As sovereign ratings are embedded in public regulation and as they have an influence on government bond prices, it is important to understand their performance thus far. Following the 2007-2009 financial crisis, CRAs were widely criticized for their contribution to the subprime crisis (see Pagano & Volpin 2010). The US Department of Justice even filed a complaint against S&P in a Los Angeles federal court (Economist 2013). He et al. (2011) find that CRAs indeed assigned more positive ratings to large issuers of structured finance products before the crisis. Efing and Hau (2013) also demonstrate that CRAs gave asset- and mortgage-backed securities a better rating if the issuer provided the CRA with more rating business. Moreover, Hau et al. (2013) show that large banks also received better ratings if the banks bought more structured finance ratings. In contrast to these failures in rating structured finance products and banks, CRAs have thus far a good track record for sovereign ratings.
Table 5: Number of Sovereign Ratings
Rating Agency Countries Year-End Ratings
S&P 129 1,888
Moody’s 109 1,823
Fitch 111 1,295
Total 147 5006
Data: for S&P from 1980-2010 (S&P 2011b), for Moody’s from 1980-2009 (Moody’s 2011), for Fitch from 1994-2010 (Fitch 2012c)
Since the resurgence of sovereign ratings, the three main CRAs have rated 147 countries and issued 5,006 ratings at the end of the year (year-end ratings) (see Table 5).2 Since 1980, S&P and Moody’s both issued more than 1,800 year-end ratings. Fitch
provided about 1,300 year-end ratings since re-entering the rating market in 1994. About 20% of all year-end ratings were for countries with a AAA/Aaa rating (see Figure 2). Until the end of the 1980s, the majority of countries were still rated AAA/Aaa. But as more and more countries received a rating, a lower percentage was rated AAA/Aaa. As a result, most rating changes occurred since the mid-1990s. 87% of S&P’s and 85% of Moody’s sovereign rating changes have taken place since 1995.
2 In the following, all sovereign rating data are from 1980-2010 for S&P (S&P 2011b), from
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Figure 2: Proportion of AAA-rated Countries by Rating Agency
Over time, sovereign ratings have been relatively stable, which indicates that CRAs seldom had to change their assessments fundamentally. Table 6 shows a transition matrix for all year-end ratings for the three main CRAs. Ratings are especially stable for better-rated countries. Countries with a AAA rating at the end of one year still got a AAA rating at the end of the next year in 97.5% of the 981 cases. Almost all rating changes within a year are only by a few rating notches. One of the few exceptions was South Korea during its financial crisis. From 1996 to 1997, all three CRAs downgraded Korea’s sovereign rating by several notches, S&P and Fitch even from AA- to B+ and B- respectively. For most rating categories, more than 70% of all ratings are not changed from one year to another. If a country comes close to default, its ratings change more often and by more rating notches.
To measure the performance of sovereign ratings, we have to analyze ratings prior to sovereign defaults. In contrast to government bond yields, sovereign ratings do not reflect exchange rate expectations, monetary policy rates or inflation rates, but are only a measure of default risk. If CRAs fulfill their task, their ratings should be good predictors for defaults. Thus far, 24 countries defaulted that were rated by at least one of the three main CRAs one year prior to the day the default occurred. Table 7 shows the default date and the foreign-currency rating one year before the default. No investment grade-rated country ever defaulted one year later. Greece was the country
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with the best rating one year prior to the default with a BB+/Ba1-rating assigned by all three CRAs. In contrast to other rating products, all three CRAs have therefore thus far not failed in their sovereign default risk assessments.
46 Table 6: Transition Matrix for Sovereign Ratings
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Table 7: Foreign-Currency Ratings One Year Prior to a Sovereign Default
Default Date Country S&P Moody's Fitch
27/02/2012 Greece BB+ Ba1 BB+ 06/11/2001 Argentina BB B1 BB 27/01/1999 Russia BB- Ba2 BB+ 16/05/2003 Uruguay BB- Ba2 BB+ 30/12/2004 Grenada BB- 29/01/1999 Pakistan B+ B2 August 1999 Ecuador B1 13/02/2003 Paraguay B B2 July 2003 Nicaragua B2 07/08/2008 Seychelles B 14/01/2010 Jamaica B B1 B 30/03/1999 Indonesia B- B3 B- January 2000 Ukraine B3 23/04/2002 Indonesia B- B3 B- June 2002 Moldova B3 CC 18/01/2005 Venezuela B- Caa1 B- 15/12/2008 Ecuador B- Caa2 CCC 21/08/2012 Belize B- B3 08/10/2012 Grenada B- 17/04/2000 Indonesia CCC+ B3 B-
June 2008 Nicaragua Caa1
01/02/2005 Dom. Republic CCC B3 CCC+
05/12/2012 Greece CCC Ca CCC
07/12/2006 Belize CCC- Caa3
Data: Default dates are from S&P (2013d: 17-18) and from Moody’s (2013d) for those countries not rated by S&P. Sorted by S&P’s foreign-currency rating one year prior to a sovereign default.
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3
Sovereign Rating Criteria: What We Know and How to
Find Out More
“The bankers, the rating agencies and the financial institutions have a much bigger voice in matters which are basically political. And, the idea that the bankers and rating agencies can just tell a democratically elected government to ignore altogether the will of the population seems to go against everything that democracy stood for.”
Amartya Sen, Economist, 1 June 2011 (Sen 2011)
As discussed in chapter 2, rating agencies have an impact on government bond prices and the domestic economy. Therefore, it matters what the agencies demand from national governments. As Amartya Sen in the citation above, many scholars claim that CRAs are in favor of certain policies and political institutions (see section 3.1.1). However, most empirical studies on sovereign rating criteria test only for a few basic macroeconomic indicators without controlling for political factors. Some scholars have built on these studies to analyze political factors, but their results are inconclusive (see section 3.1.2). This leads to the research question of this book: Do rating agencies take into account political factors and if so, which political criteria do they use (see section 3.2)? The methodologies and databases that the main CRAs publish can give us a first indication of CRAs’ criteria. In these methodologies, CRAs indeed emphasize that they go beyond simple macroeconomic indicators and also take political factors into account to measure a government’s willingness to repay (see section 3.3). Section 3.4 provides an overview of the data and quantitative and qualitative methods used in the following chapters to understand which policies and political institutions CRAs regard as indicators for a country’s willingness to repay.