IMPACT OF MACROECONOMIC

VARIABLES ON SOVEREIGN RATINGS

ON
DEVELOPED AND DEVELOPING
ECONOMIES

Akansha Saraogi - C003

Deepanshu Gupta - C015
Rishabh Jain - C035
Ritika Kanga - C036
Satakshi Shree - C040

Narsee Monjee Institute of Management

Studies, Bengaluru, India
Abstract: Sovereign Credit Ratings is the credit rating of a particular
country or sovereign entity. These ratings give an idea to the concerned
investors regarding the amount of risk associated with investing in a
particular country and also highlights the magnitude of political risk involved,
if one wants to invest .Here ,in this article ,an empirical analysis has been
carried out to study the relationship between sovereign credit ratings of a
country and some macroeconomic variables like Real GDP, Consumer Price
Index(CPI) as a percentage of GDP and Current Account Balance as a
percentage of GDP . It has been observed that while, sometimes economic
indicators follow the credit rating agencies ratings, but there have been
instances when economic indicators are not in sync with the ratings.

Keywords: Credit, Sovereign, Ratings, Variables, Economic Indicators

JEL Classification Number: G32, E44, F34, G12, G13, G1

1. INTRODUCTION

Sovereign credit rating is the credit rating of a sovereign entity. It shows the
level of economic and political risk involved in investing in a particular
country. The volatility of financial markets coupled with a history of financial
crisis reminds that no assets including sovereign debt can be truly defined as
risk free. The Sovereign Credit Rating began with Standard and Poors and
Moodys rating of US and Canada in 1970.

The sovereign rating of one country is also relevant for other countries stock
markets. If market players see rating changes as a country specific issue with
zero implications across country borders, little impact is expected. At the
same point, logical behavior due to liquidity constraints or clustering of
investors and financial sector linkages across various countries will act as a
transmission vehicle for country shocks.

Sovereign credit crisis adversely affects the global economic growth, the
reasons for the same are: collapse of countrys currency system due to which
the domestic currency depreciates as against the US dollar, inflation rate
increases, and for the general public the increased inflation rate increases the
cost of living and unemployment rate. Due to the aforementioned reasons
credit rating agencies have become the prime focus of research, especially
the three major credit rating agencies covered by Standard and Poors,
Moodys and Fitch. These credit rating agencies indulge in quantifying and
measuring countrys international borrowing or sovereign debts credit
worthiness in rating form focusing on the socio-economic and political
aspects. When the ratings provided by these agencies upon which investors
and governments rely are faulty, the economy suffers. The economic aspect
covers sovereign credit worthiness assessment i.e. how efficient a country is
in servicing external debts. The governments sovereign debt management
pattern is the major determinant of the capacity of the government in
external debt servicing.
A sovereign credit rating represents a rating agency assessment of the
potential and willingness of a sovereign obligator to meet its debt service
payments quickly.Because of increasing importance of capital markets as a
major source of funding for emerging market economies, the significance of
credit rating agencies in providing normalized assessments of credit risks
associated has continued to grow.

The research aims to establish a linkage between macro-economic variables

and sovereign risk ratings given by the rating agency to each country. The
results will constitute a set of indicators which the developing economies will
improve on. It explains the real process of sovereign risk assessment with the
help of rating agencies. Evaluations emerge as the final result of
interdisciplinary work merging analysis based quantitative methods with the
discretionary approach of judging qualitative parameters. It tests possible
macroeconomic variables which can be taken into account during sovereign
risk assessment and the linkage between the variables and ratings.

There have been various arguments by the critics about the conflicts of
interest between an issuer and an agency along with lack of transparency in
the process of ratings that has produced a defective system. It is convenient
to think that this estimation of credit rating is done by utilizing economic
indicators of an economy. We can use these ratings efficiently, if we
understand the impact of economic indicators on ratings.
There are also many subjective parameters which impacts the sovereign
ratings. Some of these are Growth prospects and Economic structure,
international investment position and external liquidity, flexibility and fiscal
performance.

The history and purpose of credit rating agencies and the way in which the
companies operate with limited responsibility will give an insight into the
responsibility the agencies have in the worst economic disaster since The
Great Depression. There are many factors that have boosted the subnational
rating business since the 1990s. Some of which are as follows: (i) willingness
to increase credibility(ii) search for better borrowing conditions(iii)
development of market-based borrowing policies(iv) competition between
agencies(v)fiscal decentralization(vi)strengthening of regulatory framework

By reducing investor risk and uncertainty, sovereign ratings has helped many
governments some with prior histories of debt defaults in order to have
access to international bond markets. Generally governments use credit
ratings to facilitate their access to international capital markets where
investors in particular the US investors want rated securities over unrated
securities of similar credit risk. In the past, governments used to seek ratings
on their foreign currency obligations only, because foreign currency bonds
were more likely to be associated with international investors than domestic
currency offerings. But, the situation is different now. International investors
have increased their demand for bonds issued in currencies other than
traditional global currencies and more governments borrowed in US capital
market and require capital rating agencies.
The adjustments of sovereign credit ratings for many developing economies
during the Asian crisis of 1997/98 have raised doubts about the accuracy of
the rating process. However, not all market participants are sure about credit
rating agencies being reliable enough to set regulatory capital requirements.

In this study, the research proposed is how macroeconomic variables affect

sovereign ratings of developed and developing nations which is elaborated in
forthcoming paragraphs.
2. LITERATURE REVIEW

Kraussl (2001) discussed the role of the credit rating agencies during the
recent financial crises. In particular, it examined whether the agencies can
add to the dynamics of emerging market crises. Academics and investors
often argue that sovereign credit ratings are responsible for pronounced
boom-bust cycles in emerging markets lending. Using a vector autoregressive
system this paper examines how US dollar bond yield spreads and the short-
term international liquidity position react to an unexpected sovereign credit
rating change. Contrary to common belief and previous studies, the empirical
results suggest that an abrupt downgrade does not necessarily intensify a
financial crisis.

Ferreira and Gama (2007) studies whether sovereign debt ratings news spill
over to international stock markets. The evidence indicated that sovereign
debt rating and credit outlook changes of one country have an asymmetric
and economically significant effect on the stock market returns of other
countries over 19892003. There is a negative reaction of 51 basis points
(two-day return spread vis--vis the US) to a credit ratings downgrade of one
notch in a common information spillover around the world. Upgrades,
however, have no significant impact on return spreads of countries abroad.
Closeness (e.g., geographic proximity) and emerging market status amplify
the effect of a spillover. Downgrade spillover effects at the industry level are
more pronounced in traded goods and small industries.

Mateev (2012) examined the impact of sovereign credit rating changes on

emerging market economies. The goal of this research was to evaluate the
relevance of credit rating agencies for efficiency of financial markets in
transition economies; in particular, do changes in sovereign ratings convey
valuable information only to local market participants, or do they trigger
contagious fluctuations in other markets, thus attributing to their financial
instability. For this reason, the study was on country-specific (or domestic)
and cross-country (or foreign) spillover effects of rating changes. To capture
the dynamic effects around the time of changes in ratings, the technique of
event studies was used. Evidence indicated that rating changes of sovereign
bonds in one country trigger significant changes in yield spreads and stock
market returns in other (neighboring) countries (the so-called cross-country
contagion effect). In line with previous research the spillover effects of rating
changes (downgrades in the case) are found to be stronger at the regional
level.

Chee, Fah and Nassir (2015) identified the determinants of sovereign credit
rating. This study included 53 countries in the study covers from year 2000 to
2011. This study examined nine macroeconomic variables and extended by
using three qualitative variables, i.e., history of default, economic
development and economic freedom. The results are consistent with previous
studies that some macroeconomics variables are determinants of rating.
Furthermore, the economic freedom variable serves as a vital factor in
determining sovereign credit rating that has been overlooked by the previous
studies. This study had added new findings and indicates that the economic
freedom of country is decisive factor in assessment.

Gaillard (2009) investigated Moody's rating methodology for non-US local and
regional governments. After highlighting the reasons for the recent increase
in bond issuances by subnational entities, it was demonstrated that sub-
sovereign ratings are essentially constrained by their respective sovereign
rating. The framework of institutional and economic relationships between
central governments and local and regional authorities explains why
sovereign ratings act as an upper limit for subnational ratings, despite the
revision of the country ceiling policy. An ordered profit model was used to
estimate the relationship between more than a hundred local and regional
government ratings and a set of economic and financial variables. The three
variables (the default history of the sovereign issuer, the GDP per capita and
the net direct debt to operating revenue ratio of the local government)
explain 80% of sub-sovereign ratings.

Dreibelbis and Breazeale (2012) reviewed different credit ratings. Credit

rating agencies, also known as debt rating agencies or bond rating agencies,
conduct analysis into the creditworthiness of various securities for a fee paid
by the issuer. Moody's and Standard & Poor's, each with comparable
histories, dominate the industry. These firms are extraordinarily important to
the maintenance of free, efficient markets which is evidenced by a unique
relationship with debt issuers, governments, and investors. However, the
responsibility and diligence of these firms are debatable. The U.S.
Government and its relationship with these quasi-government agencies may
be a hindrance to effective, independent analysis. These firms have come
under increased scrutiny with questionable ratings on some of Enron's debt
and collateralized debt obligations. The purpose of this paper is to provide a
comprehensive historical context in which to view Moody's and Standard and
Poor's recent role.

Kaminsky and Schmukler (2002) studied rating agencies as one of the culprits
in fueling financial booms and busts. This paper examined whether changes
in sovereign ratings and outlooks contribute to the instability of emerging
financial markets. Aside from the credit ratings, this paper used data on
sovereign bond yield spreads, stock prices, and U.S. interest rates. The work
was done with 16 emerging markets including East Asian, Eastern European,
and Latin American economies. The results indicated that not only they
directly impact stock and bond markets of the countries being rated, but
also they contribute to cross-country contagion, particularly during crisis
times and among neighbor countries. Moreover, financial markets in
countries with lower ratings are more affected by fluctuations in international
markets.

Kraussl (2003) discussed the role of the credit rating agencies during the
recent financial crises. In particular, it examined whether the agencies can
add to the dynamics of emerging market crises. Academics and investors
often argue that sovereign credit ratings are responsible for pronounced
boom-bust cycles in emerging markets lending. Using a vector autoregressive
system this paper examined how US dollar bond yield spreads and the short-
term international liquidity position react to an unexpected sovereign credit
rating change. Contrary to common belief and previous studies, the empirical
results suggested that an abrupt downgrade does not necessarily intensify a
financial crisis.

Richard Cantor and Frank Packer (1995) focused on the demand for sovereign
credit ratings, relationship between sovereign ratings and market yields and
agency disagreements over specific sovereign ratings. This paper revealed
that agency disagreements over sovereign ratings are very common. Their
work also had shed light on the types of sovereign ratings and their uses. This
paper highlighted the fact that sovereign ratings differ across agencies
because country risk factors can vary largely among the rating agencies.
Finally, correlations between yield orderings and ratings were measured by
the Pearson-product moment and were 0.92 in 1994 and 0.84 in the year
1995 respectively.

Otaviano Canuto, Pablo Fonseca P. Dos Santos and Paulo C.de Sa Porto
(2004), focused on the analysis of the concept and determinants of sovereign
risk and the role of credit risk agencies to assess the risk. This paper has
discussed the nature of risk ratings and has described the actual risk rating
process used by agencies. The authors have investigated the possibility of
various macroeconomic variables which could be linked with sovereign risk
ratings, ascertained by the rating agencies. In the end, it has been concluded
that credit risk classes assembled by rating agencies, show the frequency of
default events and the probability of default by bond issuers in the rating
classes.

These set of research focuses on the importance of sovereign ratings. E.

Cavallo, A. Powell and R. Rigobon (2008) in their research paper explained
about the effect of ratings on sovereign spreads. They conducted three
different tests to prove the hypothesis that changes in ratings by rating
agencies add value to the market and stated their importance in the
emerging financial markets. Sovereign ratings play a very important role in
economy. Author Cantor and Packer (1996) commented on the determinants
of Moodys and Standard and Poors Sovereign rating assignments. They
explained that out of all the factors used by Moodys and Standard and Poors
only six factors: per capita income, GDP growth, inflation, external debt, level
of economic development and default history played an important role in
determining the ratings.
Further, Norbert Gaillard (2009) in his research paper analyzed the
importance of sub national ratings and its relationship with sovereign ratings
and their determinants.
A. Aparna (2016) in her research paper carried out an empirical analysis to
find out the relationship between sovereign credit rating and macroeconomic
variables. It also stated that ways in which developing nations can improve
their sovereign ratings.

3. Methodology
The data based on macroeconomic variables has been collected from
International Monetary Fund for the years 2013 and 2014. The sovereign
rating data has been obtained from Standard and Poor (S&P) and Moodys
sites for the year 2014. The conversion of ratings to its numerical equivalents
is done on the basis of the method adopted by Cantor and Pecker (1996). In
this paper, the relationship between macroeconomic variables and Sovereign
ratings has been established using Multiple Regression Analysis. The three
macroeconomic variables chosen are Real GDP, Consumer Price Index (CPI)
as a percentage of GDP and Current Account Balance (CAB) as a percentage
of GDP. Multiple Regression Analysis is a statistical technique that is used for
predicting the dependent or the endogenous variable using several
independent or exogenous variables. The multiple regression equation is
given by
Y = 0 + 1X1 + 2X2 + 3X3 +
where Y is the numerical equivalent of the rating; X1 is Real GDP; X2 is
Consumer Price Index (CPI) and X3 is Current Account Balance (CAB). In a
regression model, the extent to which the independent variables define the
dependent variable is interpreted through the value of R- squared (R2). In this
model, R2 determines the degree to which the ratings are defined by the
three independent variables. R2 is therefore, termed as Coefficient of
Determination. In order to test the significant relationship between all the
independent variables and the dependent variable, Analysis of Variance
(ANOVA) is used. In this paper, the overall relationship of the independent
variables, with the dependent variable, i.e. Ratings has been carried out
using ANOVA, at 95 % confidence.
Apart from testing the overall relationship, the same can also be tested for
independent variables individually using the t- statistic at 95% confidence. If
the p-value for the corresponding independent variable is less than or equal
to 0.05 (i.e. 95 % confidence), it implies that the independent variable is
having a significant relationship with the dependent variable.

4. Analysis

The value of R2 determines the extent to which the dependent variable is

explained by independent variables. From Table 1 it can be observed that the
chosen three economic indicators, explain the ratings 98.3% for S & P, when
considered for the same year.

Table 1: R Squared

Value of R Description
Squared
0.983 S and P 2014 Rating with economic indicators
of 2014
0.799 S and P 2014 Rating with economic indicators
of 2013
0.983 Moodys 2014 Rating with economic indicators
of 2014
 0.883 Moodys 2014 Rating with economic indicators
of 2013

The same ratings are explained 79.9% when the economic indicators are
considered for the previous year. Similarly, the three economic indicators
explain the Moodys ratings 98.3%, while they explain 88.3%, when the
economic indicators are considered for the previous year. This implies that
S&P and Moody ratings are more consistent with present cycles. In addition
to this, it can be seen that S& P and Moody ratings are equally consistent.
The relationship of each and every independent variable with the dependent
variable i.e. ratings can be established using t-statistic. Based on Table 2 it
can be observed that Consumer Price Index (CPI) has a highly significant
relationship with both S& P and
Moodys ratings at 5% level of significance for the current cycle. This fact is
ascertained since the p-values for CPI are less than 0.05.

Table 2: Ratings and economic indicators

Model Unstandardized Standardi t- Signific

Coefficients zed statist ance
Coefficien ic
ts
B Std. Beta
Error
S and P 2014 Ratings and economic indicators of 2014
Constant -.842 0.744 -1.131 0.375
Real GDP 0.62 0.136 0.043 0.456 0.693
Consumer Price Index (% 1.691 0.174 1.020 9.719 0.010
of GDP)
Current Account Balance 0.078 0.097 0.085 0.800 0.508
(%)
S and P 2013 Ratings and economic indicators of 2014
Constant 25.732 2.422 10.626 0.009
Real GDP -.104 0.547 -0.071 -.191 0.866
Consumer Price Index (% -0.957 0.494 -0.831 -1.936 .193
of GDP)
Current Account Balance 0.030 0.118 0.028 0.255 0.809
(%)
Moodys 2014 Ratings and economic indicators of 2014
Constant 26.998 .699 38.633 0.001
Real GDP -.178 0.128 -0.131 -1.388 0.300
Consumer Price Index (% -1.550 0.163 -0.990 -9.485 0.011
of GDP)
Current Account Balance -0.045 0.091 -0.052 -0.491 0.672
(%)
Moodys 2014 Ratings and economic indicators of 2013
Constant 25.757 1.743 14.778 0.005
 Real GDP -0.146 0.393 -0.105 -0.370 0.747
Consumer Price Index (% -0.888 0.356 -0.817 -2.496 0.130
of GDP)
Current Account Balance 0.103 0.273 0.109 0.378 0.742
(%)

Based on Table 3 it can be said that there is a significant relationship

between ratings and the three economic indicators at 95% confidence i.e.
5% level of significance for the current cycle.

Table 3: S & P ratings with Indicators

Model Sum of Degree of Mean sum of F Significance

Squares freedom Squares
ANOVA Table based on 2014 S & P ratings with 2014 Indicators
Regression 89.783 3 29.928 38.600 0.025
Residual 1.551 2 .775
Total 91.333 5
ANOVA Table based on 2014 S & P ratings with 2013 Indicators
Regression 72.977 3 24.326 2.650 0.286
Residual 18.357 2 9.178
Total 91.333 5
ANOVA Table based on 2014 Moodys ratings with 2014 Indicators
Regression 80.132 3 26.711 39.064 0.025
Residual 1.368 2 0.684
Total 81.500 5
ANOVA Table based on 2014 Moodys ratings with 2013 Indicators
Regression 71.992 3 23.997 5.048 0.170
Residual 9.508 2 4.754
Total 81.500 5

This is ascertained as the p- value is less than or equal to 0.05. However, as

in the case of R2, here also it can be observed that there exists a high
degree of relationship when the economic indicators of present cycles are
considered as compared to those of the same year. Thus, the analysis shows
that all the three economic indicators that have been considered as
independent variables explain the sovereign ratings strongly. However, the
Moodys ratings are slightly more consistent as compared to S & P for
previous cycles and also the economic indicators are not strongly related to
ratings when considered for previous year.

5. Conclusion:

Sovereign Credit Ratings are of significant importance as far as financial

markets are concerned. Here, in this report, S&P and Moodys ratings are
considered which are primarily based on factors such as per capita income,
GDP growth, inflation, monetary flexibility, external debt burden, etc. Apart
from the aforementioned quantitative factors, the ratings are also based on
qualitative factors that have an impact on the credit ratings.
The economy of a country is dependent on the monetary and fiscal policy of
the said countries. Monetary policy is the policy framed by the Central Bank
in order to control credit in the country, where fiscal policy is the policy of the
government, in which adjustments are made with respect to governments
revenue and expenditure in order to influence nations economy. Efficient
monetary and fiscal policies, keeps a nations economy stable, which in turn
leads to good credit rating of the country.
Political risks also play an important role in determination of ratings. It can be
mitigated by having a strong and efficient fiscal policy, where events like
terrorism, riots, military coups etc. are beyond human control and hence
amount to a great deal to the political risk of a country.

In 2014, Standard & Poor's Ratings Services confirmed its 'AAA/A-1+' long-
and short-term unsolicited sovereign credit ratings on the United Kingdom
and it is stable. This ratings confirms the view that there is high labor- and
product-market flexibility, in UK and it is a wealthy and diversified economy.

The monetary flexibility of UK is its key credit strength. It enables wages and
prices to adjust rapidly, relative to trading partners.

In 2014, the economy of Brazil was facing a downturn condition. Therefore it

resulted in an expectation of slower economic growth and fiscal trajectories.
Moreover, the Government has less say in the face of economic shocks. There
will be continued trend of mixed, inconsistent policy making in Brazil.

The developing nations encounter with the problem of increasing current

account deficit, which has an adverse impact on the credit rating of a country.
So, therefore developing countries should focus on improving its cash inflows
in order to lower its current account deficit and thereby improving its credit
ratings so that the global investors are keen in investing in developing
countries.