Access to International Capital

1. Access to International Capital Do the Credit Ratings Agencies Help or Hurt? Asymmetric Bias and Self-fulfilling Sovereign Defaults David Tennant, Damien King, & Marlon Tracey

2. Paper argues that… CRAs have reason to be biased against poor countries Evidence suggests the bias is statistically significant The bias can be sufficient to trigger default/restructuring

3. Credit Rating Agency’s Objective CRAs wish to minimize both cost (of acquiring information) and inaccuracy (of their ratings). But there is a trade-off between the two, since accuracy is costly.

4. Characteristics of the Ratings Business It is costly to acquire information on the ability/willingness of a sovereign to service debt The weaker a country’s institutions, the poorer it is and also the worse is the quality of readily available information Default by a highly rated sovereign is worse (reputationally) than failure to default by a poorly rated one

5. Accuracy costs  COST  UNDER-ESTIMATE OVER-ESTIMATE 

6. Under-estimating default likelihood worse than over-estimating  COST  UNDER-ESTIMATE OVER-ESTIMATE 

7. Striking a balance = over-estimating  COST  UNDER-ESTIMATE OVER-ESTIMATE 

8. Optimal over-estimation worse the more costly it is to get information  COST  UNDER-ESTIMATE OVER-ESTIMATE 

9. Therefore… CRA’s estimated probability of default has a bias, the strength of which is inversely related to a country’s level of development. “Bias” because it is independent of the fundamentals that determine a country’s ability and willingness to repay its debt.

10. Paper argues that… CRAs have reason to be biased against poor countries Evidence suggests the bias is statistically significant The bias can be sufficient to trigger default/restructuring

11. Objective of Statistical Estimation Test CRAs decision to downgrade, upgrade or leave unchanged the rating of a country’s foreign currency sovereign debt.

12. Statistical testing takes account of… • Economic and institutional fundamentals • Debt, debt service, fiscal balance, GDP, investment, reserves, inflation, CA balance, Institutional quality • Country specific fixed effects • Some element of a country’s risk may be particular to that country, e.g., social capital • Heterogeneous thresholds • Threshold for re-grade not same for all countries • Time-period dummies • Willingness to re-grade changes over time • Tempering • General reluctance to change a rating due to desire for stability and upper/lower limits

13. Data Countries: 142 Years: 1997 to 2011 CRAs: S&P, Moody’s, Fitch

14. Mean Ratings

15. Factors Influencing Ratings Changes

16. Factors Influencing Upgrade Thresholds

17. Paper argues that… CRAs have reason to be biased against poor countries Evidence suggests the bias is statistically significant The bias can be sufficient to trigger default/restructuring

18. Government’s Objective Governments wish to minimize both taxes and defaults. But there is a trade-off between the two since they are alternative means of financing.

19. Characteristics of Fiscal Choices Defaulting is policy choice There is a fixed cost to defaulting CRAs can see when a government would be better off by defaulting

20. To beor not to be (a defaulter) If CRAs expect no default, default, then govt should… then govt should… default y default x not default not default

21. Conclusions • Optimal for CRAs to overestimate the probability of default • Information acquisition costlier with poorer countries • Highly rated default is reputationally worse than a poorly rated survivor • Constitutes a bias • Unrelated to ability and willingness to pay. • Evidence that S&P, Moody’s, and Fitch are reluctant to upgrade poorer countries • There is a range of debt where a CRA could rationally predict either default or no default • Within that range, poor countries are more likely to get an unwarranted lower rating, which can trigger a decision to default