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Understanding Sovereign Ratings and Their Implications for Emerging Economies
The rating methodologies of the big three credit rating agencies—S&P, Moody’s, and Fitch—are scrutinised and evaluated. The factors driving sovereign ratings are examined using a regression framework and machine learning techniques with a panel of 162 countries covering ratings from 2000 to 2018. Across all models, institutional quality is the most significant factor driving sovereign ratings, suggesting that building more vital institutions can lower a sovereign’s borrowing costs by improving sovereign ratings. Additionally, only sustainable GDP growth propelled by strong structural reforms and productive investment increase CRA ratings. The findings suggest that the over-reliance of market participants on CRA ratings to assess sovereign creditworthiness may be unwarranted, particularly during crisis periods.
All opinions expressed in this paper reflect those of the authors and not necessarily those of CAFRAL.
The authors wish to thank Sitikantha Pattanaik for invaluable guidance and support during this project. They also thank Harendra Kumar Behera for providing data and for helpful discussions. They gratefully acknowledge Sangeetha Matthews and Silu Muduli for useful comments.
The COVID-19 pandemic saw countries adopt large fiscal stimulus packages and unconventional monetary measures to combat the pandemic’s economic fallout. These measures raised questions of sovereigns’ fiscal capacity and debt sustainability, especially for emerging market economies (EMEs). In turn, credit rating agencies (CRAs) downgraded several EMEs, including India.1 Moody’s downgraded India’s rating from Baa2 (negative) to Baa3 (negative) on 1 June 2020. Fitch, too, changed its outlook on India’s rating from BBB- (stable) to (negative) on 18 June 2020.2
Despite these downgrades, there has been limited adverse impact on capital markets in India, possibly indicating that the sovereign ratings themselves have limited new information, and market-based measures may be more timely indicators of a sovereign’s creditworthiness. The question then arises, if CRA ratings are not informative, do they still matter? Mechanistic reliance by market participants leads to large effects of CRA rating changes as rating thresholds are often integrated into laws, regulations, and market practices, often leading to herding and cliff effects (Financial Stability Board 2010a,
2010b). CRA policies also prevent them from rating firms in a country above the sovereign rating, and thus sovereign ratings determine firms’ rating and costs of borrowing (Almeida et al 2017; Adelino and Ferreira 2016). For instance, after India’s downgrade by Moody’s, six major public sector entities were also downgraded. Rating downgrades may also lead to negative feedback loops, as rating downgrades can worsen economic conditions, leading to further downgrades (Aizenman et al 2013). India’s rating is just above non-investment grade status, and even a one-notch downgrade can trigger large foreign capital outflows.
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