Financial crises, credit ratings, and bank failures : emerging market instability - do sovereign ratings affect country risk and stock returns?

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Changes in sovereign debt ratings and outlooks affect financial markets in emerging economies. They affect not only the instrument being rated (bonds) but also stocks. They directly impact the markets of the countries rated and generate cross country contagion. The effects of rating and outlook changes are stronger during crises, in nontransparent economies, and in neighboring countries. Upgrades tend to take place during market rallies, whereas downgrades occur during downturns, providing support to the idea that credit rating agencies contribute to the instability in emerging financial markets.
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 77387 the world bank economic review, vol. 16, no. 2 171–195 Financial Crises, Credit Ratings, and Bank Failures Emerging Market Instability: Do Sovereign Ratings Affect Country Risk and Stock Returns? Graciela Kaminsky and Sergio L. Schmukler Changes in sovereign debt ratings and outlooks affect financial markets in emerging economies. They affect not only the instrument being rated (bonds) but also stocks. They directly impact the markets of the countries rated and generate cross-country contagion. The effects of rating and outlook changes are stronger during crises, in nontransparent economies, and in neighboring countries. Upgrades tend to take place during market rallies, whereas downgrades occur during downturns, providing sup- port to the idea that credit rating agencies contribute to the instability in emerging financial markets. Worldwide financial market instability has been the focus of attention in both academic and policy circles. Following the series of currency crashes in the past decade, most of the discussion has centered on balance of payments crises. This attention on crises is not going to fade any time soon, with the financial crashes in Argentina and Turkey in 2001 surely fueling an avid interest in crises well into the new millennium. But currency collapses are not the only crises to have attracted attention. The daily volatility of stock and bond markets during nor- mal periods has also stirred interest, with, for example, the vagaries of the nasdaq index in the United States making the daily headlines. Many have argued that globalization is at the heart of this volatility, with highly diversified investors paying little attention to economic fundamentals and fol- lowing the herd in the presence of asymmetric information.1 Policies that can lead to moral hazard, including bailouts by both international institutions and governments, have also been blamed for financial volatility and financial excesses (see, for example, Dooley 1998, McKinnon and Pill 1997). Graciela Kaminsky is with George Washington University. Her e-mail address is [email protected] Sergio Schmukler is with the Development Research Group at the World Bank. His e-mail address is [email protected] We are grateful to Eduardo Borensztein, François Bourguignon, Hali Edison, Cam Harvey, Richard Levich, Rick Mishkin, Carmen Reinhart, three anonymous referees, and two members of the World Bank Economic Review editorial board, as well as participants at the New York University and University of Maryland World Bank conferences and workshops for helpful com- ments and suggestions. We thank Gloria Alonso, Tatiana Didier, and Chris van Klaveren for excellent research assistance. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors and do not necessarily represent the views of the World Bank. 1. See, for example, Calvo and Mendoza (2000). This argument has provided ammunition to those who have supported the reintroduction of capital controls, including Krugman (1998) and Stiglitz (2000). © 2002 The International Bank for Reconstruction and Development / THE WORLD BANK 171 172 the world bank economic review, vol. 16, no. 2 The list of culprits does not stop here. Rating agencies have recently come under scrutiny as promoters of financial excesses. As Ferri and others (1999) suggest, their procyclical behavior (upgrading countries in good times and downgrading them in bad times) may have magnified the boom-bust pattern in stock markets.2 Rating changes may also reveal new (private) information about a country, fueling rallies or downturns. This effect is likely to be stronger in emerging markets, where problems of asymmetric information and transpar- ency are more severe. Changes in ratings may also act as a wake-up call, with upgrades or downgrades in one country affecting other, similar economies. Even if rating agencies do not behave procyclically, their announcements may still trigger market jitters because many institutional investors can hold only investment-grade instruments. Downgrading (or upgrading) sovereign debt below (or above) investment grade may thus have a drastic impact on prices because these rating changes can affect the pool of investors. These effects are not con- fined to the pool of investors acquiring sovereign debt. When a credit rating agency downgrades a country’s sovereign debt, all debt instruments in that country may have to be downgraded accordingly because of the sovereign ceiling doctrine. Commercial banks downgraded to subinvestment grade will find it costly to issue internationally recognized letters of credit for domestic exporters and import- ers, isolating the country from international capital markets. Downgrading cor- porate debt to subinvestment grade means that firms will face difficulties issuing debt on international capital markets. Research on the effects of rating changes flourished in the 1990s. Most of this work focused on the effects of ratings on the instruments being rated or on the instruments of the institutions being rated. Cantor and Packer (1996), Larrain and others (1997), and Reisen and von Maztlan (1999), for example, examine the effects of sovereign ratings on emerging market bond yield spreads. Other researchers have focused on ratings of banks and nonfinancial firms. Hand and others (1992) estimate the effects of ratings of corporate firms on the securi- ties they issue. Using bank-level data from emerging markets, Richards and Deddouche (1999) examine the impact of bank ratings on bank stock prices. Research has not examined whether changes in ratings of assets from one country trigger contagious fluctuations in other countries, and it has largely neglected whether changes in ratings of one type of security affect other asset markets.3 These two possible spillover effects of credit ratings are important to analyze for several reasons. First, cross-country contagion effects can be large, as spillover effects of the Russian default on industrial and developing econo- 2. Mora (2001) extends these results. She agrees that ratings are procyclical but questions the no- tion that changes in ratings increased the cost of borrowing and decreased the supply of international credit during the East Asian crisis. 3. To our knowledge, the only article that examines the contagious role of credit ratings is Kaminsky and Schmukler (1999). Erb and others (1996a, 1996b, 1996c) study how the effect of changes in rat- ings of one type of security affect other asset markets, studying the link between expected stock returns and future fixed-income returns with different measures of country risk. Kaminsky and Schmukler 173 mies showed.4 Rating agencies may contribute to this comovement in financial markets around the world. Second, news about one type of security can affect yields of other securities, through various channels. For example, stock markets can be adversely affected by the downgrading of sovereign bonds because gov- ernments may raise taxes on firms (reducing firms’ future stream of profits) to neutralize the adverse budget effect of higher interest rates on government bonds triggered by the downgrade. These cross-asset effects can be large, heightening financial instability. Another line of research on emerging market instability has focused largely on the effects of changes in monetary policy in financial centers. The results have been conflicting. Eichengreen and Mody (1998) and Kamin and von Kleist (1999) find that U.S. interest rate shocks do not affect sovereign bond spreads, whereas Herrera and Perry (2000) find that they do. The Eichengreen and Mody (1998) and Kamin and von Kleist (1999) studies do not include episodes of crises, and the Herrera and Perry (2000) work does. These conflicting results may be recon- ciled if economic fragility makes countries more sensitive to changes in interna- tional financial markets. The degree of economic fragility can be captured by country ratings. Thus, we are able to link the research on the effects of monetary shocks in financial centers on emerging market instability to the research on credit ratings.5 This article complements earlier research on rating agencies by examining the cross-country and cross-security spillover effects of rating changes. It contrib- utes to the literature on contagion and international transmission of shocks by examining the effect of domestic vulnerability, as measured by the ratings of credit agencies, on the extent of international spillovers. The article is organized as follows. Section I describes the institutional features of rating agencies. Section II presents the data. Section III describes the methodol- ogy. Section IV discusses the results. Section V summarizes the conclusions. I. Institutional Features of Rating Agencies Three major international agencies—Moody’s, Standard and Poor’s (s&p), and Fitch-ibca— rate debt.6 These agencies assign ratings to different types of bor- rowers and financial instruments. We study sovereign ratings (also known as country ratings), the ratings of both domestic and foreign currency–denominated sovereign debt. 4. The word contagion is used in a broad sense to denote cross-country spillover effects, regardless of the nature of the shock. For alternative definitions and related articles, see http://www.worldbank.org/ contagion. 5. Another factor that can influence the transmission of international shocks is the exchange rate regime. Frankel and others (2000), for example, find that world interest rates shocks have a stronger effect on countries under pegs. 6. Another important agency is Institutional Investors. Unlike the other three agencies, Institutional Investors reports ratings only twice a year at a predetermined date. It also tends to change its ratings more often than the other agencies. Because of these differences, we excluded Institutional Investors from the sample. 174 the world bank economic review, vol. 16, no. 2 Rating agencies assess the capacity of sovereign borrowers to service their debt. Each of the three agencies has its own rating scale (see appendix table 1). Moody’s scale, for example, ranges from Aaa to C. Rating agencies also provide an out- look, or watchlist, that includes prospective changes in ratings. The outlook is typically positive, stable, or negative. A positive (negative) outlook means that a rating may be revised upward (downward). Moody’s, s&p , and Fitch-ibca upgrade or downgrade particular countries almost simultaneously (figure 1). All three agencies downgraded the East Asian countries immediately following the start of the crisis in July 1997; all three simultaneously upgraded the same countries once the crisis faded.7 The number of upgrades and downgrades rose after the Mexican crisis (figure 2). Downgrades increased considerably after the devaluation of the Thai baht, the Korean crisis, and the Russian default, with a peak of 25 downgrades in Decem- ber 1997. After November 1998 many countries started to be upgraded, but down- grades were also announced in the midst of the Brazilian crisis in January 1999. A large proportion of changes in outlook are followed by a change in rating (table 1). Between 1990 and 2000, 78 percent of changes in s&p outlook were followed by changes in ratings. Rating changes followed outlook changes 69 percent of the time at Moody’s and 50 percent of the time at Fitch-ibca. The time interval between changes in outlook and changes in rating varies across agencies. Most of the changes in rating occurred within two months for Moody’s and Fitch-ibca. For s&p most of the upgrades took place five or more months after the change in outlook was announced. II. Data We examine data from 16 emerging markets: Argentina, Brazil, Chile, Colombia, Indonesia, Malaysia, Mexico, Peru, the Philippines, Poland, the Republic of Ko- rea, the Russian Federation, Taiwan (China), Thailand, Turkey, and Venezuela. The data cover the period January 1990– June 2000. We chose countries in the three regions (East Asia, Eastern Europe, and Latin America) that suffered crises and contagion during the 1990s and for which data were available. (Appendix table 2 reports the time periods for which data were available for each country.) The sample includes 244 changes in ratings and outlooks, 99 upgrades, and 145 downgrades (tables 2 and 3). Most of these changes were changes in ratings rather than changes in outlooks. Countries with currency collapses during the 1990s—such as Brazil, Indonesia, Malaysia, the Republic of Korea, the Russian Federation, and Thailand—were frequently reevaluated by rating agencies. Sovereign bond yield spreads were obtained from JP Morgan’s Emerging Markets Bond Index (embi). The yield spread index for each country is either the embi or the embi+, based on availability. The two indexes track foreign cur- rency–denominated government bond yields for several emerging market econo- 7. For a detailed study of how ratings are changed, see Cruces (2001). Kaminsky and Schmukler 175 Figure 1. Ratings of Foreign-Currency Sovereign Debt for Selected Countries Source: Bloomberg. mies and compare them with the yields of benchmark instruments issued by indus- trial countries. The securities included in the embi index are Brady bonds, which are traded internationally in highly liquid markets. The embi+ is a more com- prehensive index and includes benchmark Eurobonds, loans, and Argentine do- mestic debt. embi and embi+ (henceforth embi) spreads are commonly used as measures of country premia, country risk, or default risk. When the probability of a sovereign default increases, bond prices decrease and yield spreads increase. Data on stock prices, U.S. interest rates, and credit ratings come from Bloomberg and Datastream. Stock market price indexes for each country are measured in U.S. dollars to be able to compare returns across countries in the same unit of account. Returns in dollars are the ones relevant for international investors. The U.S. interest rate is the one-month interbank offer rate. Daily changes (in absolute values) in bond and stock markets oscillate about 2.5 percentage points for sovereign spreads and about 1.6 percentage points for stock prices (table 4). The number of observations is high (about 11,000 for bond spreads and 22,000 for stock prices). Figure 2. Changes in Ratings and Outlooks 1990–2000 176 Source: Authors’ calculations. Table 1. Number of Changes in Ratings Following Change in Outlook Moody’s s &p Fitch-ibca Items Upgrades Downgrades Upgrades Downgrades Upgrades Downgrades Total number of 13 16 13 23 5 3 changes in outlooks Total number of 9 11 13 15 3 1 changes in ratings 177 Within 1 month 0 2 1 4 1 1 2 months 6 7 0 4 1 0 3 months 1 1 0 4 1 0 4 months 2 1 1 1 0 0 More than 4 months 0 0 11 2 0 0 Source: Authors’ calculations. 178 the world bank economic review, vol. 16, no. 2 Table 2. Number of Upgrades and Downgrades, by Rating Agency Ratings Outlooks Agency Total changes Upgrades Downgrades Upgrades Downgrades Moody’s 77 19 29 13 16 Foreign-currency debt 37 14 23 Domestic-currency debt 11 5 6 S& P 112 28 48 13 23 Foreign-currency debt 45 19 26 Domestic-currency debt 31 9 22 Fitch-IBCA 55 21 26 5 3 Foreign-currency debt 30 15 15 Domestic-currency debt 17 6 11 Total 244 68 103 31 42 Source: Authors’ calculations. III. Methodology To study the effects of ratings and outlooks on financial markets, we estimate panel regressions and perform event studies. The panel regressions focus on the immediate response of financial markets to rating and outlook changes. The event studies examine the dynamic response of financial markets around the time of important events. Panel Regressions The panel estimations study the daily reactions of country premia and stock re- turns to changes in ratings, outlooks, and U.S. interest rates. The fact that we use daily data does not allow us to control for country fundamentals, which are typically reported on a monthly or quarterly basis, but we do control for past changes of the explanatory variables. We use only one lag, because additional lags appear to be insignificant. We estimate different regressions for both country premia and stock prices. We start with a benchmark regression, which we then modify to examine to test various hypotheses: (1) DYi,t = a + dDYi,t–1 + bDRt + gDitUS + εi,t, such that i = 1, . . . , N and t = 1, . . . , T. DYi,t represents the log change in spreads and the log change in stock market prices. The subindexes i and t stand for country and time. DRt stands for the change in ratings and outlooks. It is equal to 1 (–1) if there is an upgrade (downgrade) in rating or outlook at time t by any agency of any type of debt (denominated in foreign or domestic currency) from any country in the sample; otherwise it is equal to zero. DitUS stands for the change in U.S. interest rates; strictly speaking, the interest rate is 100 × log(1 + itUS). Kaminsky and Schmukler 179 Table 3. Number of Upgrades and Downgrades, by Country Ratings Outlooks Agency Total changes Upgrades Downgrades Upgrades Downgrades Argentina 14 4 3 3 4 Brazil 19 9 6 3 1 Chile 5 3 1
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