Access to International CapitalDo the Credit Ratings Agencies Help or Hurt?

Asymmetric Bias and Self-fulfilling Sovereign DefaultsDavid Tennant, Damien King, & Marlon Tracey

Paper argues that…

• CRAs have reason to be biased against poor countries• Evidence suggests the bias is statistically significant• The bias can be sufficient to trigger default/restructuring

Credit Rating

Agency’s Objective

CRAs wish to minimize both cost (of acquiring information) and inaccuracy (of their ratings).But there is a trade-off between the two, since accuracy is costly.

Characteristics of the

Ratings Business

• It is costly to acquire information on the ability/willingness of a sovereign to service debt• The weaker a country’s

institutions, the poorer it is and also the worse is the quality of readily available information• Default by a highly rated

sovereign is worse (reputationally) than failure to default by a poorly rated one

Accuracy costs

C

OS

T

OVER-ESTIMATE UNDER-ESTIMATE

Under-estimating default likelihood

worse than over-estimatin

g

C

OS

T

OVER-ESTIMATE UNDER-ESTIMATE

Striking a balance =

over-estimatin

g C

OS

T

OVER-ESTIMATE UNDER-ESTIMATE

Optimal over-

estimation worse

the more costly it is

to get informatio

n

C

OS

T

OVER-ESTIMATE UNDER-ESTIMATE

Therefore…

• CRA’s estimated probability of default has a bias, the strength of which is inversely related to a country’s level of development.• “Bias” because it is independent of the fundamentals that determine a country’s ability and willingness to repay its debt.

Paper argues that…

• CRAs have reason to be biased against poor countries• Evidence suggests the bias is statistically significant• The bias can be sufficient to trigger default/restructuring

Objective of

Statistical Estimatio

n

Test CRAs decision to downgrade, upgrade or leave unchanged the rating of a country’s foreign currency sovereign debt.

Statistical testing

takes account

of…

• Economic and institutional fundamentals• Debt, debt service, fiscal balance, GDP,

investment, reserves, inflation, CA balance, Institutional quality

• Country specific fixed effects• Some element of a country’s risk may be

particular to that country, e.g., social capital

• Heterogeneous thresholds• Threshold for re-grade not same for all

countries• Time-period dummies• Willingness to re-grade changes over

time• Tempering• General reluctance to change a rating

due to desire for stability and upper/lower limits

Data • Countries: 142• Years: 1997 to 2011• CRAs: S&P, Moody’s, Fitch

Mean Ratings

Low Middle Upper

S&P 8.3 10.2 17.71.89 3.26 3.14

Moody’s 8.4 10.3 17.8

2.21 3.25 3.22

Fitch 8.3 10.4 18.02.26 3.37 3.10

Factors Influencing Ratings Changes

  S&PMoody’

s Fitch∇ Debt -5.89 -2.47 -5.76∇ Debt Service 1.98 0.83 -3.43

∇ Real GDP per cap 0.09 0.07 0.08∇ Investment 3.65 5.11 5.71

∇ ln Export 2.67 1.52 0.34

∇ Reserve/Import 0.11 0.09 0.02

∇ Current Account Bal. -6.84 -2.67 -4.41

∇ Inflation -3.99 -0.45 -2.51

∇ Institutional Quality 1.11 1.07 2.14

Factors Influencin

g Upgrade Threshold

s

  S&PMoody’

s FitchLow Income 0.62 0.73 1.14Middle Income 0.08 0.22 0.32

Paper argues that…

• CRAs have reason to be biased against poor countries• Evidence suggests the bias is statistically significant• The bias can be sufficient to trigger default/restructuring

Government’s

Objective

Governments wish to minimize both taxes and defaults.But there is a trade-off between the two since they are alternative means of financing.

Characteristics of Fiscal

Choices

• Defaulting is policy choice• There is a fixed cost to defaulting• CRAs can see when a government would be better off by defaulting

default,

default

no default,

default

not default

If CRAsexpectthen

govt should…

To beor not to

be (a defaulter)

not default

then govt should…

y

x

Conclusions

• Optimal for CRAs to overestimate the probability of default• Information acquisition costlier with poorer

countries• Highly rated default is reputationally worse

than a poorly rated survivor• Constitutes a bias• Unrelated to ability and willingness to pay.

• Evidence that S&P, Moody’s, and Fitch are reluctant to upgrade poorer countries

• There is a range of debt where a CRA could rationally predict either default or no default

• Within that range, poor countries are more likely to get an unwarranted lower rating, which can trigger a decision to default