Do credit rating agencies reward fiscal prudence?

• Published date: 01 April 2022
• Author: João T. Jalles
• Date: 01 April 2022
• DOI: http://doi.org/10.1111/infi.12404

Received: 15 May 2020

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Accepted: 25 January 2022

DOI: 10.1111/infi.12404

ORIGINAL ARTICLE

Do credit rating agencies reward

fiscal prudence?

João T. Jalles

1,2,3,4

1

Department of Economics, Instituto

Superior de Economia e Gestão (ISEG),

Universidade de Lisboa, Lisboa, Portugal

2

Research in Economics and

Mathematics (REM) and Research Unit

on Complexity and Economics (UECE),

ISEG, Universidade de Lisboa, Lisbon,

Portugal

3

Economics for Policy, Nova School of

Business and Economics, Universidade

Nova de Lisboa, Carcavelos, Portugal

4

IPAG Business School, Paris, France

Correspondence

João T. Jalles, Instituto Superior de

Economia e Gestão (ISEG), Universidade

de Lisboa, Rua do Quelhas 6, 1200‐781

Lisboa, Portugal.

Email: joaojalles@gmail.com

Funding information

Fundação para a Ciência e a Tecnologia,

Grant/Award Number: UIDB/05069/

2020 and UID/SOC/04521/2020

Abstract

Governments are responsible for economic policy im-

plementation, and their actions affect financial and

capital market outcomes. Specifically, the way fiscal

policy is conducted matters when credit agencies have

to decide on how to rate a sovereign. This paper em-

pirically assesses the effect of a new time‐varying

measure of fiscal counter‐cyclicality on the sovereign

credit ratings of the main agencies: Fitch, Standard &

Poor's, and Moody's. I focus on a heterogeneous sample

of 63 advanced and developing economies between

1980 and 2015. First, we find that the degree of fiscal

counter‐cyclicality is generally positive and has been

increasing over time, being larger in advanced econo-

mies. Second, the more counter‐cyclical a fiscal policy

is, the better the assessment a rating agency gives to

that country, particularly if it is an advanced one. This

suggests that fiscal prudence and stabilization concerns

are rewarded. Our results are robust to several sensi-

tivity and robustness checks.

KEYWORDS

errors‐in‐variables, filtering, fiscal cyclicality, instrumental

variables, ordered probit, time‐varying coefficients

JEL CLASSIFICATION

C22, C25, C33, E44, F30, G15

International Finance. 2022;25:2–22.wileyonlinelibrary.com/journal/infi2

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© 2022 John Wiley & Sons Ltd.

1|INTRODUCTION

The legacy of the Global Financial Crisis has put rating agencies under unprecedented criticism

(Wighton, 2009). Moreover, fiscal policy has gained prominence, given the perceived impotence

of traditional monetary policy instruments to boost aggregate demand sufficiently. At the same

time, fiscal policy has become increasingly constrained because of high debt‐to‐gross domestic

product (GDP) ratios. On the one hand, economic, institutional, and government character-

istics are usually perceived as relevant determinants of capital markets developments, notably

regarding sovereign ratings.

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On the other, fiscal policy is responsible for the allocation and

distribution of public resources, but it also has a stabilizing role against business cycle fluc-

tuations (van der Ploeg, 2005). Against this background, there has been renewed interest in

examining how fiscal stabilization policies can spur medium‐term growth (Furceri & Jalles,

2018).

2

As governments are responsible for the implementation of economic policy, their be-

haviour also plays a role as a potential determinant of financial and capital market outcomes.

At the same time, research has found that the more counter‐cyclical fiscal/monetary policy is,

the shorter and less severe economic crises/downturns are (Vegh & Vuletin, 2014).

3

This paper answers one key research question: to what extent does the degree of (counter‐)

cyclicality of a government's fiscal policy matter for rating agencies? To answer this question,

this paper makes several contributions. To obtain measures of fiscal cyclicality, one has to

decide on a proxy of economic activity against which a budgetary measure is regressed.

I estimate new measures of the output gap using the recent filtering technique suggested by

Hamilton (2018). I then use these in country‐specific time‐varying models to obtain time‐

varying counter‐cyclicality estimates and evaluate how they have evolved over time. From a

policymaking point of view, it is important to understand how fiscal policy behaves over the

business cycle in the face of today's need for greater government (fiscal) accountability, dis-

cipline, and effectiveness.

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While several studies recognize the difficulties in providing accurate

estimates of fiscal cyclicality, they also acknowledge the need to have at least approximations of

it (Auerbach & Feenberg, 2000). Mindful that the way a government conducts its fiscal policy is

relevant for sovereign rating assessments (Depken et al., 2007), we empirically assess, in a panel

setting, to what extent the previously computed new measures of fiscal (counter‐) cyclicality

matter for credit rating agencies. The use of time‐varying cyclicality coefficients in a panel

regression setting overcomes the major limitation of other papers that typically rely solely on

cross‐country regressions and are not able to account for country‐specific as well as global

factors. The terms ‘fiscal prudence’and ‘fiscal profligacy’are often used, somewhat loosely, to

denote whether fiscal policies tend to lead to a sustainable or unsustainable fiscal position

(Mauro et al., 2015). In the context of this paper, I associate ‘fiscal prudence’with governments

that act in a fiscally counter‐cyclical way and check whether credit rating agencies reward such

behaviour. For this purpose, we use an unbalanced panel of 63 countries between 1980

and 2015.

I find that the degree of fiscal counter‐cyclicality is generally positive and has been in-

creasing over time, being larger in advanced economies. However, in several developing

countries, ‘graduation’from what has been called the ‘procyclicality trap’is evident (see

Frankel et al., 2013 for details). I also find that the more counter‐cyclical fiscal policy is, the

better the assessment a rating agency gives to that country, particularly if it is an advanced one.

The cyclical nature of fiscal policy does not seem to matter statistically for credit rating agencies

in the case of developing countries. All in all, my results—which are robust to several

JALLES

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