Emerging Markets Instability: Do Sovereign Ratings Affect Country Risk and Stock Returns?

Transcription

1 Emerging Markes Insabiliy: Do Sovereign Raings Affec Counry Risk and Sock Reurns? Graciela Kaminsky George Washingon Universiy and Sergio Schmukler * World Bank February 28, 2001 Absrac Financial marke insabiliy has been he focus of aenion of boh academic and policy circles. Raing agencies have been under paricular scruiny laely as promoers of financial excesses, upgrading counries in good imes and downgrading hem in bad imes. Using a panel of emerging economies, his paper examines wheher sovereign raings affec financial markes. We find ha changes in sovereign raings have an impac on counry risk and sock reurns. We also find ha hese changes are ransmied across counries, wih neighbor-counry effecs being more significan. Raing upgrades (downgrades) end o occur following marke rallies (downurns). Counries wih more vulnerable economies, as measured by low raings, are more sensiive o changes in U.S. ineres raes. JEL Classificaion Codes: F30, G12, G14, G15, G29 Keywords: credi raings; emerging markes; counry risk; sock reurns; financial markes; spillover effecs * We are graeful o Richard Levich, Rick Mishkin, Carmen Reinhar, and paricipans a he workshops held a NYU for helpful commens and feedback. We hank Gloria Alonso and Chris van Klaveren for excellen research assisance. The findings, inerpreaions, and conclusions expressed in his paper are enirely hose of he auhors and do no necessarily represen he views of he Inernaional Moneary Fund or he World Bank. Conac address: The World Bank, 1818 H Sree NW, Washingon, DC Phone (202) Fax: (202) addresses: graciela@gwu.edu, sschmukler@worldbank.org

2 1. Inroducion Worldwide financial marke insabiliy has been he focus of aenion of boh academic and policy circles. Naurally, following he series of currency crashes in he 1990s, mos of he discussion has cenered on currency crises. The laes crisis in Turkey in February 2001 will cerainly conribue o keeping an avid ineres in he riggers of crises well ino he new millennium. Bu currency collapses are no he only ones o have araced aenion. The daily volailiy of sock and bond markes in non-crisis imes have also sirred ineres, wih, for example, he vagaries of he NASDAQ index in he Unied Saes making he daily headlines of newspapers around he globe. Many have argued ha globalizaion is a he hear of his volailiy, wih highly diversified invesors no paying much aenion o economic fundamenals and following he herd in he presence of asymmeric informaion. (See, for example, Calvo and Mendoza (2000)). Naurally, his argumen has provided ammuniion o hose supporing he re-inroducion of capial conrols, as argued in Krugman (1998) and Sigliz (2000). Policies ha can lead o moral hazard, including bailous by boh inernaional insiuions and governmens, have also been suggesed as oher culpris of financial volailiy and financial excesses. (See, for example, McKinnon and Pill (1997) and Dooley (1998)). The lis of culpris does no sop here. Raing agencies have also been under scruiny laely as promoers of financial excesses. As discussed in Ferr Liu, and Sigliz (1999), heir pro-cyclical behavior, upgrading counries in good imes and downgrading hem in bad imes, may have conribued o magnifying he boom-bus paern in sock markes. Even if raing agencies do no behave pro-cyclically, heir announcemens may sill rigger marke jiers. This is because mos insiuional invesors can only hold 1

3 invesmen grade insrumens (i.e. securiies wih raings above a cerain hreshold). Thus, changes in raings, downgrading (upgrading) sovereign deb below (above) invesmen grade, may have a drasic impac on prices, because hese raing changes affec he pool of invesors. 1 Raing changes may also unveil new (privae) informaion abou a counry and hus hey may fuel rallies or downurns. This effec is likely o be sronger in emerging markes, where problems of asymmeric informaion and ransparency are more severe. Finally, changes in raings migh ac as a wake-up call, wih raing changes for one counry affecing oher counries wih similar economies. Research on he effecs of changes in sovereign raings has flourished in he 1990s. This work has mosly focused on he effecs of raings on he insrumens being raed. For example, Canor and Packer (1996) and Reisen and Von Malzan (1997) and (1999) examine he effecs of raing changes of sovereign deb and find a significan effec on bond yield spreads. Similarly, Hand, Holhausen, and Lefwich (1992) show ha raing announcemens direcly affec corporae securiies. Richards and Deddouche (1999), using emerging marke bank-level daa, examine he impac of raing changes on bank sock prices, bu do no find saisically significan effecs. Previous research has no examined, however, wheher raing changes for one counry rigger conagious flucuaions in asse markes in neighboring counries nor has i examined wheher raings for one ype of securiy affec oher asse markes. To our knowledge, he only excepion is Kaminsky and Schmukler (1999), who examine spillover effecs of raing changes, among differen ypes of news, in neighboring 1 These effecs are no jus confined o he pool of invesors acquiring sovereign deb. When a credi raing agency downgrades sovereign deb of a counry, all deb insrumens from ha counry migh have o be downgraded accordingly because of he sovereign ceiling docrine. As a resul, commercial banks in he counry ha urn ou o be raed as sub-invesmen grade can no longer issue inernaionally recognized 2

4 counries and find ha news regarding he crediworhiness of a sovereign borrower affecs oher counries sock and bond markes. Cross-counry conagion effecs can be large, winess he spillover effecs of he Russian defaul on developed and developing counries. 2 Raing agencies may conribue o hese comovemens in financial markes around he world. Similarly, news for one paricular marke can affec yields of oher securiies. These effecs can, in some episodes, become quie dramaic, as was he case of he defaul of he Sae of Minas Gerais on he Brazilian real. Again, raing agencies may conribue o heighen financial insabiliy. Neiher has previous research examined wheher economic vulnerabiliy may rigger a large reacion of domesic financial markes o inernaional evens. For example, hikes in world ineres raes may affec more drasically counries wih economies in disress (wih banking fragiliies, liquidiy problems due o high concenraion of shor-erm deb, or near insolvency) han counries wih healhier economies. 3 This vulnerabiliy effec may, in fac, explain some conflicing resuls in he empirical lieraure ha examines inernaional ransmission of shocks. For example, Eichengreen and Mody (1998) and Kamin and von Kleis (1999) find ha U.S. ineres rae shocks do no affec sovereign bond spreads, while Herrera and Perry (2000) find ha hey do. Ineresingly, he Eichengreen and Mody (1998) and Kamin and von Kleis (1999) sudies include daa only up o 1997 (before he crises) while he Herrera and leers of credi for domesic exporers and imporers, isolaing he counry from inernaional capial markes. Similarly, corporaions will no be able o issue deb in inernaional capial markes. 2 The word conagion here is used in a broad sense o denoe cross-counry spillover effecs, regardless of he naure of he shock. For alernaive definiions and relaed papers see 3 On a similar vein, Frankel, Schmukler, and Serven (2000) sudy he ransmission of inernaional ineres raes o counries wih differen exchange rae regimes. 3

5 Perry (2000) sample includes observaions on he crises in Asia, Russia, and Brazil, and hus comprises episodes wih very fragile economies. This paper complemens he previous research on raing agencies by also examining hese possible cross-counry and securiy-marke spillover-effecs of raing changes. I also conribues o he lieraure on conagion and inernaional ransmission of shocks by examining he effec of domesic vulnerabiliy, as measured by he raings of inernaional agencies, on he exen of inernaional spillovers. Our resuls can be summarized as follows. Firs, raing changes significanly affec bond and sock markes, wih yield spreads increasing on average 3 percen and sock reurns declining abou 1 percen following a downgrade. Second, raing changes also conribue o conagion or spillover effecs, wih raing changes among emerging markes riggering changes in boh yield spreads and sock reurns in foreign counries. Sill, he effec is smaller han ha of raing changes of he domesic economy. Third, similar o he findings in he lieraure on conagion, he conagion effecs of raing changes are of a regional naure. 4 Fourh, fragile economies, as measured by he inernaional raings, are more severely affeced by changes in U.S. ineres raes. In fac, ineres raes hikes in financial ceners fuel increases in sovereign risk 50 percen larger in vulnerable circumsances, relaive o he changes when counries have more healhy economies. 4 See, for example, Kaminsky and Reinhar (2000a). 4

6 Lasly, domesic-counry raing upgrades ake place following marke rallies, while downgrades occur afer marke downurns. Foreign changes in raings have a susained effec. The res of he paper is organized as follows. Secion 2 describes he mehodology. Secion 3 presens he daa. Secion 4 discusses he resuls. Secion 5 concludes. 2. Mehodology To sudy he effecs of raings and vulnerabiliy, we follow wo differen mehodologies. Firs, we esimae panel regressions. Second, we perform even sudies. The wo mehodologies are complemenary in he sense ha hey show differen aspecs of he daa. A. Panel Regressions The panel esimaions sudy he reacion of counry risk and sock reurns o changes in raings and U.S. ineres raes. The fac ha we use daily daa does no allow us o conrol for counry fundamenals, which are ypically repored on a monhly or quarerly basis. Bu we do conrol for pas changes of he explanaory variables. We use only one lag since furher lags appear o be insignifican. We esimae differen specificaions for boh counry risk and sock prices. The firs specificaion is he following pooled panel:, (1) US Y = α + δ' Y 1 + β ' R + γ ' i + ε such ha i = 1,...,N and = 1,...,T. 5

7 Y represens alernaively he log change in spreads and he log change in sock marke prices. The sub-indexes i and sand for counry and ime, respecively. The error erm ε can be characerized by an independenly disribued random variable wih 2 mean zero and variance σ. We esimae equaion (1) using leas squares, allowing for heeroskedasic residuals. R sands for he change in raings. The variable R is equal o 1 (-1) if here is an upgrade (downgrade) a ime by any agency on any ype of deb (foreign or domesic currency) from any counry in he sample. The variable is equal o zero oherwise. If changes in raings convey new informaion o marke paricipans, we expec β ˆ < 0 in he regression for counry risk; namely, raing upgrades (downgrades) lead o decreases (increases) in counry risk. Analogously, in he regression for sock reurns, we expec β ˆ > 0. US i sands for he change in U.S. ineres raes; sricly speaking, he ineres rae US is log( ) i. As argued in Kamin and von Kleis (1999), here are differen channels hrough which changes in U.S. ineres raes can affec counry risk. Firs, if here is a posiive probabiliy ha a governmen will no pay is deb, increases in U.S. raes will promp a higher rise in he ineres rae of he governmen s deb. The higher increase is o compensae he probabiliy of no repaymen. Second, rises in U.S. ineres raes increase he burden of he deb, decreasing a counry s repaymen capaciy. Third, increases in U.S. raes can decrease invesors appeie for risk, reducing he demand for risky asses from emerging counries, hus increasing he counry risk. In sum, if increases in U.S. raes lead o higher counry risk, we expec γ ˆ > 0 in he equaion for 6

8 counry risk. A similar explanaion can be argued for sock reurns. In fac, governmens can levy axes on corporaions if hey face higher deb paymens. Therefore, we expec ha U.S. ineres raes negaively affec sock reurns, or ha γ ˆ < 0 in he equaion for sock reurns. As a second specificaion, we esimae:. (2) i i j j US Y i, = α + δ' Y 1 + β ' Ri, + β ' R + γ ' i + ε The variable is equal o 1 (-1) if here is an upgrade (downgrade) a ime i R i, by any agency on any ype of deb (foreign or domesic currency) from counry i. The variable is equal o zero oherwise. The variable is similar o he laer bu akes he j R i, value 1 (-1) when here is an upgrade (downgrade) in counry j for j i. Tha is, his specificaion ries o examine wheher here is a conagious effec of credi raings. The hird specificaion we esimae is: Y dc dc fc fc j, dc j, dc j, fc j, fc = + δ' Y 1 + β ' R + β ' R + β ' Ri, + β ' R + γ ' α i + ε US.(3) The difference beween his specificaion and he previous one is ha we separae he raings ino raings for domesic-currency deb (dc) and raings for foreign-currency deb (fc), boh for he domesic and foreign counries, i and j. If raings are imporan, we expec he domesic counry foreign-currency raings (fc) o be significan in he equaion for counry risk, because his is he insrumen ha credi raings are evaluaing. In oher i fc words, we expec a saisically significan β > 0. A-prior he esimaed coefficien ˆ, for domesic-currency deb, dc ˆβ, is no expeced o affec he counry risk, afer conrolling for changes in foreign-currency raings. Sill, he coefficien for domesic- 7

9 currency deb capures an exchange rae risk and may provide furher insighs ino he vulnerabiliy of he economy. The fourh specificaion we esimae is: Y = α + δ' Y + β nr, dc ' R 1 nr, dc i, + β dc + β ' R nr, fc dc i, ' R + β nr, fc fc ' R + γ ' i fc US + β + ε r, dc ' R r, dc + β r, fc ' R nr, fc i,. (4) The variable is equal o 1 (-1) if here is an upgrade (downgrade) a ime r dc R, by any agency on domesic-currency deb from counry r (for r i). r represens a counry ha belongs o he same geographic region (Eas Asia, Easern Europe, and Lain America) as i. The variable is equal o zero oherwise. The variable is similar o nr dc R, he laer bu akes he value 1 (-1) for counries ouside he geographic region. The variables wih he superscrip fc denoe upgrades and downgrades on foreign-currency deb. In his specificaion we examine wheher he conagious effec of credi raings is similar wihin a region or across regions. The fifh specificaion we esimae is: Y = α + δ' Y + β nr, dc ' R 1 nr, dc i, + β dc + β ' R nr, fc dc i, ' R + β nr, fc fc + γ ' R R fc ' i US + β + ε r, dc ' R r, dc + β r, fc ' R nr, fc i,. (5) This specificaion is similar o he previous one, bu we allow for he vulnerabiliy effec. Tha is, we use differen coefficiens, γ R, for he sensiiviy o changes in U.S. raes. In paricular, we divide he observaions ino wo differen groups, observaions wih low and high raings. We expec ha counries wih high raings should be less affeced by changes in U.S. raes due o he hree channels described above. (A similar argumen can be made for sock reurns.) Firs, given ha higher raings mean a lower probabiliy of defaul, changes in U.S. ineres raes will impac more spreads of counries 8

10 wih lower raings. Second, counries wih higher raings end o have a lower level of deb, so he burden of he deb will increase less in counries wih high raings when U.S. raes increase. Third, if here is a fligh o qualiy when he U.S. raes increase, spread from riskier counries (counries wih lower raings) should reac more srongly. The specificaions described assume a zero correlaion beween he error erm and he explanaory variables. This correlaion may arise if he explanaory variables are endogenously deermined. We do no expec changes in U.S. ineres raes or changes in raings o respond o conemporaneous daily changes in emerging marke spreads or sock prices. However, a correlaion beween he lagged dependen variable and he error erm is possible. This correlaion can arise if he error erm is if, for example, he rue original model were in levels. In ha case, he error erm in our equaions would be in firs differences and correlaed wih he lagged endogenous variable by consrucion. To correc for poenial biased coefficiens, we esimae he more complee specificaion, equaion (5), using insrumenal variables. As insrumens, we use lagged values of he lagged dependen variable, as suggesed by Anderson and Hsiao (1982). B. Even Sudies The above specificaions sudy he conemporaneous effec of raings on spreads and sock reurns. However, hey do no examine any possible dynamic effecs of upgrades and downgrades. To have a sense of any dynamic effecs ha migh be aking place, we use even sudies. Dynamics effecs are ineresing because marke paricipans can anicipae changes in raings. Therefore, he conemporaneous effec migh be smaller han he oal effec of raing changes. Moreover, credi raings can ac 9

11 procyclically, downgrading counries during bad imes and upgrading hem during good imes. We will no be able o disenangle hese wo observaionally equivalen hypoheses, bu we are able o observe wheher downurns and rallies ake place before downgrades and upgrades. Dynamics effecs are also ineresing because he effec of upgrades and downgrades can dissipae over ime. The even sudy looks a counry risk and sock marke spreads (domesic sock markes prices relaive o he U.S. S&P500 index) in a 10-day window around an upgrade or downgrade. All spreads and prices are se o 100 a day 10, in ha way we can easily measure he cumulaive effecs over ime and we can, a he same ime, compare spreads across counries. To perform he even sudies we work wih clean evens, i.e. upgrades and downgrades ha do no overlap in windows of +/- 10 days. This disincion is imporan when considering an even window, o be able o isolae he effec of each change in raing. Figure 1 plos he raings over ime for hree major raing agencies for a sample of counries. The figure suggess ha many upgrades and downgrades across raing agencies occur simulaneously across agencies. In paricular, he Eas Asian counries are downgraded during he Asian crisis and upgraded aferwards. Only few changes ake place before he crisis in he case of Malaysia and Souh Korea Daa Our daa se conains daily series of EMBI spreads, sock reurns, ineres raes, and credi raings. We work wih 16 emerging markes including Eas Asian, Easern 5 For a deailed sudy on how raings are changed, see Cruces (2001). 10

12 European, and Lain American economies. The counries are in he daa se are: Argenina, Brazil, Chile, Colombia, Indonesia, Korea (Souh), Malaysia, Mexico, Peru, Philippines, Poland, Russia, Taiwan, Thailand, Turkey, and Venezuela. The daa se covers he period January 1990-June Appendix Table 1 displays he available daa for each counry and variable. JP Morgan produces he EMBI and EMBI+ (henceforh EMBI) series for a group of emerging markes, bu also on a counry-by-counry basis. The index by counry is a oal reurn index ha racks raded deb insrumens denominaed in foreign currency. The insrumens used are Brady bonds, benchmark Eurobonds, loans, and Argenine domesic deb. The EMBI spreads mosly reflec he difference beween each counry s sovereign bond yields relaive o yields of benchmark insrumens issued from developed counries. The spreads are commonly used as measures of counry risk or defaul risk. When he probabiliy of a sovereign defaul increases vis-à-vis he U.S., bond prices decrease and yield spreads increase. The oher variables ha we use in his paper, sock reurns, ineres raes, and credi raings, were downloaded from Bloomberg. Sock marke price indexes for each counry are measured in U.S. dollars. We use raings on sovereign deb issued in domesic and foreign currency. These raings ry o measure he abiliy of he issuer o pay back is deb. We work wih raings from hree major inernaional raing agencies: Moody s, Sandard and Poor s, and Fich-IBCA. Table 1 provides some measures of financial marke insabiliy in our sample. Daily changes (in absolue values) in boh markes are large and oscillae around 2.5 percen for sovereign spreads and around 1.6 percen for socks. Our number of observaions is high (abou 11 housand for bond spreads and 22 housand for sock 11

13 prices). Tables 1 and 2 examine he characerisics of he changes in raing in our sample. Table 2 repors he number of upgrades and downgrades per raing agency and Table 3 repors he number of upgrades and downgrades per counry. This las able shows ha counries wih currency collapses during he 1990s, such as Korea, Malaysia, Brazil, and Indonesia, were frequenly re-evaluaed by raing agencies. Appendix Table 2 shows he scale and ype of raings used by each raing agency. 4. Resuls We examine firs he impac effec of changes in raings and hen we concenrae on he dynamics aspecs of marke responses o raing changes. A. Panel Regressions The panel regression resuls for he counry risk are repored in Table 4. The columns of he able display he alernaive specificaions. The firs column shows ha he coefficien for he lag dependen variable is posiive and saisically significan. The coefficien for he changes in raings (domesic and foreign) is negaive and saisically significan, alhough small when compared o he average daily change in spreads. In days of raing changes, spreads only change by abou 0.5 percen while he average absolue change of spreads in our sample is abou 2 percen. The second column examines separaely wheher changes in domesic raings have differen effecs from changes in raings of foreign counries. Ineresingly, we now find ha changes in raings of domesic deb no only have a saisically significan effec, bu his effec is also economically imporan, wih raing changes leading o 12

14 changes in he spreads of abou 2.5 percen. Foreign raings also maer, bu heir effec is subsanially smaller averaging abou 0.4 percen over he sample. Our sample on raings includes raings on foreign-currency deb and domesic-currency deb. The firs raing capures sovereign risk while he second also makes an assessmen of devaluaion risk. Since we are examining sovereign yield spreads, raings on domesic-currency deb should no affec yield spreads once conrolled for raings direcly relaed o counry risk. Thus, column 3 examines separaely he effecs of raings on foreign- and domesiccurrency deb. As expeced, raings on foreign-currency deb are no saisically significan. Moreover, raings on sovereign deb, once esimaed independenly from hose of domesic-currency deb, have sronger effecs on sovereign risk, as capured by he yield spreads. On average, changes in he assessmen of raing agencies abou counry risk lead o spread changes averaging abou 3.2 percen. The crises of he 1990s and he speed a which a crisis in one counry engulfed he region and even spread around he globe have spawned a sill growing lieraure on conagion. Much of he research ceners on he role of financial links versus rade links. While opinions abou he channels of ransmission diverge, 6 almos everybody agrees ha in several cases conagion has been mosly regional. The Tequila crisis was basically confined o Lain American counries and he crisis in Thailand spread only o Asian economies. 7 We now examine wheher hese regional conagion effecs are also presen when we examine conagion effecs of credi raings. The resuls are repored in columns 4 and 5. Ineresingly, regional effecs seem o be sronger han hose from counries 6 For example, Kaminsky and Reinhar (2000a) and Kaminsky, Lyons, and Schmukler (2000) have poined o he role of financial links and have focused on he behavior of inernaional banks and muual funds. Corse Pesen and Roubini (2000) in conras have focused on he role of rade links. 13

15 from oher regions, wih he wihin-he-region raing changes leading o an average increase in yields of 0.8 percen while he across-regions raing changes only riggering an average change in spreads of abou 0.4 percen. I is he raing agencies assessmen of currency risk (raings on domesic-currency denominaed deb) he one ha maers for regional conagion bu i is he raing agencies assessmen of sovereign risk he one ha maers when assessing across regions spillover effecs of raings. Afer Calvo, Leiderman, and Reinhar (1993) brough o he limeligh he close relaionship beween he capial inflows episode o emerging markes during he early 1990s o moneary policy in he Unied Saes, he number of papers wrien on his opic has increased significanly. A large number of papers has focused on he relaionship beween capial flows or foreign exchange reserves and ineres raes in financial ceners, ohers have focused on he links beween reurns in emerging markes and reurns in financial ceners. Ohers, as described in he inroducion, have focused on he effecs of ineres rae hikes on ineres raes and counry risk. Ineresingly, while hese links were quie srong in he early 1990s, hese links dilued somewha in he mid-1990s, bu reappeared in he lae 1990s. The changing relaionship beween financial markes in emerging economies and in financial ceners is paricularly clear in he research sudying he deerminans of counry risk, as examined in he inroducion (see, Kamin and von Keis (1999), on one hand, and Herrera and Perry (2000), on he oher). While examining he deerminans of his ime-varying relaionship is beyond he scope of his paper, we will now examine wheher hikes in ineres raes in financial ceners are ransmied more srongly o 7 Kaminsky and Reinhar (2000b) analyze why some crises become sysemic while some ohers are confined o he naional borders or a mos are of a regional naure. 14

16 vulnerable economies. We divide he sample ino wo equal pars according o he counry raings. The resuls indicae ha vulnerable economies are more srongly affeced by he vagaries of inernaional financial markes han healhier economies. The effec is abou 50 percen higher. Table 5 repors similar esimaions for sock marke reurns. The resuls are less srong han in he case of sovereign deb. This is no unexpeced since assessmens on sovereign risk should affec more closely yields on sovereign deb raher han sock reurns. Sill, sock reurns seem o reac more srongly o flucuaions in ineres raes in financial ceners when he economy ends o be more fragile, as capured by low raings from credi agencies. B. Even Sudies In he panel esimaions, we jus focus he insananeous response of bond and sock markes in emerging economies. To capure wheher credi raings have a persisen effec on he mood of invesors, we rely on even-sudy mehods commonly used in he finance lieraure. The even-sudy mehodology also allows us o examine he claim ha raing agencies behave procyclically, upgrading counries in good saes and downgrading hem in imes of crises. Thus, we examine he behavior of asse markes around he ime of he raing changes (+/- 10 day-windows). Sandard even sudy mehodology requires linking raing evens o abnormal reurns. Tha is why we base he even sudy on he yield spreads beween sovereign governmen deb and he benchmark insrumens from indusrial counries. In he case of socks, we use he dollar 15

17 sock spreads beween emerging markes sock prices and he S&P500 U.S. sock marke index. Figures 2 and 3 summarize he even-sudy resuls in some deail for he case of domesic upgrades and downgrades. The four plos in each figure show he cumulaive abnormal reurns over ha window around he ime of changes in raings. The panels on he lef examine he effecs of upgrades while he panels on he righ repor he effecs of downgrades. The op panels examine raing changes of boh foreign- and domesiccurrency denominaed deb, he boom panels do he same for changes in raings of jus foreign-currency denominaed deb. Boh figures only look a he responses in he days before and afer raings of he domesic deb. Day zero is he day of changes in raings. Wih respec o he behavior of markes in he days leading o he raing changes, he evidence seem o suppor he hypohesis ha raing agencies may have conribued o amplify he boom-bus paern in emerging markes. Overall upgrades occur when markes are rallying and downgrades when emerging markes are collapsing. This effec seems o be sronger in he case of downgrades. For example, bond spreads increase up o 9 percen in he 10-days prior o downgrades. Similarly, he sock marke spreads decline up o 7 percen. Naurally, hese flucuaions could reflec an anicipaion effec. Sill, we are mos inclined o inerpre hem as evidence of procyclical behavior of raing agencies. In fac, our resuls are consisen wih he findings in Reinhar (2001). In ha paper, he auhor examines wheher raing agencies acions anicipaed he crises of he 1990s. Wih a large sample of counries and crises, he auhor concludes ha raing changes far from being leading indicaors of crises have urned ou o be lagging indicaors of financial collapses. 16

18 Wih respec o he afermah of he raing changes, he resuls are more ambiguous. We firs examine he responses of bond yields. The resuls sugges an asymmeric response of bond spreads afer upgrades and downgrades. In paricular, according o his even sudy analysis, he effecs of downgrades end o be somewha more susained while he effecs of upgrades are usually reversed wihin wo days. Typically, afer experiencing an upgrade, bond spreads decline abou 2 percen bu wihin en days bond spreads increase by abou 4 percen, relaive o he value a day -10. A differen picure emerges from he analysis of downurns. While he conemporaneous reacion is similar o ha of an upgrade (he spread changes by abou 2 percen), following downgrades, he bond marke does no recover. On he conrary, spreads coninue o increase by a leas 2 percen. The effecs are somewha sronger when we examine downgrades of foreign-currency denominaed bonds only. Spreads widened an exra 5 percen. In conras, he effecs of upgrades seem o be long lasing in he sock marke, wih domesic sock markes gaining an exra 2 percen reurn relaive o ha of he sock index in he Unied Saes. This is no he case for downgrades. Figure 4 displays even sudies for foreign evens. Insead of using as an even upgrades and downgrades on sovereign raings from he domesic counry, he figure displays he behavior of EMBI spreads and sock spreads around upgrades and downgrades of spreads from oher emerging markes. The figures on he lef display upgrades, while he figures on he righ show downgrades. The op panel uses EMBI spreads, while he boom one uses sock spreads. The resuls show ha foreign-currency upgrades are followed by large decreased in EMBI spreads and large increases in sock 17

19 marke prices. Foreign downgrades are followed by increases in EMBI spreads alhough he resuls are no saisically very imporan. 5. Conclusions This paper complemens previous research on he effecs of credi raings on financial markes in emerging economies. Mos of he previous research has focused on quanifying he effecs of changes in raings of a counry on sovereign risk as measured by he yield spread of domesic insrumens relaive o developed counry benchmark insrumens. In his paper, no only did we expand his exercise wih updaed daa, bu also we esed new hypoheses o have a more complee characerizaion on he effecs of sovereign raing changes. We found ha raing changes have effecs boh on he insrumens being raed and on oher insrumens wihin he same counry. We found ha sovereign raings have a significan impac on sock reurns. We also examined wheher raings of oher counries sovereign deb have he poenial o rigger conagion in financial markes. We found ha raing changes have spillover effecs o oher counries. The effecs end o be limied o he neighbor counries. This paper also complemens he previous lieraure on financial marke linkages. This lieraure has examined he effecs of changes in ineres raes in financial ceners. The resuls in his lieraure have been mixed, wih for example sovereign risk being affeced posiively by ineres rae hikes in some episodes bu no in ohers. One imporan resricion in all hese sudies is ha counry risk obeys a common linear specificaion. One possibiliy is ha ineres rae hikes may have more damaging effecs in counries near insolvency or wih very fragile economies. We invesigaed his 18

20 possibiliy and examined wheher counries wih lower raings are affeced more severely by changes in U.S. ineres raes. We found ha counries wih more vulnerable economies are affeced 50 percen more by flucuaions of ineres raes in he res of he world. While our resuls help o undersand beer he movemens of financial markes in emerging economies, we are far from explaining daily volailiy. While his is a hard ask no only for developing counries by also for maure markes, 8 here is sill room for improvemen. Wih respec o undersanding beer he effecs of raings, here are several poenial exensions o his paper. We have no examined ye wheher changes in raings have more impac during crisis imes han during ranquil imes. Oher exensions can be addressed wih new daa. For example, if raings are informaive, i will be insrucive o analyze wheher sovereign raings are more informaive for less ransparen counries han for more ransparen counries. Furher exensions imply using oher raings, beyond sovereign deb raings. I would be ineresing o work wih corporae raings o invesigae wheher raings convey differen informaion for differen groups of firms. For example, one can expec ha firms issuing ADRs, wih more ransparen accouning sandards and for which more informaion is available, o be less affeced by raings han firms rading in less ransparen local markes. Also, since raing agencies also assess exchange rae risk, we could examine wheher hese raings are informaive by looking a wheher hey affec differenly counries and companies wih differen wih exchange rae exposure. Also, i would be ineresing o examine wheher firms producing raded-goods 8 R 2 in all sudies explaining daily variaions in sock prices or bond yields is very low. 19

21 are less affeced by counry-risk, ha is wheher collaeral (valued in inernaional markes) can ac as a buffer o counry-risk changes. 20

22 References Anderson, T., and Hsiao, C., 1982, Formulaion and Esimaion of Dynamic Models Using Panel Daa, Journal of Economerics, 18: Calvo, G., Leiderman, L., and Reinhar, C., 1993, Capial Inflows and Real Exchange Rae Appreciaion in Lain America: The Role of Exernal Facors, Saff Papers Inernaional Moneary Fund, 40: Calvo, G. and Mendoza, E., 2000, Raional Conagion and he Globalizaion of Securiies Markes, Journal of Inernaional Economics, June. Canor, R. and Packer, F., 1996, Deerminans and Impac of Sovereign Credi Raings, Federal Reserve Bank of New York, Economic Policy Review 2:2, Corse G., Pesen P., and N. Roubin N., 2000, Compeiive Devaluaions: A Welfare-Based Approach Journal of Inernaional Economics, June. Cruces, J., 2001, Saisical Properies of Sovereign Credi Raings, mimeo, Washingon Universiy and Universidad de San Andres, Argenina. Dooley, M., 1998, A Model of Crises in Emerging Markes, NBER Working Paper No. W6300. Eichengreen, Barry, and Mody, Ashoka, 1998, Wha Explains Changing Spreads on Emerging-Marke Deb: Fundamenals or Marke Senimen? NBER working paper no. W6408. Frankel, J., Schmukler, S., and Serven, L., 2000, Global Transmission of Ineres Raes: Moneary Independence and he Currency Regime World Bank working paper No Ferr G., Liu, G., and Sigliz, J., 1999, The Procyclical Role of Raing Agencies: Evidence from he Eas Asian Crisis, Economic Noes 3: Hand, J., Holhausen, R., and Lefwich, R., 1992, The Effec of Bond Raing Agency Announcemens on Bond and Sock Prices, The Journal of Finance, 157:2, Herrera, Saniago and Perry, Guillermo, 2000, Deerminans of Lain Spreads in he New Economy Era: The Role of U.S. Ineres Raes and Oher Exernal Variables, mimeo, World Bank. Holhausen, R., and Lefwich, R., 1986, The Effec of Bond Raing Changes on Sock Prices, Journal of Financial Economics, 17,

23 Kamin, Seven and von Kleis, Karsen, 1999, The Evoluion and Deerminans of Emerging Marke Credi Spreads in he 1990s, Inernaional Finance Discussion Paper , Federal Reserve Board. Kaminsky, G., Lyons, R., and Schmukler, S., 2000, Managers, Invesors, and Crisis: Muual Fund Sraegies in Emerging Markes NBER Working paper No Kaminsky, G. and Reinhar, C., 2000a, On Crises, Conagion, and Confusion, Journal of Inernaional Economics, June. Kaminsky, G. and Reinhar, C., 2000b, The Cener and he Periphery: Tales of Financial Turmoils, February Kaminsky, G. and Schmukler, S., 1999, Wha Triggers Marke Jiers? Journal of Inernaional Money and Finance, June, 18: Krugman, P., 1998, Saving Asia: I is Time o Ge Radical, Forune, Sepember 7, pp Larrain, G., Reisen, H. and Von Malzan, J., 1997, Emerging Marke Risk and Sovereign Credi Raing, OECD Developmen Cenre, Technical Papers, No McKinnon, R. and H. Pill, 1997, Credible Economic Overborrowing, American Economic Review, 87, 2, Liberalizaions and Reisen, H. and Von Malzan, J., 1999, Boom and Bus and Sovereign Raings, OECD Developmen Cenre, Technical Paper No Reinhar, C., 2001, Do Sovereign Credi Raings Anicipae Financial Crises? Evidence from Emerging Markes, mimeo, Universiy of Maryland. Richards, A. and Deddouche, D., 1999, Bank Raing Changes and Bank Sock Reurns: Puzzling Evidence from Emerging Markes, IMF Working Paper. Sigliz, Joseph, 2000, Capial Marke Liberalizaion, Economic Growh, and Insabiliy, World Developmen, Vol. 28 N6 pp

24 Table 1 Summary Saisics The able displays summary saisics for all he observaions used in he EMBI spreads and sock reurns regressions. Mean Median Sandard Minimum Maximum Number of Deviaion Observaions Log change in EMBI spreads ,122 Log change in absolue value of EMBI spreads ,122 Log change in sock prices ,788 Log change in absolue value of sock prices ,788

25 Table 2 Toal Upgrades and Downgrades by Raing Agency The able displays he oal changes in raings for long-erm sovereign deb in foreign and local currency. The sample used is he one available for sock reurns. Toal Agency changes Upgrades Downgrades Moody's Foreign currency deb Local currency deb S&P's Foreign currency deb Local currency deb Fich Foreign currency deb Local currency deb Toal

26 Table 3 Toal Raing Changes by Counry The able displays he oal changes in raings for long-erm sovereign deb in foreign and local currency. Agency Toal changes Upgrades Downgrades Argenina Brazil Chile Colombia Indonesia Korea (Souh) Malaysia Mexico Peru Phillipines Poland Russia Taiwan Thailand Turkey Venezuela Toal

27 Table 4 Panel Esimaes Dependen Variable: Log Change in EMBI Spreads The able repors panel esimaes wih robus sandard errors, using he Whie correcion for heeroskedasiciy. T-saisics are in parenhesis. The insrumenal variables (IV) esimaion (specificaion 6) uses a second lag of he lagged dependen variable as an insrumen. *,**,*** indicae 10,5,1 percen level of significance respecively. The change in raings describe upgrades and downgrades on sovereign deb from differen counries (any, domesic, foreign, regional, non-regional). "Foreign and domesic currency" denoe foreign-currency and domesic-currency deb. See he main ex for more informaion on how hese variables are consruced. Explanaory Variables Alernaive Specificaions IV Lagged dependen variable * * * * * (1.906) (1.909) (1.900) (1.894) (1.923) (-1.156) Any counry, foreign and domesic currency Domesic counry, foreign and domesic currency Domesic counry, foreign currency *** *** *** (-3.943) (-3.988) (-3.994) Domesic counry, domesic currency * (0.580) (0.558) (0.560) Foreign counries, foreign and domesic currency Foreign counries, foreign currency Foreign counries, domesic currency Regional counries, foreign and domesic currency Change in raings: (-3.415) *** (-2.574) ** (-3.079) *** (-0.938) (-1.593) (0.138) (-3.73) *** Regional counries, foreign currency (-0.144) (-0.145) (-0.318) Regional counries, domesic currency * * ** (-1.911) (-1.904) (-2.120) Non-regional counries, foreign and domesic Non-regional counries, foreign currency * * (-1.921) (-1.880) (-0.933) Non-regional counries, domesic currency (0.258) (0.278) (1.005) Change in U.S. ineres raes: Change in U.S. ineres raes *** *** *** ** (2.747) (2.746) (2.761) (2.747) Change in U.S. ineres raes * high raings * (1.577) (1.714) Change in U.S. ineres raes * low raings ** ** (2.348) (2.490) Consan (-1.105) (-1.025) (-1.020) (-1.029) (-0.940) (-0.764) R-squared Number of Observaions 11,122 11,122 11,122 11,122 10,923 10,408

28 Table 5 Panel Esimaes Dependen Variable: Log Change in Sock Prices The able repors panel esimaes wih robus sandard errors, using he Whie correcion for heeroskedasiciy. T-saisics are in parenhesis. The insrumenal variables (IV) esimaion (specificaion 6) uses a second lag of he lagged dependen variable as an insrumen. *,**,*** indicae 10,5,1 percen level of significance respecively. Th change in raings describe upgrades and downgrades on sovereign deb from differen counries (any, domesic, foreign, regional, non-regional). "Foreign and domesic currency" denoe foreign-currency and domesic-currency deb. See he main ex for more informaion on how hese variables are consruced. Explanaory Variables Alernaive Specificaions IV Lagged dependen variable *** *** *** *** *** (4.462) (4.435) (4.430) (4.416) (4.409) (1.568) Any counry, foreign and domesic currency Domesic counry, foreign and domesic currency Domesic counry, foreign currency (1.139) (0.868) (0.865) Domesic counry, domesic currency (0.812) (0.800) (0.865) Foreign counries, foreign and domesic currency Foreign counries, foreign currency Foreign counries, domesic currency Regional counries, foreign and domesic currency Change in raings: (3.496) *** (3.186) *** (1.770) * (1.219) (2.015) ** (0.045) (0.629) Regional counries, foreign currency *** *** ** (3.441) (3.467) (2.243) Regional counries, domesic currency (-0.056) (-0.080) (-0.204) Non-regional counries, foreign and domesic Non-regional counries, foreign currency (-0.159) (-0.164) (-0.351) Non-regional counries, domesic currency * * (1.952) (1.951) (1.508) Change in U.S. ineres raes: Change in U.S. ineres raes ** ** ** (-2.509) (-2.509) (-2.538) Change in U.S. ineres raes * high raings (-1.280) Change in U.S. ineres raes * low raings ** * (-2.245) (-2.564) ** (-1.797) (-0.963) Consan (-0.133) (-0.116) (-0.068) (-0.071) (-0.186) (0.283) R-squared Number of Observaions 21,788 21,788 21,788 21,788 21,247 20,508

29 Table 6 Number Clean Evens by Counry Evens are for 10-day windows, including foreign-currency and domesic-currency deb. The evens are for domesic counry evens. The sample used is he one available for sock reurns. Toal Upgrades Downgrades evens Lain America Argenina Brazil Chile Colombia Mexico Peru Venezuela Toal Eas Asia Indonesia Korea Malaysia Philippines Taiwan Thailand Toal Easern Europe Poland Russia Turkey Toal Gran Toal

30 Figure 1 Raings of Foreign Currency Sovereign Deb for Seleced Counries The figures repor he sovereign raings from hree credi raing agencies for a seleced group of counries. Sovereign leers are published in leers (AAA, Aaaa3SS,...). The scale is differen for each agency. Appendix Table 2 gives a mapping beween each raing leers and a numerical scale Moody's Argenina S&P's Fich-IBCA Moody's S&P's Malaysia Fich-IBCA Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Brazil Moody's S&P's Fich-IBCA Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Souh Korea Moody's S&P's Fich-IBCA Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan S&P's Venezuela Moody's Fich-IBCA Moody's S&P's Thailand Fich-IBCA Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00

31 Figure 2 Even Sudies of EMBI Spreads The figures display he log of EMBI spreads (normalized o 100 a day -10), +/- one sandard deviaion. The evens are only relaed o upgrades and downgrades in he domesic counry. Upgrades of foreign- and domesic-currency deb Days relaive o announcemen Downgrades of foreign- and domesic-currency deb Days relaive o announcemen Number of clean evens: 28 Number of clean evens: 17 Upgrades of foreign-currency deb Days relaive o announcemen Downgrades of foreign-currency deb Days relaive o announcemen Number of clean evens: 22 Number of clean evens: 14

32 Figure 3 Even Sudies of Sock Marke Indexes The figures display he log of local sock marke index relaive o he U.S. S&P 500 (normalized o 100 a day -10), +/- one sandard deviaion. The evens are only relaed o upgrades and downgrades in he domesic counry. Upgrades of foreign- and domesic-currency deb Downgrades of foreign- and domesic-currency deb Days relaive o announcemen Days relaive o announcemen Number of clean evens: 39 Number of clean evens: 34 Upgrades of foreign- and domesic-currency deb Downgrades of foreign- and domesic-currency deb Days relaive o announcemen Days relaive o announcemen Number of clean evens: 35 Number of clean evens: 23

33 Figure 4 Even Sudies -- Foreign-Counry Evens The op panel displays EMBI spreads, while he boom panel diplays sock spreads, i.e. he log of local sock marke index relaive o he U.S. S&P 500 (normalized o 100 a day -10). Boh panels also plo +/- one sandard deviaion. The evens are only relaed o upgrades and downgrades in foreign counries, boh on foreign-currency and domesic-currency deb. EMBI Spreads Upgrades of foreign- and domesic-currency deb Days relaive o announcemen EMBI Spreads Downgrades of foreign- and domesic-currency deb Days relaive o announcemen Number of clean evens: 99 Number of clean evens: 63 Sock Spreads Upgrades of foreign- and domesic-currency deb Sock Spreads Downgrades of foreign- and domesic-currency deb Days relaive o announcemen Days relaive o announcemen Number of clean evens: 84 Number of clean evens: 116

34 Counry Appendix Table 1 Daa Availabiliy EMBI Spreads Sock Reurns Sovereign Raings Iniial dae End dae Iniial dae End dae Iniial dae End dae Argenina April 30, 1993 June 30, 2000 January 3, 1992 June 30, 2000 January 1, 1990 June 30, 2000 Brazil December 31, 1991 June 30, 2000 January 23, 1992 June 30, 2000 January 1, 1990 June 30, 2000 Chile January 2, 1992 June 30, 2000 December 7, 1992 June 30, 2000 Colombia January 2, 1996 June 30, 2000 January 1, 1990 June 30, 2000 Indonesia November 5, 1991 June 30, 2000 December 7, 1992 June 30, 2000 Korea April 30, 1998 June 30, 2000 June 30, 1995 June 30, 2000 January 1, 1990 June 30, 2000 Malaysia June 30, 1995 June 30, 2000 January 1, 1990 June 30, 2000 Mexico December 31, 1991 June 30, 2000 January 2, 1995 June 30, 2000 December 18, 1990 June 30, 2000 Peru May 30, 1997 June 30, 2000 January 2, 1996 June 30, 2000 February 5, 1996 June 30, 2000 Philippines January 4, 1993 January 30, 1997 January 4, 1993 June 30, 2000 June 30, 1993 June 30, 2000 Poland January 17, 1995 June 30, 2000 April 3, 1996 June 30, 2000 June 1, 1995 June 30, 2000 Russia December 31, 1997 June 30, 2000 December 1, 1993 June 30, 2000 April 11, 1994 June 30, 2000 Taiwan January 2, 1996 June 30, 2000 January 1, 1990 June 30, 2000 Thailand January 2, 1996 June 30, 2000 January 1, 1990 June 30, 2000 Turkey June 30, 1995 December 30, 1999 May 5, 1992 June 30, 2000 Venezuela December 31, 1991 June 30, 2000 April 23, 1996 June 30, 2000 January 1, 1990 June 30, 2000

35 Appendix Table 2 Scale of Raings for Sovereign Deb Moody's S&P FITCH- IBCA Raing Number Raing Number Raing Number Raing Number Aaa3SS 8.5 Ba2 5.1 AAA 8 AAA 8 Aaa3S 8.8 Ba1SS 5.3 AA AA Aaa3 8.7 Ba1S 5.5 AA 7 AA 7 Aaa2SS 8.9 Ba1 5.4 AA AA Aaa2S 9.2 Ba 5 A A Aaa2 9.1 B3SS 3.5 A 6 A 6 Aaa1SS 9.3 B3S 3.8 A A Aaa1S 9.5 B3 3.7 BBB BBB Aaa1 9.4 B2SS 3.9 BBB 5 BBB 5 Aaa 9 B2S 4.2 BBB BBB Aa3SS 7.5 B2 4.1 BB BB Aa3S 7.8 B1SS 4.3 BB 4 BB 4 Aa3 7.7 B1S 4.5 BB BB Aa2SS 7.9 B1 4.4 B B Aa2S 8.2 B 4 B 3 B 3 Aa2 8.1 Caa3SS 2.5 B B Aa1SS 8.3 Caa3S 2.8 CCC 2 CCC Aa1S 8.5 Caa3 2.7 CC 1 CCC 2 Aa1 8.4 Caa2SS 2.9 CCC Aa 8 Caa2S 3.2 CC 1.33 A3SS 6.5 Caa2 3.1 C 1 A3S 6.8 Caa1SS 3.3 A3 6.7 Caa1S 3.5 A2SS 6.9 Caa1 3.4 A2S 7.2 Caa 3 A2 7.1 Ca3SS 1.5 A1SS 7.3 Ca3S 1.8 A1S 7.5 Ca3 1.7 A1 7.4 Ca2SS 1.9 A 7 Ca2S 2.2 Baa3SS 5.5 Ca2 2.1 Baa3S 5.8 Ca1SS 2.3 Baa3 5.7 Ca1S 2.5 Baa2SS 5.9 Ca1 2.4 Baa2S 6.2 Ca 2 Baa2 6.1 C3SS 0.5 Baa1SS 6.3 C3S 0.8 Baa1S 6.5 C3 0.7 Baa1 6.4 C2SS 0.9 Baa 6 C2S 1.2 Ba3SS 4.5 C2 1.1 Ba3S 4.8 C1SS 1.3 Ba3 4.7 C1S 1.5 Ba2SS 4.9 C1 1.4 Ba2S 5.2 C 1 Source: Bloomberg