Bad News Spreads

• Author: Rabah Arezki, Bertrand Candelon, and Amadou N.R. Sy
• Position: an Economist and is a Deputy Division Chief, both in the IMF Institute. is Professor of International Monetary Economics at Maastricht University.

THE recent European sovereign debt crisis was concentrated in a few countries, but its effects were felt in financial markets throughout the euro area. Following downgrades of credit ratings for countries such as Greece, Ireland, Portugal, and Spain, sovereign bond spreads widened, the costs of insuring sovereign debt (as measured by credit default swap—CDS—spreads) rose, and stock markets well beyond the affected countries felt the pressure (see chart).

The resulting debate over the role of credit rating agencies during crises and the interdependence of different financial markets has focused on changes in sovereign debt ratings. These measure the likelihood that a government will fail to meet its financial obligations and whether these changes have spillover effects across countries and markets in a highly integrated environment, such as the euro area, which includes 16 European economies.

The financial intertwining of European economies over the past decade has created unique conditions for the study of the effects of rating news on financial markets, but the issue is not unique to Europe. The current debate surrounding the agencies that assign credit ratings echoes discussions during the Asian financial crisis of 1997–98, when sovereign debt problems hopscotched from economy to economy.

Unfortunately, there has been little research on the spillover effects of rating news. Gande and Parsley (2005), using data on bond spreads for emerging markets from 1991 to 2000, found that when one country’s rating is downgraded it has a significant negative effect on the sovereign bond spreads of other countries. In more integrated financial markets, however, the shock of a rating downgrade is likely to have effects beyond bond markets. Indeed, more recent studies (for example, Ehrmann, Fratzscher, and Rigobon, 2010) analyze the transmission of shocks across markets and countries and find evidence of substantial international spillovers, both within and across asset classes, affecting, for example, money, bond, and equity markets as well as exchange rates.

Kaminsky and Schmukler (2002) provide some evidence that changes in sovereign debt ratings and outlooks affect financial markets in emerging economies. They find that sovereign ratings affect not only the instrument being rated (bonds) but also stocks.

We examine the impact of rating news on CDS markets, but also consider systematically the potential spillover effects within the structure of...