Output spillovers from changes in sovereign credit ratings
Introduction
Recent sovereign debt crises in several countries have prompted major credit rating agencies to downgrade their sovereign credit ratings. The effects of such rating revisions are not limited to the re-rated countries. Researchers show that a sovereign rating revision of one country may have significant spillover effects on financial markets in other countries (e.g., Kaminsky, Schmukler, 2002, Gande, Parsley, 2005, Ferreira, Gama, 2007, Ismailescu, Kazemi, 2010, Afonso et al, 2012, Beetsma et al, 2013). So far, there has been no examination of the effects of sovereign rating revisions on the economic growth rates of other countries. Investigation of this issue is important because economic growth is perhaps the most important aspect of national economic performance (Quinn and Toyoda, 2008). There is also an increasing amount of literature that analyzes the influence of an economic shock in one country on another country's output (e.g., Aly, Strazicich, 2011, Auerbach, Gorodnichenko, 2013). These studies, however, have not investigated the importance of output spillovers related to a sovereign credit rating revision.
In this study, we examine whether a sovereign credit rating revision of one country produces significant spillover effects on other countries' economic growth, and if so, through what mechanisms. Gande and Parsley (2005) and Ismailescu and Kazemi (2010) suggest that trade and financial linkages are the most likely channels for transmission of the spillover effects of sovereign rating revisions. The net impact of sovereign rating revisions on the economic performance of other countries will depend on the interaction of various effects through trade channels. Sovereign debt renegotiation is associated with a significant decline in trade between a debtor and its creditors (Martinez, Sandleris, 2011, Rose, 2005). A downgraded country suffers damage to its terms of trade or trade credit, allowing other countries to benefit from economic growth as the downgraded country becomes less able to compete in the international product market. In this case, negative changes in sovereign credit ratings lead to “differential spillovers” for other countries. When a country experiences negative rating changes, however, its trade counterparties may also suffer income effects, with a downturn in economic activities and reduced imports by the downgraded country. Counterparties may suffer as well if investors become concerned about bilateral trade linkages and third-party export markets of major trade partners (Kaminsky and Reinhart, 2000), and consequently reduce their investment. Frankel and Rose (1996) observe that a country's economic and political stability, which is tied closely to its credit risk, is positively associated with the strength of its currency. A significant depreciation of a downgraded country's currency may make its exports more competitive, which adversely affects the economic performance of its trade partners. In this case, negative changes in sovereign credit ratings may lead to “common spillovers” for other countries. The converse holds for positive changes in sovereign credit ratings.
One country's sovereign rating revision may also affect other countries' economic growth through financial channels, again depending on the interaction of various effects. Creditors assessing the increased risk of the downgraded country may tighten credit lines of other countries exposed to the risk of potential losses (Allen and Gale, 2000). Countries with a strong relation to major correspondent banks in the downgraded country may hence be financially vulnerable and experience what we call common spillovers, adversely affecting their economic performance (Levine and Zervos, 1998). Reinhart and Rogoff (2004) and Gande and Parsley (2014), however, suggest that negative sovereign rating revisions are significantly associated with capital outflows from the downgraded country. In this case, other countries with better credit will benefit from net capital inflows and experience differential spillovers, which increase with the severity of the cumulative downgrade abroad, allowing better-credit countries to improve economic growth (Bekaert, Harvey, 1998, Bekaert, Harvey, 2000, Levine, Zervos, 1998). The converse holds for positive sovereign rating changes.
We examine changes in the consensus economic growth forecasts of other countries (non-event countries) in the two-month period after Standard & Poor's (S&P) revises the long-term foreign currency sovereign credit rating of a particular country (the event country) from 1989 to 2012. We show evidence of significant output spillover effects to the non-event countries potentially affected by the sovereign rating revision. That is, both positive and negative rating changes are associated with a significant downward revision in the forecast of other countries' economic growth. For a one-notch rating upgrade (downgrade), other countries on average suffer a downward revision of about 0.03% (0.07%) in the forecast of annual output growth rates in the two-month period after the rating revision. We further show that a rating upgrade has significantly more impact on non-event countries that have greater forecast errors in economic growth. A rating downgrade in the event country has more of an impact on non-event countries that are less transparent, lower rated, or subject to greater forecast errors. These results hold after accounting for other factors that could affect non-event countries' output growth.
To assess how the output spillover effects of sovereign credit rating revisions depend on trade and financial channels, we define a set of variables to proxy for the direct and indirect trade and financial linkages between event and non-event countries. The trade linkage variables include bilateral trade flows between event and non-event countries, the imports of event countries, and the terms of trade of event countries. The financial linkage variables include bilateral capital flows between event and non-event countries, bilateral bank claims between event and non-event countries, common lender sharing by event and non-event countries, the foreign direct investment of event countries, and the capital flows of event countries. We find that positive rating events remain associated with a significant downward revision in forecasts of other countries' economic growth rates after accounting for these linkages. We also find that, for positive rating events, the forecast revisions for non-event countries are significantly negatively related to both the terms of trade and the foreign direct investment of event countries, and significantly positively related to the capital flows of event countries. These results indicate that positive rating events produce both differential spillovers and common spillovers. Differential spillovers dominate common spillovers, however, so that positive rating events are associated with a significant downward revision in the forecast of other countries' economic growth.
As for negative rating events, there is still a significant downward revision in forecasts of other countries' economic growth rates in the post-event period after accounting for the trade and financial linkages. We also show that, for negative rating events, the forecast revisions for non-event countries are significantly negatively related to the terms of trade and foreign direct investment of event countries and significantly positively related to the capital flows of event countries. Thus, similar to the findings for positive rating events, negative rating events produce both differential and common spillovers. In this case, however, common spillovers dominate differential spillovers so that negative rating events are again associated with a downward revision in the forecast of other countries' economic growth.
We perform a number of robustness checks. We control for cultural or institutional linkages and physical proximity that could affect the output spillover effects, and the conclusions remain unchanged. The results also hold after taking into account the potential effects of economic development, debt level, investor protection, and quality of institutions. Thus, we find robust evidence that both upgrades and downgrades in a country's sovereign credit ratings adversely affect the economic growth prospects of other countries through trade and financial linkages.
The paper is organized as follows. We first describe in the next section the sample selection process and empirical models. Section 3 presents the empirical results and explores the transmission mechanisms. Section 4 discusses a number of robustness checks. The final section summarizes our findings.
Section snippets
Sample
We collect a sample of S&P sovereign credit ratings for long-term foreign currency-denominated debt from the S&P website (http://www.standardandpoors.com). We focus on S&P sovereign credit ratings because Gande and Parsley (2005) and Ismailescu and Kazemi (2010) indicate that S&P is the most active of the rating agencies in making rating changes; this gives us a larger data set. S&P rating changes are also less likely to be anticipated by market investors and tend to precede the rating changes
Forecast revisions in non-event countries' economic growth around sovereign rating changes
Table 2 shows the regression analysis of the forecast revisions in GDP growth rates of non-event countries, where the t-values are computed with White's (1980) heteroskedasticity-consistent standard errors that correct for clustering at the event country level. We find in Column (1) a coefficient on Event of −0.0003 for positive rating events, statistically significant at the 1% level; that is, a one-notch upgrade in sovereign credit ratings will on average reduce the forecast of annual output
Robustness checks
We conduct a number of checks of the effects of sovereign credit rating revisions on the economic growth of other countries to account for the potential effects of economic development status, debt level, investor protection, and institutional quality. To save space, we report in Table 4 only the results for the main variables of interest. The number of observations varies across regressions because of data availability. The complete regression results are available upon request.
Summary
Sovereign credit ratings reflect a country's capacity and willingness to honor its debt obligations in full and on time. Prior research on the spillover effects of changes in sovereign ratings has so far focused on the responses of financial markets. Our work contributes to the literature by examining the effects of sovereign rating revisions on the real economic activities of potentially affected countries.
We examine how a sovereign rating revision of one country influences the consensus
Acknowledgments
We thank Geert Bekaert, Dosoung Choi, Kim Wai Ho, Chia-Wei Huang, Frank C. Jen, Kees Koedijk (the Co-ordination Editor), Cheng-few Lee, Yanzhi Wang, and especially an anonymous referee for helpful comments and suggestions. We also thank Grace Chen of Thomson Reuters for kindly providing Consensus Economics® forecast data. Sheng-Syan Chen and Hsien-Yi Chen gratefully acknowledge financial support from Excellent Research Projects of National Taiwan University and Ministry of Science and
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