On Emerging Economy Spreads and Ratings

Transcription

1 On Emerging Economy Spreads and Ratings Andrew Powell and Juan Francisco Martinez 1 April 2007 Preliminary Draft Comments Welcome We analyze alternative models for ratings. Recent ratings improvements are explained by improvements in economic fundamentals driven by a small number of world factors. On the other hand, financial variables are required, in addition to fundamentals, to explain recent spread compression. We suggest emerging market spreads are low largely due to a combination of world real factors and global liquidity or risk aversion. We exploit the differences in opinion between rating agencies and find evidence that these opinions matter for spreads. JEL Codes: F37, G14, G15, C23 Keywords: Ratings, Spreads, Panel Data. 1 Both authors are in the Research Department of the Inter American Development Bank. The opinions in this paper are solely those of the authors and do not necessarily reflect the opinion of the IDB, the board of directors nor the countries that they represent. We thank John Chambers of Standard and Poor s and Mauro Leos from Moody s for information and for extremely useful conversations and participants at the JP Morgan investors conference in Guatemala for comments on an earlier draft. Comments welcome to Andrew Powell at andrewp(at)iadb.org.

2 I. Introduction At the time of writing the first draft of this paper, emerging country spreads were at a record low of close to 170 basis points 2. The ratings of the two agencies considered in this paper indicate marked improvements in the credit quality of emerging sovereigns from the depths of the post-russia crisis of In Figure 1 we plot the cumulative upgrades and downgrades for emerging countries from 1992 and the EMBI global spread from Figure 1: Cumulative Ratings Changes and Spreads: Emerging Countries Cumulative Upgrades S&P Emerging EMBI Global (right axis) EMBI Global - Basis Points Moody's Emerging There are several papers on modeling ratings. We replicate recent results but we have doubts regarding the inclusion of some particular variables that have incorrect signs or that may not be independent. We also discuss the inclusion of different measures of debt. Still, a model limited to harder economic variables explains a reasonable percentage of the time variation of ratings. This is perhaps not so surprising as we also find that 3 2 The first draft preceded the volatility in stock markets commencing February 27 th 2007.

3 global factors explain more then 80% of the variation in ratings and almost 80% of the variation in economic fundamentals and ratings. We plan to continue to analyze this methodology to interpret this result. However, our main interest is to analyze the recent reduction in spreads. This is clearly an important question for the public and private sector alike. Moreover, the answer may suggest whether spreads are likely to remain at these levels or what factors should be monitored that may alter the current environment. Our results suggest that fundamentals do not explain the whole reduction in spreads but that if we include global financial variables then we can explain much of the decrease in spreads. In general we suggest that without the improvement in the global financial environment, spreads would be some 150 to 170 basis points higher on average for emerging economies. We also consider whether ratings matter for spreads. This is not a new question but when defined properly it is not easily answered. In this paper we consider a new method to consider the question; namely we exploit the differences in opinions between rating agencies. The two agencies considered in this paper do not always agree. Indeed roughly 50% of country-rating observations suggest disagreements. Our results using a type of difference in difference method suggests that these opinions do appear to matter. The paper is organized as follows. In the next section we discuss models of ratings. We then turn to models of spreads in section 3. In section 4 we discuss whether ratings matter. Section 5 concludes.

4 2. Models of Ratings There is a small but growing literature on modeling sovereign ratings. In this section we consider traditional models of ratings and then we consider a principal components analysis for ratings and for the economic fundamentals that we find drive ratings in the traditional models. a) on traditional models of ratings Cantor and Packer (1996) is a standard starting point while Afonso et al (2007) includes an excellent review and a comprehensive treatment of alternative models. Moody s (2003) on local ratings and Moody s (2004) on long term foreign currency ratings are interesting examples of work from the rating agencies themselves. Models of ratings tend to include variables reflecting a) economic progress (growth, GDP per capita etc), b) debt and the external sector including reserves, c) variables that attempt to capture political or institutional characteristics (especially Government Effectiveness) and dummy variables that capture debt payment history. Models with a surprisingly small set of variables are quite successful in capturing the cross sectional variation in ratings and, albeit to a lesser extent, ratings movements over time. However, there are several issues that are worthy of discussion related to these models. Models of ratings have been conducted using panel data. These regressions can be run simply with OLS, with random effects or fixed effects or within the context of a dynamic model, perhaps employing GMM techniques such as the Arellano-Bond or Blundell- Bond estimators. We leave for now the possibility of a dynamic model for ratings as a topic for future research. In Afonso (2007), a case is made for random effects and for including the time averages of variables in the regression. The idea is that the time averages then capture the cross sectional variations and the time varying variables capture movements over time and the authors obtain appealing results. However, our interest here

5 is to model rating movements to see if movements in ratings can account for spread reductions. Moreover, our interpretation of the statistical tests reported, and ours below, is that they support the use of a fixed effects model; although in the end the models are similar 3. A second issue regarding estimation technique is how to express the dependent variable; the rating. Ratings are generally expressed according to a non-numerical scale and hence an argument can be made that a non-cardinal approach, such as an ordered probit, may be most appropriate. Afonso et al (2007) suggest that an ordinal approach may have some advantages. However, in some cases the estimated distances between rating grades do not reject equality implying converting the ratings to a numerical scale with an equal distance between each rating is a pretty good approximation and the differences in the models taking each approach are fairly small. Again, in part as our interest is not ratings per se, we will take the approach of using a numerical scale for ratings. When we model spreads we will use both a numerical (log) scale and as an alternative approach that does control for differences between rating-grades as being unequal. 3 We also tested for the presence of time effects. In our preferred specification the time effects were not significant.

6 Table 1: Explaining Standard and Poor s Ratings (1) (2) (3) (4) (5) (6) GDP PC (%) (5.15)*** (3.54)*** (3.84)*** (3.97)*** (4.74)*** (1.87)* Growth (%) (0.71) (1.15) (0.48) (0.12) (0.08) (2.96)** Unemployment (%) (0.19) (0.66) (0.27) (0.90) (0.43) (0.60) Inflation (%) (0.53) (0.61) (3.99)*** (4.29)*** (4.41)*** (2.48)** Gross Central Government Debt Over GDP (%) (4.01)*** (3.17)*** Fiscal Balance over GDP (%) (2.27)** (2.00)* (2.36)** (1.85)* (1.63) (1.65) Government Effectiveness ( ) (2.68)*** (2.76)*** Foreign Debt to Exports (%) (1.49) (1.52) (1.77)* (0.45) (0.57) (0.28) Current Account Balance (%) (2.65)*** (2.41)** Reserves to GDP (%) (1.53) (1.50) (0.60) (0.82) (0.55) (1.68) Tax Revenue to Total Debt (%) (2.54)** (2.60)** (2.46)** (3.19)*** Original Sin 3 (%) (1.22) (1.26) Volatility of Real Exchange Rate (%) (2.30)** (1.81)* (1.08) Foreign Currency Public Debt (% Total) (2.47)** In Default (0,1) (4.87)*** (5.09)*** (14.06)*** (11.28)*** (11.36)*** (7.85)*** Default since 1970 (0,1) (1.42) EU Enter Dummy (0,1) (3.13)*** (1.17) (2.33)** (3.19)*** (2.78)*** EU Step Dummy (0,1) (2.53)** (1.37) (1.89)* (1.65) (1.02) LAC Dummy (0,1) (1.75)* US Treasury Yield (10 Years, %) (2.25)** US High Yield (10 Years, %) (0.40) VIX Index (%) (0.43) Constant (11.64)*** (3.16)*** (4.10)*** (3.89)*** (1.44) (2.80)** Effects Random Fixed Fixed Fixed Fixed Fixed Time Effects No Yes Yes No No No Observations Number of group(wbcode) Rsq-Overall Rsq-Within Rsq-Between Robust z statistics in parentheses In column 1: variable time-averages, a LAC and an industrialized country dummy are included but not shown * significant at 10%; ** significant at 5%; *** significant at 1%

7 Table 2: Explaining Moody s Ratings (1) (2) (3) (4) (5) (6) GDP PC (%) (4.19)*** (3.57)*** (3.41)*** (2.67)** (2.95)*** (1.03) Growth (%) (0.42) (0.87) (0.72) (0.31) (0.26) (2.91)** Unemployment (%) (0.46) (0.42) (0.16) (1.44) (1.12) (0.10) Inflation (%) (0.91) (0.01) (2.45)** (0.61) (0.65) (0.92) Gross Central Government Debt Over GDP (%) (2.22)** (1.07) Fiscal Balance (%) (0.28) (0.27) (0.32) (0.09) (0.01) (0.41) Government Effectiveness ( ) (2.65)*** (2.08)** Foreign Debt to Exports (%) (0.77) (1.10) (1.57) (0.82) (0.91) (0.45) Current Account Balance (%) (2.85)*** (2.47)** Reserves to GDP (%) (1.25) (1.76)* (0.74) (0.24) (0.01) (1.04) Tax Revenue to Total Debt (%) (2.36)** (2.77)*** (2.69)** (6.99)*** Original Sin 3 (%) (0.60) (0.58) Volatility of Real Exchange Rate (%) (3.26)*** (2.87)*** (0.95) Foreign Currency Public Debt (% Total) (3.44)*** In Default (0,1) (0.70) (0.77) (3.26)*** (2.88)*** (2.96)*** (1.83)* Default since 1970 (0,1) (1.87)* EU Enter Dummy (0,1) (7.75)*** (5.36)*** (7.30)*** (7.13)*** (6.00)*** EU Step Dummy (0,1) (4.10)*** (2.82)*** (4.79)*** (3.77)*** (2.97)*** LAC Dummy (0,1) (2.26)** US Treasury Yield (10 Years, %) (1.68) US High Yield (10 Years, %) (0.55) VIX Index (%) (0.38) Constant (8.32)*** (0.87) (4.71)*** (3.63)*** (1.78)* (2.71)** Effects Random Fixed Fixed Fixed Fixed Fixed Time Effects No Yes Yes No No No Observations Number of group(wbcode) Rsq-Overall Rsq-Within Rsq-Between Robust z statistics in parentheses In column 1: variable time-averages, a LAC and an industrialized country dummy are included but not shown * significant at 10%; ** significant at 5%; *** significant at 1%

8 The first column of both Table 1 (for Standard and Poor s) and Table 2 (for Moody s) below replicate the preferred model of Afonso et al (2007) but for developing countries only our interest in this paper. This model is estimated with random effects and includes not only the variables listed but also the means of each variable not shown 4. The variables that are significant include GDP per capita, Gross Government Debt divided by GDP, Fiscal Balance, Government Effectiveness and the Current Account deficit. We also include an EU-entry dummy (1 if a country enters the EU for the year of its entry) and an EU membership step-dummy, (1 for each observation the country is a member of the EU). The dummy variable for in-default takes a value of 1 if the country is in default according to that rating agency and zero otherwise. As can be seen the fit of the model is excellent with an R-Squared of 0.87 overall for the case of Standard and Poor s ratings and 0.78 for Moody s ratings 5. However, this specification includes a number of variables that merit discussion. First note that the current account deficit has the wrong sign. When the current account is more positive, the rating is worse not better. This is a general result in models that include this variable and is not limited to this specification. It seems likely that this is not a good explanation of the rating but rather reflects a reverse causality that countries with better ratings can afford to larger current account deficits, the US being a good example. A second aspect is the role played by Government Effectiveness. As can be seen in the tables above, this variable is highly significant. However, it might be described as a summary of surveys; the majority of which are perceptions of aspects of government behavior 6. There is therefore a potential concern that the opinion of the rating agency is derived from another opinion or set of opinions and it is difficult to believe that the latter is totally independent from the former. Moreover, Government Effectiveness is just one indicator that might be included. Table 3 below shows a selection of such potential 4 As discussed, the authors suggest this is a way of incorporating long-term effects (the variable means) and also dynamics (the actual variable), controlling for unobservable variables with the random effects. 5 These values are slightly lower than those reported in Afonso et al (2007) but our sample is only developing countries. 6 See Kaufman et al (2006) for a description of the methodology.

9 indicators and illustrates that they are all highly correlated and each is highly correlated with the ratings of Moody s and S&P. A third comment is regarding statistics on debt. Debt is measured in different ways and depending on theoretical considerations one definition may be more relevant than others 7. Debt may be defined as to who issued it, (central government, or a wider definition of the public sector, or the private sector); it may be gross or net of certain assets held; it may be foreign or domestic according to three different definitions ( a) currency of denomination b) residence or c) where the debt was issued i.e.: legislation). Finally debt may be normalized by different variables. Popular choices are GDP, tax revenues and for foreign debt, exports or other elements of the balance of payments. These different dimensions allow a wide variety of debt variables to be chosen. A common source is the IMF s International Financial Statistics, but this is not particularly homogeneous in its definition across countries 8. The World Bank s Global Development Finance database has only external debt, by a residence criterion. The BIS has a comprehensive database on international securities and a separate one on banking. These sources have information on currency composition but are not comprehensive measures of debt as they may miss much domestic debt. The joint IMF, World Bank, BIS, OECD database attempts to combine various sources but each with its own definitions and hence is not necessarily homogenous or easily aggregated. 7 It is assumed here that the model is to explain the rating on long term foreign currency debt issued in a foreign jurisdiction. 8 In particular, some countries report net debt rather than gross.

10 Table 3 Overrated? Source (*) Voice and Accountability Control of Corruption Government Effectiveness Political Stability Rule of Law Regulatory Quality Growth Competitive Index Ranking (t) Growth Competitive Index Score Business Competitive Index Ranking Company operations and strategy ranking Quality of the national business environment ranking Growth Competitive Index Ranking (t-1) Real GDP per Capita Rating Standard and Poor's Rating Moody's Voice and Accountability Control of Corruption Government Effectiveness Political Stability Rule of Law Regulatory Quality Growth Competitive Index Ranking (t) Growth Competitive Index Score Business Competitive Index Ranking Company operations and strategy ranking Quality of the national business environment ranking Growth Competitive Index Ranking (t-1) Real GDP per Capita Rating Standard and Poor's Rating Moody's (*) Source: Own calculations, based on World Bank (1 to 6, year 2004), World Economic Forum (7 to 12, year 2005), WEO (12, year 2004), S&P (13, year 2004) and Moody's (14, year 2004). Based on a total of 98 countries. In our view, the ratios that are most relevant are a) Tax Revenues to total Government (Sovereign) Debt as a measure of the Governments ability to tax relative to its liabilities and b) Total (Private plus Public) External Debt to Exports as a measure of a country s need to obtain resources from the rest of the world to pay creditors from the rest of the world and c) a ratio of debt in foreign currency to total debt as a measure of the riskiness of debt composition. However, we realize that this is certainly not a unique choice. Unfortunately, even for these fairly simple ratios standard sources are not ideal. None of the above sources has a particularly good measure of total sovereign debt measured in a homogenous way across countries for measure (a). For measure (b), sources would appear to be better although there are discrepancies between the standard sources listed.

11 Finally, none of the sources mentioned has the currency composition of debt across countries in a homogenous way. In the recent IDB publication, Living with Debt Interamerican Development Bank (2006) - there is a discussion of these issues and a new database comes along with the publication that attempts to homogenize statistics across a group of countries including domestic and foreign debt. This data is focused on Latin America although some comparator countries are also included although for total (central) Government a wider selection of countries is available. We use the measure of debt here to construct the variable tax revenues to total debt. There is also a new database produced by IMF economists with much the same objective see Jeanne and Guiscina (2006). This database has debt composition (foreign currency versus domestic currency) for a wider selection of emerging countries. We also use this ratio for the relevant sample. Hausmann (2006) and Hausmann and Panizza (2006) stress the currency composition of liabilities as a significant problem for developing countries. They use the BIS data on securities to define a variable, Original Sin 3 that captures the use of a country s currency as an international unit of account. Original Sin 3 is calculated using the BIS securities database and is the total debt issued in the currency of the country divided by the external debt issued by that country. The idea is that this captures the ability of a country to issue debt in its own currency. It is argued that debt issued by all issuers in the currency of the country of interest is a better variable than that issued just by the country of interest as a country could always issue debt in say dollars and then swap that into local currency if a swap market exists. Hausmann (2006) and Garcia and Rigobon (2004) stress the interaction of currency composition and exchange rate dynamics in developing countries. We also then think a relevant variable is the volatility of the real exchange rate. In the tables above we present a set of columns where we experiment taking out the Current Account deficit and Government Effectiveness and including different specifications of the debt variables and the volatility of the real exchange.

12 The second column of the tables simply replaces the time averages with fixed effects and includes time effects as well. As can be seen by the statistics of the regression there is a slight improvement in the R-Squared for the time (within) variation and the Hausmann statistic suggests that fixed effects are preferred 9. While we understand the desire to provide a complete explanation of ratings, our interest in this paper is to explain the time variation and we think that this is best achieved using regressions with fixed and where necessary time effects. The third column shows the results with fixed effects but takes out Government Effectiveness and the current account deficit. We also switch the debt ratio from debt to GDP to tax revenues to total debt that we consider a better measure of the size of debt from a risk standpoint. As expected the R-Squareds do fall due to the exclusion of Government Effectiveness. This specification explains about 59% (S&P) and 41% (Moody s) of the within variation. In column 4 we add the real exchange rate volatility and Original Sin 3 OSIN3.. However, the OSIN3 variable is not significant. There is some evidence however that higher real exchange rate volatility leads to a poorer rating. We also lose some observations and, probably due to this, the R-Squared falls slightly for S&P not for Moody s. In column 5 we analyze whether global variables such as the US Treasury yield or the VIX or High Yield US corporate index affect credit ratings. Surprisingly if anything we find that increases in US interest rates are associated with better credit ratings. The fall in spreads over the recent period can certainly not be explained by changes in US interest rates. We also find no evidence that the High Yield or the VIX index affects ratings. This suggests that there is no feedback from higher liquidity or lower risk aversion to better ratings. We will come back to this point below when we model spreads. 9 This test is (probability measure of ) for S&P and (probability measure ) for Moody s suggesting that fixed effects are preferred.

13 In column 6, we use the percentage of total debt issued in foreign currency from the Jeanne and Guiscina (2006) database. Unfortunately this is only available for a limited number of countries but for this reduced sample we do indeed find that it is significant. This result reinforces the view that debt composition matters and if anything suggests that the initiative to get better data on currency composition of debt is a worthwhile exercise. Comparing the models for Moody s and Standard and Poor s there are differences. We return to consider these differences between the agencies in Section 4 below. Table 4: Actual and Fitted Ratings Last Observations Country Actual S&P Fitted S&P Actual Moody's Fitted Moody's Argentina B- BB- B3 B1 Brazil BB- BB- Ba3 B1 Chile A AA- Baa1 A2 Colombia BB BB+ Ba2 Ba1 Mexico BBB BBB- Baa1 Baa3 Peru BB BB Ba3 Ba2 Venezuela B+ B+ B2 B1 Source: S&P, Moody's and Own Calculations (our model, 2005) (*)Legend: Fitted 2 notches below = Green, 2 notches above=red Table 4 compares the predicted values of the model versus the actual ratings for selected countries in Latin America for the last observations December The model includes fixed effects and hence by definition the time averages of the predicted values are equal to the actuals. However, we note several differences in the actual and the fitted for the last observation. Here we comment on those cases where there is a difference of at least 2 notches between the actual and the fitted. Argentina appears to have too low a rating given its fundamentals (and the model includes dummies for default histories), Chile has too low a rating given its fundamentals and Moody s appears to be generous in the case of Mexico. In terms of one notch differences there is also some evidence that Colombia and Peru have higher predicted ratings than actual ones for at least one agency

14 and Moody s is somewhat generous in the case of Brazil as the actual is one notch higher than the predicted. b) factor models of ratings and of economic fundamentals In this section we present results conducting a factor analysis regarding ratings changes. It turns out that the changes in ratings of emerging economies can be represented by a small number of (global) factors. In Table 5 we present the results of the analysis. Just 2 factors can explain some 81% of the movement in ratings of all emerging economies and 3 factors can explain almost 90% of the movement. As we have established in the previous section that economic fundamentals appear to drive ratings rather than, say, global liquidity or risk aversion, we can be fairly confident that these global factors are real rather than financial in nature. Indeed, and perhaps more surprisingly, we also find that we can explain the changes in economic fundamentals that explain a large proportion of ratings changes by just a few (global) factors. In particular 2 factors explain almost 56% of the variation in 7 economic fundamentals across all emerging economies in the EMBI and 3 factors explain almost 69%. Finally we find that 2 factors explain 68% of the variation in the economic fundamentals and the ratings changes of S&P and Moody s and 3 factors explain almost 80% of the variation in these 9 series across the different emerging economies. These results show that the recent improvements in ratings, or underlying credit quality, is very largely due to a rather small number of global (real) factors. We plan to analyze in more detail what these global factors may be and whether using suitable rotations an interpretation of the factors can be provided.

15 Table 5: Principal Component Analysis of Credit Ratings and Economic Fundamentals Component Credit Ratings Both Agencies: S&P and Moody's Unrotated Components Rotated Components (orthogonal varimax) Eigenvalue Difference Proportion Cumulative Eigenvalue Difference Proportion Cumulative % 63.1% % 46.2% % 81.1% % 70.6% % 89.8% % 89.8% S&P Agency Moody's Unrotated Components % 50.5% % 61.1% % 73.0% % 75.5% % 81.3% % 84.2% Rotated Components (orthogonal varimax) % 43.1% % 60.4% % 73.0% % 75.5% % 81.3% % 84.2% Economic Fundamentals (*) Credit Ratings + Economic Fundamentals Unrotated Components % 37.1% % 47.2% % 55.9% % 68.2% % 68.7% % 79.4% Rotated Components (orthogonal varimax) % 33.4% % 38.2% % 55.9% % 68.2% % 68.7% % 79.4% Source: Own calculations for EM economies, based on: S&P, Moody's (Sovereign Credit Rating foreign currency long term) ; Economic Fundamentals (*): WEO (Growth (%), Inflation (%), Fiscal Balance (% of GDP), Tax revenues over Total Debt (%), Reserves (% GDP), Exchange Rate Volatility (%)), World Bank (Total Debt to exports (%)).

16 3. Models of Spreads In this section we discuss models for spreads. Our interest is two-fold. First we wish to see how much of the reduction in spreads can be accounted for by country fundamentals and how much by other, including financial, factors. In this regard it is often useful to use the rating as a convenient summary of information regarding credit quality. A second question we wish to consider is whether the ratings matter. This turns out to be a somewhat difficult question to answer if the question is posed correctly. First, we regress the spread on ratings and then on ratings and global financial variables, such as US Treasury yields, US High Yield spreads and the VIX index as a test of whether the current level of spreads is justified by fundamentals or whether global factors are important 10. There is some discussion in the literature as to the appropriate way to do this, as once again the rating is not a cardinal variable. One way is simply to regress the spread or the log of the spread on dummies for each rating grade. In an appendix to this paper we present the results of such an analysis. However, a simpler method is to regress the log of the spread on the log of the rating. We find that this simplification does not change the main results. As our regressions include fixed effects we are again focusing on ratings changes rather than explaining the cross sectional variation in spreads and ratings. 10 It is also tempting to include the general EMBI index. If included then the country in question should be excluded from the EMBI index in other words in the panel for each country j it should be the general EMBI index excluding country j on the right hand side. However, even then, if country i affects country j, there is an issue of endogeneity. We prefer not to include the EMBI as we wish to consider global factors that are exogenous to emerging markets in general. We believe that employing variables such as the US Treasury, US corporate High Yield and VIX indices yield a cleaner test of the hypotheses that we wish to consider.

17 Table 6: Explaining Spreads with Ratings (1) (2) (3) (4) Credit Rating (logs) (10.96)*** (5.19)*** (8.76)*** (11.22)*** Us Treasury 10 years (%) (1.85)* (1.64) Vix Index (%) (8.94)*** (8.60)*** US High Yield (%) (1.69) (0.80) Constant (37.84)*** (11.19)*** (7.39)*** (12.91)*** Observations Number of group(wbcode) Rating from S&P Moody's S&P Moody's Rsq-Overall Rsq-Within Rsq-Between Robust t statistics in parentheses * significant at 10%; ** significant at 5%; *** significant at 1% The results indicate that ratings are indeed highly significant for explaining spreads 11. However we cannot fully explain the movement in spreads with ratings alone, if financial variables such as the VIX, the US high yield and a US interest rate are added they are significant in explaining spreads 12. Of particular interest is the in sample prediction of the model with and without the financial variables added. Figures 2a and 2b illustrates these for the cases of Argentina, Brazil, Chile and Mexico. It is clear that without the financial variables current spreads are not well-predicted and indeed even with financial variables added current spreads still appear low. 11 As discussed above, we leave for future research a dynamic version. Assuming both series are I(1) the above might be interpreted as the long run or cointegrating vector see Gonzales Rozada et al (2006) for an analysis of the relation between spreads along these lines. 12 This also holds for the model in the appendix with ratings dummies and hence is not a result of the log(ratings) variable being employed.

18 Figure 2a: Actual and Fitted Values for Spreads ARGENTINA Basis Points Actual S&P Moody's S&P + Global Factors Moody's + Global Factors Dec-97 Mar-98 Jun-98 Sep-98 Dec-98 Mar-99 Jun-99 Sep-99 Dec-99 Mar-00 Jun-00 Sep-00 Dec-00 Mar-01 Jun-01 Sep-01 Dec-01 Mar-02 Jun-02 Sep-02 Dec-02 Mar-03 Jun-03 Sep-03 Dec-03 Mar-04 Jun-04 Sep-04 Dec-04 Mar-05 Jun-05 Sep-05 Dec-05 Mar-06 Jun-06 Sep-06 Dec-06 BRAZIL Jan-97 Apr-97 Jul-97 Oct-97 Jan-98 Apr-98 Jul-98 Oct-98 Jan-99 Apr-99 Jul-99 Oct-99 Jan-00 Apr-00 Jul-00 Oct-00 Jan-01 Apr-01 Jul-01 Oct-01 Jan-02 Apr-02 Jul-02 Oct-02 Jan-03 Apr-03 Jul-03 Oct-03 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Basis Points Actual S&P Moody's S&P + Global Factors Moody's + Global Factors

19 Figure 2b: Actual and Fitted Values for Spreads CHILE Actual S&P Moody's S&P + Global Factors Moody's + Global Factors Basis Points May-99 Aug-99 Nov-99 Feb-00 May-00 Aug-00 Nov-00 Feb-01 May-01 Aug-01 Nov-01 Feb-02 May-02 Aug-02 Nov-02 Feb-03 May-03 Aug-03 Nov-03 Feb-04 May-04 Aug-04 Nov-04 Feb-05 May-05 Aug-05 Nov-05 Feb-06 May-06 Aug-06 Nov-06 MEXICO 700 Basis Points Dec-97 Mar-98 Jun-98 Sep-98 Dec-98 Mar-99 Jun-99 Sep-99 Dec-99 Mar-00 Jun-00 Sep-00 Dec-00 Mar-01 Jun-01 Sep-01 Dec-01 Mar-02 Jun-02 Sep-02 Dec-02 Mar-03 Jun-03 Sep-03 Dec-03 Mar-04 Jun-04 Sep-04 Dec-04 Mar-05 Jun-05 Sep-05 Dec-05 Mar-06 Actual S&P Moody's S&P + Global Factors Moody's + Global Factors Jun-06 Sep-06 Dec-06

20 Indeed if we exclude the financial variables, the average error of the model in the last observation is between 153 (S&P) and 176 (Moody s) basis points across all emerging economies. Including the financial variables the average error of the model across countries is some 22 (S&P) or 41 (Moody s) basis points in the last observation 13. More generally, if considering a variance decomposition we find that the global financial variables explain almost 20% of the variation in spreads, although spreads explain 40% (Moody s) and almost 60% (S&P). This is illustrated in Figure 3 below. Figure 3: Variance Decomposition of Country EMBI Spreads 70% 60% 50% 40% 30% 20% 10% 0% Rating Global Financial Factors fixed effect S&P Moody's It is not clear which of the three financial variables (US Treasury, US High Yield or VIX index) should be included in the regression above nor is it clear what these variables actually represent. Alternatives include a) the time value of money, b) liquidity or c) risk aversion or some combination of these concepts. 13 We stress that these regressions have individual fixed effects and hence, by definition, the time average of the predicted spread is equal to the actual spread across the whole sample. Again these results are not particularly sensitive to the use of dummies for each rating grade rather than the log of the rating. The last observation is Dec 2006.

21 Figure 4: Component Loading of 2 Factors to Explain Global Financial Variables Hence, we also conduct a factor analysis of these three financial variables and find that two factors explain a very high proportion of the three. In Figure 3 we graph the loadings of these two factors. The graph suggests that Factor 1 is more akin to risk as captures the variation in the VIX and the US corporate High Yield spread whereas Factor 2 appears to be more related to liquidity or the time value of money as it appears to capture the US 10 year bond yield. We place these two factors in the regression. The results are displayed in Table 7 and what appears to matter for emerging economy spreads is the factor most associated with risk; the US high yield and the VIX index and the least associated with the US treasury yield.

22 Table 7: Explaining Spreads with Ratings and Financial Factors (1) (2) Credit Rating (logs) (8.91)*** (10.57)*** Financial Vars Factor (15.59)*** (12.70)*** Financial Vars Factor (1.09) (0.81) Constant (33.20)*** (25.94)*** Rating Agency S&P Moody's Observations Number of group(wbcode) Rsq-Overall Rsq-Within Rsq-Between Robust t statistics in parentheses * significant at 10%; ** significant at 5%; *** significant at 1% All regressions include fixed effects 4. Do opinions matter? In the above we simply regressed spreads on ratings using ratings as a convenient summary of fundamentals. However, this does not answer the question whether ratings matter. This question is to be understood as do ratings matter, controlling for fundamentals. However, this is somewhat problematic to test as ratings to a large extent summarize fundamentals. One technique is to regress ratings on fundamentals and then regress spreads on fundamentals but also include the residuals from the first regression. This was the technique employed in Eichengreen and Mody (1998). The residual of the regression of ratings might be interpreted as the opinion of the agency over and above the credit quality explained by the economic fundamentals. We conduct such an analysis and display the results in Table 8 below. We find that the residual is highly significant suggesting that

23 the opinions of rating agencies are important controlling for fundamentals. However, such a regression can be criticized. If the error term of the first regression is an opinion of the agency in question then how can it can conform to the appropriate statistical properties of an error to ensure that the regression is valid? In a sense it is simply a leap of faith to claim that the error here is the opinion of the agency plus the actual error of the regression and we have no way of really telling which is which. A second methodology is to estimate a system of equations with the rating and the spread as the two endogenous variables. We employ annual data and use the end of period spread. Given most economic variables are known before the end of the year or at least there are generally reasonable forecasts thereof we suggest that ratings affect spreads but we do not allow that spreads affect ratings. We also exploit the fact that the global financial variables affect spreads but not ratings. We find that even with all the economic fundamentals included in the spreads regression, we find that ratings affect spreads. We then proceed to eliminate economic fundamentals from the spreads regression that do not appear as significant or have the wrong sign. We conclude with the regression again presented in Table 8. Our main findings are that a) ratings appear to matter for spreads over and above fundamentals b) that growth affects spreads over and above ratings c) that the fiscal balance affects spreads over and above Moody s ratings (or perhaps Moody s weights the fiscal balance as less important than the market ) d) that EU membership appears to affect spreads over and above S&P ratings (or perhaps that S&P weights EU membership as less important than the market ). However, once again such an analysis has its limitations. On the one hand we have imposed the restriction that the effect of spreads on ratings is zero and second we have eliminated fundamentals from the spreads regression in a somewhat ad hoc fashion.

24 Table 8 Do Opinions Matter? Employing Residuals of Rating Regression Estimating a System Rating Spread Rating Spread Rating Spread Rating Spread Rating Agency S&P Moody's S&P Moody's (1) (2) (3) (4) (5) (6) (7) (8) Credit Residual/Credit rating (5.16)*** (5.16)*** (12.14)*** (11.58)*** Growth (%) (3.97)*** (2.67)** (1.90)* (2.35)** (3.99)*** (2.20)** (2.80)*** GDP PC (%) (0.12) (2.71)*** (0.31) (2.36)** (7.77)*** (7.07)*** Unemployment (%) (0.90) (0.44) (1.44) (0.74) (1.66)* (0.10) Inflation (%) (4.29)*** (2.99)*** (0.61) (0.57) (0.74) (0.23) (1.01) (0.52) Fiscal Balance over GDP (%) (1.85)* (1.84)* (0.09) (1.80)* (1.13) (0.98) (0.80) (2.80)*** Foreign Debt to Exports (%) (0.45) (6.39)*** (0.82) (5.71)*** (0.33) (2.50)** Tax Revenue to Total Debt (%) (2.60)** (1.88)* (2.77)*** (2.60)*** (3.00)*** (0.42) Reserves to GDP (%) (0.82) (7.75)*** (0.24) (6.98)*** (1.98)** (2.54)** Original Sin 3 (%) (1.22) (1.70)* (0.60) (1.26) (0.53) (1.00) Volatility of Real Exchange Rate (%) (2.30)** (2.78)*** (3.26)*** (2.13)** (2.49)** (2.19)** In Default (0,1) (11.28)*** (6.36)*** (2.88)*** (4.78)*** (13.70)*** (7.30)*** EU Enter Dummy (0,1) (3.19)*** (5.41)*** (7.13)*** (4.98)*** (0.25) (1.67)* (1.53) (0.39) EU Step Dummy (0,1) (1.65) (5.03)*** (3.77)*** (4.27)*** (1.37) (0.64) Vix Index (%) (0.90) (1.39) (1.87)* (0.29) US High Yield (10 y %) (5.08)*** (4.61)*** (5.25)*** (5.72)*** US Treasury (10 y %) (0.36) (0.61) (1.42) (0.30) Constant (3.89)*** (17.15)*** (3.63)*** (16.82)*** (4.30)*** (13.67)*** (3.29)*** (15.60)*** Type of Regression S&P Moody's S&P Moody's Observations Number of group(wbcode) Rsq-Overall Rsq-Within Rsq-Between Robust t statistics in parentheses * significant at 10%; ** significant at 5%; *** significant at 1%

25 An alternative would be to conduct an event study where daily spreads are observed around ratings changes. A potential problem with this latter methodology is that fundamentals are changing and hence it is not obvious whether any change in spread accompanied by a rating change is due to the change in rating or a change in the fundamentals. Moreover, while event studies in corporate finance normally focus on events that are arguably shocks the announcement of a merger or stock split rating agencies do their best to make rating changes predictable announcing an outlook, a credit watch and even a list of credit drivers that are suggestive of when a rating change would come 14. These actions by the agencies make the methodology of the event study problematic. However, as noted above the rating agencies do not always agree! Considering the available rating history for S&P and Moody s, they disagree about as much as they agree in the sense that roughly 50% of the observations regarding emerging economies suggest disagreement. Figure 4 illustrates the disagreements by country and over time. 14 For example, it might be announced that a constraint to an upgrade for Peru is tax administration and hence its overall tax revenue as a percentage of GDP or debt. Thus, if Peru s tax administration improves the market will start to predict an upgrade.

26 Figure 4: Rating Disagreements 4 3 Standard and Poor's Higher Rating ARG Moody's Higher Rating AUS BGR BHR BLZ BMU BOL BRA BRB CAN CHL CHN COL CRI CYP CZE DNK DOM ECU EGY ESP EST FIN GTM HKG HRV HUN IDN IND IRL ISL ISR ITA JAM JPN KAZ KOR KWT LAO LBN LTU LVA MAR MEX MLT MNG MYS NOR NZL OMN PAK PAN PER PHL PNG POL PRT PRY QAT ROM RUS SAU SGP SLV SUR SVK SVN SWE THA TTO TUN TUR TWN UKR URY VEN VNM ZAF In order to investigate these disagreements further we conducted a regression of rating differences on the economic fundamentals that we found to be important in explaining ratings above. As we have many zero observations in the dependent variable we did this employing an ordered Probit and an ordered Logit. The results are highly consistent across the two methodologies and are reported in Table 9.

27 Table 9: Explaining Rating Differences Dependent Variable is Moody Rating Minus S&P Rating (1) (2) (3) (4) Growth (%) (1.61) (0.99) (2.39)** (2.04)** Unemployment (%) (0.38) (0.13) (0.99) (0.50) Inflation (%) (3.08)*** (4.28)*** (2.31)** (3.05)*** Fiscal Balance over GDP (%) (3.66)*** (4.00)*** (3.27)*** (3.86)*** Debt to Exports (% GDF) (2.80)*** (3.48)*** (2.45)** (3.00)*** Tax Revenue to Total Debt (%) (2.77)*** (2.45)** (2.15)** (1.70)* Reserves to GDP (%) (4.12)*** (4.30)*** (3.60)*** (3.96)*** Original Sin 3 (%) (1.23) (1.29) (1.24) (1.11) Volatility of Real Exchange Rate (%) (1.24) (0.68) (2.10)** (1.68)* Regression type Ordered Probit Ordered Logit Ordered Probit Ordered Logit Consider agreements Yes Yes No No Observations Robust z statistics in parentheses * significant at 10%; ** significant at 5%; *** significant at 1% We find many significant differences. For example higher fiscal surplus, higher tax revenue and higher reserves and lower inflation all imply higher S&P ratings relative to Moody s. On the other hand, higher debt to exports implies a lower Moody s rating relative to S&P. While the same variables may be relevant for the ratings of each agency, it appears that there are significant differences in how the agencies weight these different fundamentals. These differences allow us to develop a new methodology to consider if these opinions matter. In the following regressions we regress spreads on the ratings of one agency (say S&P) and a dummy which takes the value of one if the other agency (say Moody s)

28 upgrades the country by one notch and the other agency does not. The dummy takes a value of 2 if the upgrade is two notches or 1 if there is a one notch downgrade etc. We conduct these regressions for both agencies. These regressions are then a test of whether an upgrade (or downgrade) by one agency matters if the other agency does not upgrade (downgrade). As we also include fixed effects, it is then a type of difference in difference regression. We find that in both cases the changes in the second agency matter even when there is no change in the first agency rating. This leads further support to the notion that ratings do matter. Table 10 Opinions Matter (1) (2) Credit Rating Agency 1 (logs) (11.25)*** (8.40)*** Upgrade/Downgrade Other Agency (1.84)* (4.49)*** Us Treasury 10 years (%) (1.68) (2.54)** Vix Index (%) (8.60)*** (9.14)*** US High Yield (%) (1.69) (1.23) Constant (9.74)*** (9.77)*** Rating Agency 1 S&P Moody's Observations Number of group(wbcode) Rsq-Overall Rsq-Within Rsq-Between Robust t statistics in parentheses * significant at 10%; ** significant at 5%; *** significant at 1% Regressions include fixed effects 5. Conclusions In this paper we have investigated a number of issues related to ratings and spreads. First as in the previous literature we find a small number of economic fundamentals explains ratings of two leading rating agencies. We find some evidence for the inclusion of debt

29 composition although data limitations remain binding to enhance this analysis. We find that global financial variables do not help to explain ratings but we find that very few global factors explain ratings, the economic fundamentals behind ratings or both. Our conclusion is that ratings improvements have been largely driven by improvements in fundamentals largely driven by real world factors. We also present models of spreads and investigate whether the recent reductions in spreads has been justified by the improvement in fundamentals. The answer is a resounding no. Spreads have fallen further than fundamentals have improved and we provide estimates for selected countries. The overall result is that spreads are some 150 to 170 basis points lower than those justified by the improvement in ratings alone. We also note that rating agencies do not always agree. In fact they disagree about 50% of the time. We find that while in general the same economic variables tend to explain ratings, different agencies appear to weight the factors differently. We exploit these differences to test whether opinions matter and the results suggest that indeed they do.

30 References Afonso, Antonio, Pedro Gomes and Philip Rother, (2007) What hides behind Sovereign debt ratings?, European Central Bank, N 711, January Eichengreen, Barry and Ashoka Mody (1998) What Explains Changing Spreads On Emerging-Market Debt: Fundamentals Or Market Sentiment?, NBER Working Paper N 6408, February Cantor, Richard and Frank Packer, (1996) Determinants and Impact of Sovereign Credit Ratings, FRBNY Economic Policy Review, October Garcia, Mario and Roberto Rigobon (2004) A risk management approach to emerging market s sovereign debt sustainability with application to Brazilian data, NBER Working Paper N 10336, March Gonzalez-Rozada, Martin and Eduardo Levy-Yeyati (2006) Global Factors and Emerging Market Spreads, IDB Working Paper N 552, May Hausmann, Ricardo, (2004) Good credit ratios, bad credit ratings: the role of debt structure, Chapter 3 in Rules-Based Fiscal Policy in Emerging Market Economies: Background, Analysis and Prospects, edited by George Kopits. New York: Palgrave Macmillan, Interamerican Development Bank (2006) Living with Debt, Interamerican Development Bank and the Rockefeller Center, Harvard University Press. Jeanne, Olivier and Anastasio Guscina. Government Debt in Emerging Market Countries: A New Data Set, IMF Working Paper06/98, April Kaufmann, D. and A. Kraay, and M. Mastruzzi, (2006) Governance Matters V: Governance Indicators for mimeo World Bank, available on September 15, 2006