Sovereign Credit Ratings in Developing Economies: New Empirical Assessment

• DOI: http://doi.org/10.1002/ijfe.1551
• Published date: 01 October 2016
• Date: 01 October 2016
• Author: Helder Ferreira Mendonça,Diego S. P. Oliveira,Gabriel Caldas Montes

SOVEREIGN CREDIT RATINGS IN DEVELOPING ECONOMIES: NEW

EMPIRICAL ASSESSMENT

GABRIEL CALDAS MONTES, DIEGO S. P. DE OLIVEIRA and HELDER FERREIRA DE MENDONÇA*

,†

Fluminense Federal University, Economics, Niterói, Brazil

ABSTRACT

This study contributes to understanding the main determinants of sovereign ratings for developing countries making use of in-

formation from Standard & Poor’s, Moody’s, and Fitch. Based on a sample of 40 countries for the period 1994 to 2013 and

panel data approach, we extended previous works in the literature by including new economic aspects, as well as, new institu-

tional and governance variables (e.g. inflation targeting, financial openness, democracy, corruption, etc.). The findings denote

that, besides the traditional macroeconomic variables, adoption of inflation targeting, financial openness, democracy, law and

order, and less corruption are important to improve the sovereign ratings. Copyright © 2016 John Wiley & Sons, Ltd.

Received 28 September 2015; Revised 06 April 2016; Accepted 12 April 2016

JEL CODE: C23; E44; F34; H63

KEY WORDS: sovereign rating; inflation targeting; financial openness; democracy; corruption

1. INTRODUCTION

Sovereign ratings are a condensed assessment of a government’s ability and willingness to repay its public debt on

time. A rating is a forward-looking estimate of the default probability, i.e. sovereign credit ratings are supposed to

serve as a summary measure of a country’s likelihood of default (Cantor and Packer, 1996; Reinhart, 2002). Such

measures of the probability of default are particularly relevant for economic agents (Bissoondoyal-Bheenick, 2005;

Afonso et al., 2011).

In recent years, the demand for sovereign ratings has increased mainly because of the globalization of markets.

Investors and particularly managed funds are increasingly focused on international diversification. A change in

sovereign ratings can be a major input in the re-weighting of international portfolios (Bissoondoyal-Bheenick,

2005). Therefore, governments and investors have the need to understand what factors rating agencies put more

emphasis on when attributing a rating score.

The main private credit risk rating agencies are Moody’s Investors Service, Standard & Poor’s, and Fitch rat-

ings. These agencies use a combination of several quantitative and qualitative variables (economic, social, and po-

litical) in order to assign a credit rating to a debtor. Because they do not announce their methodologies explicitly,

an important issue is to identify the main factors behind their assignment of sovereign credit ratings. Furthermore,

according to Reinhart (2002), the sovereign credit ratings play a critical role for the case of developing countries.

Although there are studies on the determinants of sovereign ratings (Cantor and Packer, 1996; Afonso, 2003;

Altenkirch, 2005; Hill et al., 2010; Afonso et al., 2011), the literature that addresses solely the category of devel-

oping countries is still scarce (Archer et al., 2007; Biglaiser and Staats, 2012; Erdem and Varli, 2014).

Sovereign credit ratings play a very important role in order to attract international capital for developing coun-

tries. One reason is that these ratings are valuable information to investors concerning the probability of default of

sovereign bonds. With this in mind, this study contributes to understanding the main determinants of sovereign

*Correspondence to: Helder Ferreira de Mendonça, Fluminense Federal University, Economics, Rua Dr. Sodré, 59, Vila Suíça, Miguel Pereira,

Rio de Janeiro 26900-00, Brazil.

†

Email: helderfm@hotmail.com

Copyright © 2016 John Wiley & Sons, Ltd.

International Journal of Finance & Economics

Int. J. Fin. Econ. 21: 382–397 (2016)

Published online 24 May 2016 in Wiley Online Library

(wileyonlinelibrary.com). DOI: 10.1002/ijfe.1551

ratings for developing countries making use of information from Standard & Poor’s, Moody’s, and Fitch. Based on

a sample of 40 countries for the period 1994 to 2013 and panel data approach, we extended previous works in the

literature by including new economic aspects, as well as, new institutional and governance variables (e.g. inflation

targeting, financial openness, democracy, corruption, etc.).

This paper is organized as follows. Section 2 presents a brief review of the literature on sovereign credit ratings.

Section 3 describes data and variables as well as the empirical model and methodology. Section 4 presents estima-

tion results and respective analysis. Section 5 presents a robustness analysis taking into account the average of the

sovereign ratings from Standard & Poor’s, Moody’s, and Fitch. Section 6 concludes the paper.

2. LITERATURE REVIEW

The literature regarding sovereign credit ratings is vast. Some works analyse the influence of changes in sovereign

ratings on the domestic financial sector and on the inflows of international capital. This is the case of Kim and Wu

(2008), which restricted their investigation to developing countries during 1995–2005. They found evidence that

long-term foreign currency sovereign credit ratings are important for improving financial intermediary develop-

ment and for attracting capital flows. Other studies focus on the accuracy of the rating agencies. For instance,

Gaillard (2013) analysed the accuracy of the three main agencies from January 2001 to January 2013. His findings

suggest that ratings issued by Fitch, Moody’s, and S&P became less accurate after the default of Greece in 2012.

On the other hand, Schumacher (2014) provides evidence that rating changes are able to exacerbate a country’s

boom–bust cycle.

There are studies concerned to identify the factors behind the assessment of sovereign ratings. This literature shows

that there is a basic set of macroeconomic variables which affect sovereign credit ratings. These variables are: per capita

income, inflation rate, GDP growth rate, external debt, fiscal balance, and sovereign default history. Cantor and Packer

(1996) investigate the main determinants of sovereign credit ratings available from S&P and Moody’s. Their findings

indicate that per capita income, GDP growth rate, and economic development positively affect sovereign credit ratings

whilst inflation rate, external debt, and default history have a negative influence on ratings. Using the rating classifications

from S&P and Moody’s, Afonso (2003) expanded the analysis taking into account a sample of 81 developed and devel-

oping countries in June 2001 and the results did not change considerably.

In order to avoid the possible bias present in OLS and POLS models, Altenkirch (2005) combined a general-to-

specific model selection with dynamic panel data estimation. Contrary to the previous studies, inflation rate had

mixed results regarding its significance, and only political rights and the export growth rate showed significant

results in all dynamic panel data estimations.

Bissoondoyal-Bheenick (2005) analyses the determinants of sovereign ratings provided by Standard and Poor’s

and Moody’s. The main finding of the paper is that current economic and financial indicators alone do not determine

ratings. Furthermore, the relevance of economic variables is not the same across the different rating categories.

Economic variables do not carry the same importance for the sample of high rated countries with a long financial

stability history as compared to the low rated sample of countries that are still undergoing structural changes.

Hill et al. (2010), taking into account sovereign ratings provided by Standard and Poor’s, Moody’s, and Fitch’s,

and a sample of 129 countries for the period from April 1990 to March 2006 analysed the determinants of ratings.

The results showed that six variables are common determinants of all three agencies on sovereign ratings: per

capita income, GDP growth and its square, default history, the Institutional Investor rating, and the risk premium.

Based on the same above-mentioned sovereign ratings, Afonso et al. (2011) investigated their determinants from

1995 to 2005. Paying attention on short-run and long-run effects, it is observed that per capita income, GDP growth

rate, government debt, and the fiscal balance have a short-run effect on sovereign default ratings, whilst govern-

ment effectiveness, external debt, foreign reserves, and the default history are important long-run determinants.

Regarding the literature on the determinants of sovereign credit ratings for developing countries based on three

main sovereign credit ratings (Standard and Poor’s, Moody’s, and Fitch), Archer et al. (2007) take into account a

sample of 50 developing countries for the period 1987 to 2003. Using panel data analysis, the findings indicated

that political variables have little impact, whilst economic factors (e.g. GDP growth rate, inflation rate, commitment

to trade, and default history) are significant on sovereign credit default ratings. Based on the same framework and a

SOVEREIGN CREDIT RATINGS IN DEVELOPING ECONOMIES 383

Copyright © 2016 John Wiley & Sons, Ltd. Int. J. Fin. Econ. 21: 382–397 (2016)

DOI: 10.1002/ijfe