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«Credit Rating Agency Downgrades and the Eurozone Sovereign Debt Crises Christopher F Baum∗ (Boston College, DIW Berlin) Margarita Karpava (MediaCom ...»

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Credit Rating Agency Downgrades and

the Eurozone Sovereign Debt Crises

Christopher F Baum∗ (Boston College, DIW Berlin)

Margarita Karpava (MediaCom London)

Dorothea Schäfer (DIW Berlin, JIBS)

Andreas Stephan (JIBS, DIW Berlin, Ratio Institute Stockholm)

January 30, 2014


This paper studies the impact of credit rating agency (CRA) downgrade announcements on

the value of the Euro and the yields of French, Italian, German and Spanish long-term sovereign

bonds during the culmination of the Eurozone debt crisis in 2011–2012. The employed GARCH models show that CRA downgrade announcements negatively affected the value of the Euro currency and also increased its volatility. Downgrading increased the yields of French, Italian and Spanish bonds but lowered the German bond’s yields, although Germany’s rating status was never touched by CRA. There is no evidence for Granger causality from bond yields to rating announcements. We infer from these findings that CRA announcements significantly influenced crisis-time capital allocation in the Eurozone. Their downgradings caused investors to rebalance their portfolios across member countries, out of ailing states’ debt into more stable borrowers’ securities.

Keywords: Credit Rating Agencies, Euro Crisis, Sovereign Debt, Euro Exchange Rate JEL classification: G24, G01, G12, G14, E42, E43, E44, F31, F42, F65 ∗ Corresponding author: Department of Economics, Boston College, 140 Commonwealth Avenue, Chestnut Hill MA 02135 USA. Email: baum@bc.edu.

1 Introduction In January 2012, the credit rating agency Standard & Poor’s (S&P) downgraded the sovereign debt ratings of nine Eurozone countries, including France, which lost its previous AAA rating. S&P also cut Austria’s triple-A rating and relegated the sovereign debt of Portugal and Cyprus to junk status. The downgrading announcements received a great deal of public attention. Politicians in several Eurozone countries reacted by downplaying the role of rating announcements from credit rating agencies (CRAs) in an effort to ease the expected turbulence within the Eurozone.

The purpose of this paper is to examine the impact of CRA downgrade announcements on the Eurozone during the sovereign debt crisis of 2011–2012. Specifically, we study the role of rating announcements on exchange rate movements and government bond yields. We construct a database covering nearly 150 announcements of S&P, Moody’s, and Fitch during the sovereign debt crisis.

The Euro began to depreciate in early 2009 when the large public deficits of several Euro countries became the topic of public debate. At the same time, the major credit rating agencies started downgrading Greek and Irish sovereign bonds due to these countries’ government budget deficits.

A series of negative watch and outlook revisions were announced by S&P and Fitch, followed by massive downgrade announcements for Eurozone countries in early January 2012.

Financial investors, in particular banks and insurance companies, used to invest heavily in sovereign bonds of Eurozone countries. Downgrading may therefore not only increase the likelihood that other members of the currency union will be forced to bail out the ailing country but also weaken its own domestic banks. Both issues may pose a threat to the sustainability of their own government debt levels. Foreign investors may therefore interpret negative rating news on one country as a signal of worsening fundamentals in the Eurozone as a whole and subsequently withdraw their funds. This reaction may worsen the fundamental economic situation and trigger even further withdrawals.

The rating announcement would then become a self-full-filling prophecy and trigger a currency crisis. Such a sequence of events was observed in the Asian crisis (Morris & Shin 1998). Moreover, downgrades could initiate speculation against the Euro, placing even more pressure on its value.

Although some problems of the Eurozone are similar to the ones observed in the Asian crisis, there exists one decisive difference. Eurozone member states share a common currency but each country still possesses full fiscal sovereignty. This unique construction opens up the possibility to internally reallocate a Euro-dominated portfolio. Such an option was not available in the Asian crisis. If a CRA announcement triggered a portfolio rebalancing across member countries, from the debt of ailing states into more stable issuers’ securities, a repricing of risks would occur within the Eurozone but the Euro exchange rate would be rather immune to CRA announcements.

There is anecdotal evidence that such portfolio reallocation effects indeed matter. For example, in recent months the Swedish National Bank (Riksbank) has shifted its Euro currency reserves from Spanish and Italian bonds to German bonds.1 However, so far, little effort has been made to systematically analyze and understand the link between downgradings of particular members, the repricing of risk within the Eurozone and the movements of the common currency. To date, most studies on the impact of credit rating announcements deal with stock and bond markets. To the best of our knowledge, we are the first to analyze the relationship between sovereign credit rating announcements, investors’ portfolio decisions and the value of the common currency of sovereign member states during the culmination of the Eurozone crisis in 2011 and 2012.

Similar to the previous impact studies, this paper adopts an event-study methodology combined with an econometric GARCH model in order to estimate the impact of rating announcements by the three leading agencies (Standard & Poor’s, Moody’s, and Fitch). We use three different models but the same econometric methodology: an exchange rate model and two CAPM models to explain sovereign bond yields for selected countries.

Our major finding is the following. CRA watchlist and outlook events have almost no significant impact on the value of the Euro currency. In contrast, sovereign downgrading has a statistically significant impact, as it leads to a depreciation of the Euro against the US dollar and other major currencies. Downgrading increases the excess yields of French, Italian and Spanish government bonds but at the same time lowers German bond yields. In some cases CRA announcements increase the volatilities of Euro exchange rates and sovereign bond yields, indicating higher market uncertainty around the events. We find no evidence for reverse Granger causality from bonds’ yields to CRA announcements. Overall, these findings corroborate that investors rebalanced their portfolios See the Swedish economic newspaper Dagens Industri, June 4, 2013.

across member countries, out of ailing states’ debt into more stable securities. Consequently, CRA announcements may have distributional effects.

The remainder of the paper is organized as follows. The next section describes the background of the credit rating agency industry and reviews previous literature related to the impact of CRAs.

In Section 3, we present a brief summary of rating announcements during the European sovereign debt crisis. Section 4 presents a comparison with the Asian financial crisis of 1997–1998. In Section 5, we develop the empirical methodology and Section 6 provides the results. Finally, Section 7 concludes.

2 Background and Previous Research Credit rating agencies were created with the objective of solving information asymmetry problems in financial markets as they provide an assessment of a borrower’s ability and willingness to repay its debt securities. The role of credit rating agencies in the global financial system as well as quality of their credit risk assessments has been widely debated. Credit rating agencies have often been criticized for violating their primary function of minimizing information uncertainty in financial markets. In line with this conclusion, Carlson & Hale (2005), using a global games framework, find that the existence of credit rating agencies may threaten market stability as it increases the incidence of multiple equilibria. Bannier & Tyrell (2005) report that a unique equilibrium can be restored by making the rating process more transparent, enabling market participants to independently assess quality and validity of credit ratings. The more accurate are credit rating announcements, the greater is the efficiency of investor decisions, and hence, is the market outcome.

Rating agencies assign a grade to the bond issuer according to the relative probability of default, which is measured by the country’s political and economic fundamentals. The credit ratings industry is dominated by the three leading agencies: Standard & Poor’s (S&P), Moody’s Investors Service and Fitch Ratings. Even though the three credit rating agencies use different rating scales of measurement, there is a high degree of correspondence between them. A table with a corresponding definition of rating grades, assigned by each CRA, is listed in Table 1.

Credit ratings tend to differ among CRAs, which can be mainly attributed to different estimation methodologies and proxy variables considered in the analysis. S&P focuses mostly on the forwardlooking probability of default. Moody’s bases its rating decisions on the expected loss, which is a function of both the probability of default and the expected recovery rate. Finally, Fitch takes into consideration both the probability of default and the recovery rate (Elkhoury 2009).

Prior studies report that sovereign credit ratings are primarily affected by the following economic indicators: GDP per capita, GDP growth, public debt as a percentage of GDP, budget deficit as a percentage of GDP and inflation level within the country (Cantor & Packer 1996). A history of sovereign default, the level of economic development and government effectiveness within the country have also been identified as important in determining sovereign credit ratings (Afonso et al.

2012). Information as to how CRAs assign weights to each variable they consider in assessment of the credit risk is not publically available.

The effects of sovereign credit ratings on debt and equity markets have been studied by many researchers. Brooks et al. (2004) report that rating downgrades negatively affect stock market returns. At the same time the dollar value of the domestic currency decreases. Kräussl (2005) shows that negative ratings significantly increase an index of speculative market pressure which consists of daily nominal exchange rate changes, daily short-term interest rate changes and daily stock market changes. In contrast, rating upgrades and positive outlooks show a weak or even insignificant impact. Kim & Wu (2008) claim that long-term credit ratings support the development of financial markets in emerging economies.

Hooper et al. (2008) examine the impact of credit rating events on international financial markets using a database of 42 countries over the period 1995 to 2003. They provide evidence that rating upgrades significantly increased USD denominated stock market returns and decreased volatility.

Downgrades show the corresponding contrary effect. However the market responses for both return and volatility are asymmetric and more pronounced for downgrades. A recent paper by Wu & Treepongkaruna (2008) empirically tested the impact of sovereign credit rating news on volatility of stock returns and currency markets during the Asian financial crisis. Both market measures were found to be strongly affected by changes in sovereign credit ratings with currency markets being more responsive to credit rating news, while changes in sovereign outlooks had much stronger impact on stock price volatility than did actual rating announcements.

Several research papers also find strong contagion effects of watch and outlook changes on stock, bond and CDS markets of nearby countries. Hamilton & Cantor (2004) and Alsati et al. (2005) find evidence that rating events such as outlooks and watchlist assignements increase the predictive power of sovereign credit rating announcements, as they shed light on which governments are likely to default on their debt or to be downgraded in the foreseen future.

2.1 Credibility of CRA rating announcements The reliability of CRA announcements in times of crisis has often been questioned. Ferri & Stiglitz (1999) report that prior to the Asian financial crisis, credit ratings were higher than economic fundamentals would suggest, while ex post ratings were much lower than the model predicted. This evidence suggests a procyclical rating behavior. Reinhart (2002) confirms that rating agencies lag behind the market. Following the markets with downgrading rather than leading it might accelerate the panic among investors, drive money out of the country and sovereign yield spreads up (Reisen & von Maltzan 1999). Bhatia (2002) claims that failed ratings stem from CRAs’ inclination towards ratings stability rather than accuracy of reported announcements. Mora (2006) reports indeed a considerable stickiness of ratings. Elkhoury (2009) also describes the assessment of the CRA as “tend[ing] to be sticky, lagging markets, and then overreact[ing] when they do change” (p. 1).

Moreover, Ferri & Stiglitz (1999) observe that in response to a past major rating failure CRAs tend to become overly conservative. This observation could suggest that CRA have downgraded Eurozone member states particularly aggressively in an effort to regain the reputation which was lost in the US sub-prime rating debacle. In the Asian crisis CRA downgrades posed a particular threat for the stability of ailing countries’ currencies.

We take concerns of CRAs lagging behind the market into account in our analysis of the impact of sovereign rating news on currency movements and on a subsequent adjustment of bond portfolios, as we scrutinize the results for reverse causality effects.

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