The Credit Rating Agencies and the Sovereign Ceiling

Once again, during an episode of financial turmoil, the credit rating agencies have become the target of criticism, this time on account of apparently lenient ratings granted to complex financial instruments backed by “subprime” mortgages. Whether the charges are justified or not, part of the problem lies on the narrow opinion that the ratings convey. This shortcoming also affects Latin American corporates and banks that issue debt in global financial markets on account of a practice known as the “sovereign ceiling.”Although the sovereign ceiling policy─meaning that no private firm in a particular country can receive a rating higher than that of the sovereign─is not strictly applied by the credit rating agencies any more, sovereign ratings still exert visible pressure on the ratings that private borrowers obtain. The figure below displays the frequency distribution of the difference between the ratings obtained by private firms in emerging markets and those of the governments, where the usual ratings are mapped into a numerical scale between 1 and 21.

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The large spike at zero indicates a bunching of corporate ratings at the same level as the sovereign. Few firms have pierced the sovereign ceiling; these are represented by the short bars to the right of the spike at zero. Thus, the sovereign rating is not an absolute constraint on private ratings but it still is a sort of “lite” ceiling.

In a recent joint paper with Kevin Cowan (IMF Working Paper WP/07/75) we conduct an econometric analysis on the ratings received by 509 non-financial corporations from 30 countries, six of them from Latin America. We control for other factors that determine credit ratings, both firm-specific indicators of creditworthiness and macroeconomic variables that proxy for the robustness of the government’s financial position. We find that sovereign ratings have a significant direct effect on private ratings. On average, a sovereign rating that is two notches lower implies a one private firms’ rating that is one notch lower. This “sovereign ceiling lite” can be onerous. At current levels of sovereign ratings and spreads, an average Latin American firm may be facing a cost of borrowing that is 100 to 200 basis points higher than what would be commensurate with its financial strength.

Why consider a sovereign ceiling at all? The view is that if a government defaults on its debt, it would impose capital controls that could also force private firms to miss payments on their obligations. But if the firms are economically sound, any such situation would be temporary and fully reversed. Although technically a “default,” creditors would actually come out basically whole. The ratings, however, only measure the probability of a “credit event” regardless of its seriousness. A more elaborate risk measure for emerging market economies could get around the sovereign ceiling problem and be more informative at the same time. And, in addition, the credit rating agencies could avoid being in the dock in the next credit crisis.

5 Responses to "The Credit Rating Agencies and the Sovereign Ceiling"

  1. Anonymous   October 4, 2007 at 6:34 am

    Thanks for the insight. Great article.

  2. Guest   October 4, 2007 at 5:38 pm

    Very good points; i will read your paper. What will make it more likely for private firms to pierce the sovereign ceiling? And which firms in emerging markets are able to do that? what are the features of such firms? Any systematic pattern for them?

  3. Astor   October 4, 2007 at 5:41 pm

    You say ´´an average Latin American firm may be facing a cost of borrowing that is 100 to 200 basis points higher than what would be commensurate with its financial strength.¨ But hat financial strenght is not independent of the macro outlook as a sovereign debt or financial crisis would affect the profitability and risk profile of such firms. When Argentina defaulted even sound corporates went belly up….

  4. Vitoria Saddi   October 4, 2007 at 5:52 pm

    The paper you mentioned is among my 10/20 best papers I have read in 2007.
    Though I agree with you on the idea of the sovereign ceiling you two should market your idea more (write more pieces here). This is so because few people know that corporates are rated like a dependent variable (by the rating agencies). So, clearly when Argentina goes belly up Citibank (for example) might have a downgrade and that’s it.
    We need an IMF or someone to rate the corporates.

    Best, Vitoria

  5. Eduardo and Pato   October 10, 2007 at 3:41 pm

    Guest
    Firms that have pierced the sovereign ceiling are generally among the largest: energy and utilities firms (YPF and Metrogas in Argentina), communications (America Móvil in Mexico), multinational subsidiaries (Coca-Cola Femsa in Mexico), some prominent exporters (Companhia Siderúrgica Nacional in Brazil). There are also a handful of banks (we study the case of bank ratings in a separate paper)

    Astor
    In our econometric analysis we try to control for macroeconomic conditions as distinct from the sovereign rating. And after controlling for variables such as the current account balance, growth, GDP per capita, GDP volatility, external debt and inflation, we still find a direct effect of the sovereign rating on firm ratings. You’re right about Argentine firms in 2001, but note that when Indonesia defaulted in 1999, under somewhat less dire financial conditions, none of the corporates defaulted.

    Vitoria
    It’s possible that, after a sovereign default, capital controls or other administrative measures force corporates to default as well. But the rating agencies could convey their evaluation of the firm’s situation separately from their view on the likelihood of capital controls. As the trend of private firms from emerging markets increasingly tapping international bond markets continues, this issue may gain more traction.

    Thanks for the comments!
    Eduardo and Pato