option is to drop the use of sovereign ratings in prudential regulation altogether.

Despite being blunted by the global crisis, the major agencies, i.e. Fitch, Moody’s and Standard & Poor’s, can still deliver a bludgeoning. Coming on the back of market sell-offs, Fitch and Standard & Poor’s downgrades of Greek, Portuguese and Spanish sovereign debt in late April 2010 have led to criticism that the agencies took too much notice of the market reaction to Greek bonds and credit default swaps by downgrading too severely.

That the Eurozone crisis turned so bad was partly due to the belated rating action of the rating agencies. European leaders took aim at the agencies. The German Chancellor and the French President called for a review of rating agencies and suggested stricter standards under European law, especially for the process of rating sovereign debt. The EU senior financial services regulator announced the intention at setting up a European credit rating agency.

But you do not destroy a mirror merely because it tells you that you are ugly. You should, however, discard a mirror that is blind and has nourished illusions for too long. Rather than to establish yet another rating agency, the appropriate policy response will be a thorough revision, in fact exclusion, of the role of sovereign ratings in prudential regulation and even in internal industry guidelines.

Credit rating agencies and past crises

This is not the first crisis raising questions about the credit rating “agencies”, which are in fact private, profit making firms (Goodhart 2008). That lesson was already brought home in the 1990s and early 2000s when sovereign ratings had intensified emerging market currency crises repeatedly. The 1990s had witnessed pronounced boom–bust cycles in emerging-markets lending, culminating in the Asian financial and currency crisis of 1997-8. In the 1990s credit rating agencies were already conspicuous among the many who failed to predict the Mexican and Asian currency crises.

Having failed to perceive the extent of problems as long as foreign money flowed in, the rating agencies then overreacted by downgrading the affected countries to junk status. While the explanatory power of conventional rating determinants has declined since the Asian crisis (Reisen 2003), rating performance for Argentina and Turkey in the early 2000s could still be qualified as lagging the markets, as variables of financial-sector strength. Moreover, the endogenous effects of capital flows on macroeconomic variables seem to remain underemphasised in rating assessments.

Explaining sovereign debt ratings

Sovereign ratings have been to a large extent explained by a limited number of key macroeconomic variables before the Asian crisis (Cantor and Packer 1996). Per capita income (+), GDP growth (+), consumer price inflation (-), foreign debt as percentage of exports (-), dummy for economic development (+), dummy for default history (-) are generally significant with the expected sign, while fiscal balance (+) and external balance (+) did not enter significantly the authors’ multiple regression estimates.

In principle, sovereign ratings might be able to help to attenuate boom–bust cycles. During the boom, early rating downgrades would help to dampen euphoric expectations and reduce private short-term capital flows which have repeatedly been seen to fuel credit booms and financial vulnerability in the capital-importing countries. By contrast, if sovereign ratings had no market impact, they would be unable to smooth boom–bust cycles. Worse, if sovereign ratings lag rather than lead financial markets, but have a market impact, improving ratings would reinforce euphoric expectations and stimulate excessive capital inflows during the boom whereas during the bust, downgrading might add to panic among investors, driving money out of the country and sovereign yield spreads up. If guided by outdated crisis models, sovereign ratings would fail to provide early warning signals ahead of a currency crisis, which again might reinforce herd behaviour by investors.

The problem is that credit rating agencies cannot easily acquire superior information on sovereign debt:

  • First, sovereign-risk ratings are primarily based on publicly-available information, such as foreign debt and reserves or political and fiscal constraints. This makes them different from ratings of companies. With companies, credit rating agencies may have access to inside information from domestic corporate borrowers (such as acquisitions, new products and debt issuance plans). Such advance knowledge or better information can then be conveyed to market participants through ratings on private borrowers. This is not the case with sovereign borrowers.
  • Second, in the absence of a credible international mechanism to sanction a sovereign default the premium charged to reflect the risk of default is determined by a borrower's willingness to pay, rather than by his ability to pay. There is also a problem of enforceability. The authorities cannot give an absolute promise that in future they and their successors will put foreign capital to productive use or that future returns will be used to repay foreign debt.
  • Third, rating agencies receive most of their revenue from governments to provide a debt rating. Naturally, they are loath to downgrade their clients. This may well introduce 'downgrade rigidity' into ratings especially in periods of large capital inflows.
Reactive credit agencies

Over a decade ago research at the OECD Development Centre established evidence that emerging-market sovereign credit ratings are reactive rather than preventive (Larrain 1997). As a result, they tend to amplify boom-bust cycles in sovereign lending. An event study by Reisen and von Maltzan (1999), covering 14 sample countries during 1988 and 1997, explored the market response for 30 trading days before and after rating announcements. The study found a significant impact of imminent upgrades (positive outlook) and implemented downgrades for a combination of ratings by the three leading agencies, despite strong anticipation of rating events. Granger causality tests, by correcting for joint determinants of ratings and yield spreads, found that changes in sovereign ratings do not independently lead sovereign bond markets. This result was recently confirmed in a recent study by the Inter-American Development Bank covering daily information for 32 emerging countries during 1998 and 2007 (Cavallo 2008).

Why are ratings so influential?

Herd instinct, reinforced by prudential regulation and internal industry guidelines for institutional investors, gives sovereign ratings the power to influence sovereign bond yields. Hence, sovereign ratings absolve banks and money managers willing to hold sovereign bonds from making independent judgments about sovereign risk. The important gap in risk spreads of sub-investment grade (junk) over investment-grade bonds points to a fatal regulatory non-linearity. Losing investment grade status means that pension funds, insurers, and other institutional investors face internal and prudential guidelines that prohibit them to invest into ‘junk’ bonds. The importance of rating agencies in macroprudential regulation had been reinforced by revisions to the Basel Accord on regulatory bank capital requirements. Moving from risk-insensitive (Basel I) to risk-sensitive (Basel II) capital requirements, the capital buffers banks held in anticipation of cyclical shocks to their earnings were turned to pro-cyclical by the new regulation (Repullo and Suarez 2008).

What should be done?

The answer is either to turn sovereign ratings into proper early warning signals or to drop their role in prudential regulation. Since part of the problem is that rating agencies get much of their revenue from borrowers, the industry will have to reorient its fee structure towards investors. Their dependence on borrowers is incompatible with the incentive to come up with timely negative rating. At the same time, prudential regulators should reconsider the role of sovereign ratings that they stipulate when institutional investors hold sovereign bonds. The removal of investment grading requirements for institutional portfolios might attenuate the boom-bust cycle in bonds pricing. Unless sovereign ratings can be turned into proper early warning systems, they will continue to add to the instability of international capital flows, to make returns to investors more volatile than they need be, and to reduce the benefits of capital markets for recipient countries.

Creating yet another rating agency is no solution. The public genesis of a European credit rating agency will make its ratings even more “sticky” than those of the leading agencies.


Cantor, R, and F Packer (1996), “Determinants and Impact of Sovereign Credit Ratings”, Economic Policy Review, 2(2):37-53.
Cavallo, Eduardo A, Andrew Powell, and Roberto Rigobón (2008), “Do Credit Rating Agencies Add Value? Evidence from the Sovereign Rating Business Institutions”, Inter-American Development Bank, Research Dept Working Paper 647, November.
Goodhart, Charles AE (2008), “The Financial Economists Roundtable’s statement on reforming the role of SROs in the securitisation process”, VoxEU.org, 5 December.
Larraín, Guillermo, Helmut Reisen, and Julia von Maltzan (1997), “Emerging Market Risk and Sovereign Credit Ratings”, OECD Development Centre Working Paper 124, April.
Reisen, Helmut and Julia von Maltzan (1999), “Boom and Bust and Sovereign Ratings”, International Finance, 2(2): 273-293, July.
Reisen, Helmut (2003), “Sovereign Ratings since the Asian Crisis”, OECD Development Centre Working Paper 214, November.
Repullo, Rafael and Javier Suarez (2008), “The Procyclical Effects of Basel II”, CEPR Discussion Paper 6862, June.


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