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organizations do. This limited promotion of international agreements by CRAs puts into doubt international reform efforts based only on soft standards, codes, and rules. Governments should thus be wary of relying on market enforcement alone in the current new wave of international standard-setting.

6.1

Literature on Sovereign Ratings and International

Agreements

Many international institutions and scholars expect that financial markets, and in particular rating agencies, help to enforce international agreements by taking these agreements into account in their sovereign risk assessments (section 6.1.1). However, most studies on the determinants of sovereign ratings focus on a narrow set of macroeconomic indicators and the few studies on international agreements face empirical limitations (section 6.1.2).

6.1.1

Claims on Market Enforcement and Rating Agencies

Over the last few decades, states have developed a multitude of international standards, codes, and rules. For instance, following the Asian financial crisis at the end of the 1990s, regulators established a compendium of international standards to prevent future global financial crises (FSB 2013b). One key characteristic of this

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international standard-setting process was its reliance on market enforcement (Helleiner & Pagliari 2010: 4). States expected international investors to provide “clear material incentives (such as lower risk-premiums and greater capital inflows) for developing country governments to adopt the new standards” (Mosley 2009: 10). If firms used international standards to assess risk, they could put “market pressure on governments […] to comply” (Porter 2001: 433). In particular, compliance should be achieved through “the positive impact on sovereign credit ratings of adherence to these international standards” (Arner & Taylor 2009:2). CRAs are often mentioned in official statements on market enforcement as one key actor. For instance, the International Monetary Fund expects that its Reports on the Observance of Codes and Standards will be taken into account by credit rating agencies in their sovereign rating assessments (IMF 2003: 18, IMF 2013a).

Also, many scholars claim that markets help to enforce international agreements. Simmons argues that market pressures lead to high incentives to emulate the standards adopted by the dominant financial center which can explain the spread of certain international financial agreements (2001: 601-605). According to Ho, most countries implemented the Basel Accord because of market pressure (2002: 547). In this way, compliance with Basel standards became a signal of bank stability for investors (Singer 2004: 563). According to Singer, non-compliance with a global financial standard could lead to capital flight, loss of competitiveness, and a crisis of confidence (Singer 2007: 10). Kapstein argues for “enforcement […] through the marketplace, without further government intervention” (1994: 13) and already highlighted the important role of “market watchers such as debt-rating agencies” (ibid.).

6.1.2

Limited Empirical Evidence

Despite the expectation that markets, and in particular rating agencies, enforce international financial agreements, few studies have tested whether CRAs actually take the adoption of and compliance with international agreements into account. Most studies on the determinants of sovereign ratings focus on a narrow set of macroeconomic indicators for the three main CRAs that dominate the credit rating market. Despite different methods and data sets used, econometric studies identify similar significant macroeconomic variables which determine a sovereign’s rating by these agencies (see section 3.1.2). Few studies go beyond these macroeconomic indicators and study the impact of international agreements.

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Mosley (2003b) analyzes whether CRAs take into account the adoption of the IMF’s Special Data Dissemination Standard (SDDS), one of the 12 key financial standards established following the Asian financial crisis. In her survey of CRA staff during March 2001, only 20% of CRA staff report that the SDDS plays no role in their assessments (Mosley 2003b: 347). However, Mosley directly puts into doubt her own finding because it contradicts the limited importance of the SDDS for other market participants and is based on a survey conducted for only ten CRA staff.

Petrie (2003) studies the impact on sovereign ratings for the compliance with another one of the 12 key financial standards, the Code of Good Practices on Fiscal Transparency. Since its inception, the IMF has conducted a compliance report for this standard, the fiscal transparency Reports on the Observance of Codes and Standards (ROSCs) (IMF 2002). Until March 2013, these so-called fiscal ROSCs have been published for 93 countries (IMF 2013c). In a survey, Petrie finds that 15 of the 21 sovereign rating analysts at the three major CRAs who responded to his survey read the fiscal transparency ROSCs (Petrie 2003: 11). Seven of the 21 CRA staff claim that they have used information from the fiscal ROSC as a direct input for their rating assessment (ibid.).

Hameed (2005) develops a quantitative index based on the fiscal ROSCs. For a cross- section of 32 countries with averages from 1998-2002, he finds that compliance with the fiscal ROSCs leads to better credit ratings. Arbatli and Escolano (2012) update Hameed’s results for 21 advanced and 35 developing countries using the average 2010 sovereign rating by the three major CRAs as dependent variable. They find that compliance with the fiscal ROSCs has only a direct impact for developing countries. For developed countries, compliance with fiscal ROSCs has only an indirect impact through lower debt to GDP ratios and higher primary balances. For developing countries, however, a one standard deviation increase in their fiscal ROSC index leads to a sovereign rating increase of about one rating notch in their estimation.

Two studies, Nelson (2010) and Dreher and Voigt (2011), test for the impact of compliance with and adoption of international agreements on sovereign ratings beyond the key financial standards. Instead of ratings by the three major CRAs, these studies use two other measures of sovereign risk, Euromoney and Institutional Investor ratings, which are to some extent based on, but not produced by the officially recognized CRAs. Nelson (2010) analyzes the impact on sovereign ratings for the

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compliance with Article VIII of the IMF’s Articles of Agreement. Simmons first argued that states can use compliance with this agreement on an open current account to “enhance their credibility to markets” (2000: 819). For a panel of 112 non-OECD countries from 1979-1997, Nelson finds that non-compliance with this agreement leads to worse Euromoney and Institutional Investor ratings. Nelson also tests for the impact of IMF-supported programs on sovereign risk assessments and shows that a country is downgraded by about one point if it takes an IMF loan in the previous year (Nelson 2010: 121). However, this negative impact of IMF-supported programs on sovereign ratings should be interpreted with caution. IMF programs are always started during financial crises. Unobservables, such as uncertainty in such a financial crisis, could thus rather cause the downgrade than the IMF-supported program.

Dreher and Voigt (2011) test whether an indicator that aggregates different international agreements is a significant determinant of sovereign ratings. Their indicator is based on the ratification of four United Nations (UN) conventions67_,

acceptance of International Court of Justice jurisdiction, membership of the World Trade Organization (WTO) and membership of two World Bank sub-organizations68_{. In}

a panel of 136 countries from 1984-2004, Dreher and Voigt (2011) show that the adoption of international agreements leads to significantly better Euromoney and Institutional Investor ratings.

In addition to this study on membership of IOs, I am not aware of any study that focuses on membership of regional organizations as a rating determinant. However, two studies analyze the impact of compliance with accession criteria used by the European Union and the European Monetary Union (EMU) on the sovereign debt market in general. Gray (2009) studies the impact of the EU accession process on sovereign bond spreads for a sample of 17 post-communist European countries from 1990-2006. Controlling for selection processes and substantive reforms prior to EU accession, Gray finds that closing the negotiation chapter with the EU on domestic economic policies leads to lower sovereign bond spreads. Based on many interviews, Mosley (2003a: 66-69, 2003b: 333-334) finds that the accession criteria for European

67 _{The four UN conventions are the International Convention for Civil and Political Rights and its}

Optional Protocol to abolish capital punishment, the International Convention for Economic, Social, and Cultural Rights, the Convention on the Recognition and Enforcement of Foreign Arbitral Awards and the Convention Against Torture.

68 _{The World Bank sub-organizations are the International Finance Corporation (IFC) and the}

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Monetary Union membership are also taken into account by sovereign debt market participants.

Overall, this literature review shows the lack of comprehensive empirical evidence compared to the expectations by international institutions and academics that CRAs help to enforce international agreements by taking them into account in their sovereign rating assessments. Although all of the studies emphasize the importance of the adoption of and compliance with international agreements, they face several shortcomings. First, surveys of CRA staff have low response rates and directly ask about a standard at only one point in time when the standard is high on the agenda. Second, econometric studies on fiscal ROSCs are only based on a small cross-section of countries. These studies face the risk that unobservables, such as good fiscal institutions, drive the results because they are correlated with ROSCs and sovereign ratings. For IMF programs, it is particularly difficult in an econometric study to distinguish between the impact of the crisis and the ensuing program. Third, some of the interesting hypotheses, such as the impact of compliance with accession criteria on sovereign ratings, have not been tested for sovereign ratings thus far. Finally, none of the studies tests for all existing international agreements based on a theory of which agreements matter and which do not.