Determinants and impacts of sovereign credit ratings

TLDR

The study presents the first systematic analysis of sovereign credit ratings from Moody's and Standard & Poor's. The authors analyze sovereign credit ratings of the two leading agencies, Moody's and Standard & Poor's. The analysis shows that sovereign ratings largely reflect macroeconomic fundamentals—per capita income, external debt, inflation, default history, and development level—explaining over 90% of cross‑sectional variation, while fiscal deficits are not systematically related, and ratings influence market spreads and bond yield reactions.

Abstract

In this article, we present the first systematic analysis of the sovereign credit ratings of the two leading agencies, Moody's and Standard & Poor's (S&P). We find that the ordering of risks they imply is broadly consistent with macroeconomic fundamentals. While the agencies cite a large number of criteria in their assignment of sovereign ratings, a regression using only eight factors explains more than 90 percent of the cross-sectional variation in the ratings. In particular, a country's rating appears largely determined by its per capita income, external debt burden, inflation experience, default history and level of economic development. We do not, however, find any systematic relationship between ratings and either fiscal or current deficits, perhaps because of the endogeneity of fiscal policy and international capital flows. Sovereign ratings are also closely related to market-determined credit spreads, effectively summarizing and supplementing the information content of macroeconomic indicators in the pricing of sovereign risk. Cross-sectional results suggest that the rating agencies' opinions have independent effects on market spreads. Event study analysis broadly confirms this qualitative conclusion, for the reactions of bond yields to the announcements of changes in the agencies' sovereign risk opinions are statistically significant with respect to both their sign and magnitude.