Determinants and Impact of Sovereign Credit Ratings

In “Determinants and Impact of Sovereign Credit Ratings” (Frbny Economic Policy Review, October, 1996), Richard Cantor and Frank Packer elaborate on the three analysis they carried out related to sovereign credit ratings and macroeconomic fundamentals. Using sovereign credit ratings assigned by the two leading U.S. agencies, Moody’s and Standard and Poor’s, the author made three regression analysis:

1.1 Determinants of sovereign ratings

In total, there are eight factors used by Moody and S&P in determining a country’s rating. According to the regression analysis, six out of the eight factors play an important role: (1) Per capita income; (2) GDP growth; (3) inflation; (4) external debt; (5) level of economic development; (6) default history. On the other hand, there is a lack of clear correlation between ratings and fiscal and external balances, mainly because in many cases the market forces poor credit risks into strong fiscal and external balance positions, diminishing the significance of these two factors as explanatory variables.

1.2 The cross-sectional relationship between ratings and yields

The authors carried out a regression of the log of the countries’ bond spreads against their average ratings. The results show that (1) Ratings have considerable power to explain sovereign yields (the Adjusted R squared is 92% with a standard error of 29%); (2) Sovereign yields tend to rise as ratings decline (3) Financial markets are more pessimistic than Moody’s and S&P about sovereign credit risks below A level.

1.3 The impact of rating announcements on dollar bond spreads

The impact of rating announcements on dollar bond spreads is highly significant. According to the authors, 63% of the announcements are associated with changes in spread in the expected direction during the announcement period. Besides, the analysis