Modelling the information content of sovereign credit ratings

Abstract

This study examines the information content of the sovereign credit ratings assigned by 11 international credit rating agencies to 55 countries for the period from 1989 to 1997. The empirical work is divided into three parts, which separately investigate the determinants of: (1) foreign currency sovereign ratings; (2) local currency sovereign ratings; and, (3) transfer risk -as proxied by the difference between local and foreign currency ratings. In particular, the study explores the extent to which these determinants can be explained by: quantitative and qualitative variables; by macroeconomic and balance-sheet variables; and, by average and lagged values of macroeconomic variables. It also examines the systematic differences across rating agencies and across geographic regions. It compares the robustness of ordered probit analysis and OLS regression to explain sovereign credit ratings; and, it quantifies the impact of the preferred model of sovereign creditworthiness indicators on credit ratings and on transfer risk. With respect to the analysis of foreign currency sovereign ratings, this empirical work differs from previous studies in the following ways: it uses a larger sample and more recent data than any study to date; it expands the set of explanatory variables to include balance-sheet variables; it pays attention, for the first time, to the lagged structures of explanatory variables; it utilises a more appropriate statistical model, ordered probit, given the ordinal, discrete nature of credit ratings; and, it provides accuracy measures at the rating notch level for the models while comparing ordered probit and OLS performance. Additionally, this study expands the existing literature by presenting the first systematic analyses of the determinants of local currency sovereign ratings and the determinants of transfer risk. Finally, this study comprises the first attempt to quantify the impact of the determinants of sovereign credit ratings and transfer risk. The findings reveal that there are significant differences in the determinants of foreign and local currency sovereign ratings and, that the agency assessing the sovereign's creditworthiness and the sovereign's geographic region play an important role in the determination of credit ratings. The results also suggest that uses of ratings which presuppose comparability may prove inadequate, and that differences across agencies may provide sovereigns with an incentive to select those which will provide potentially more favourable ratings. Further, ordered probit analysis proved more successful at modelling sovereign ratings than the linear specification. Important differences are also found regarding the statistical and quantitative significance of the explanatory variables.

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