Estimating the weights assigned to determinants of emerging market sovereign ratings
Van den Berg, Margitte
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The recent global financial crisis uncovered numerous problems in the fundamental analytical structure and methodologies applied by the credit rating agencies. It reintroduced the debate concerning the accuracy, objectivity and diligence with which credit rating agencies assign sovereign credit ratings (sovereign ratings). Standard & Poor’s, Moody’s Investors Service (Moody’s) and Fitch Ratings (Fitch) utilise more or less the same determinants in rating sovereigns worldwide. However, the weights assigned to each determinant differ for each of the three major credit rating agencies and hence the obstacle remains that sovereigns are rated differently by each agency. Changes in sovereign ratings influence flows of capital to emerging market economies. Sovereign ratings especially affect emerging market economies, since these economies are highly dependent on international capital flows to finance foreign currency expenditures. Sovereign default risk significantly influences flows of capital from developed economies to emerging market economies. Emerging market economies strive to maintain a stable and high rating, as long run foreign currency sovereign ratings are essential for the attraction of capital flows. The first objective of this study was to scrutinise the effect of sovereign rating announcements, either an upgrade or a downgrade, on flows of capital to emerging markets. This study demonstrates the significance of sovereign rating changes on global market reactions. An upgrade through the investment grade barrier not only reduces a sovereign’s global borrowing cost but also ensures funds from international investment. Granger causality tests determined that four emerging market economies, namely Cyprus, Hungary, Indonesia and Lithuania demonstrated changes in sovereign ratings that have an influence on flows of capital. Some of the economies suggest that bi-directional movements are possible as well, which gives the financial and capital account values the ability to forecast future ratings and vice versa. The timing of upgrades or downgrades across the three agencies was examined to establish whether rating changes occur simultaneously or whether a specific agency leads/follows with rating changes. Standard & Poor’s was identified as the main leading agency that initiated 40.74% of rating changes followed by Fitch that led 33.33% and Moody’s that led 25.93%. This study suggests that Standard & Poor’s is the leading agency, Moody’s the primary following agency and Fitch the secondary following agency within the time period of 1998Q1-2014Q1, for the particular group of emerging market economies. The second objective of this study was to examine the links between sovereign ratings and the weights assigned to the determinants within the sovereign rating methodologies. The analysis focused on Standard & Poor’s, Moody’s and Fitch in an attempt to verify which macro-economic variables have a significant influence on sovereign ratings. In addition, determining whether emerging market economies are rated differently by each credit rating agency. Three estimation techniques were applied to yield the empirical results. These three chosen methods are firstly the ordered probit method, secondly the Ordinary Least Squares (OLS) method with panel options fixed and random effects and thirdly the pooled OLS method with panel options fixed and random effects. The results of the empirical analysis found seven macro-economic variables significant, which has an imperative influence on sovereign ratings. These variables are fiscal balance as a percentage of GDP, external debt as a percentage of GDP, external debt as a percentage of exports, real GDP growth, real effective exchange rate and current account as a percentage of GDP.