Rating Sovereign Debt in a Monetary Union – Original Sin by Transnational Governance

It is frequently argued that credit rating agencies (CRAs) have acted procyclically in their rating of sovereign debt in the European Monetary Union (EMU). They are believed to have under-rated sovereign risk in the early years of EMU, when integrated financial markets provided easier access to liquidity, and to have contributed to the recent Eurozone debt crisis by over-rating the lack of (individual) monetary sovereignty that EMU entails for its member states. Yet, there is little direct evidence for this so far. While CRAs are quite explicit about their risk assessments concerning public debt that is denominated in foreign currency, the same cannot be said about their treatment of sovereign debt issued in the currency of a monetary union. We examine the major CRAs’ methodologies for rating sovereign debt and test their ratings for a monetary union bonus in good times and a malus, akin to the ‘original sin’ problem of emerging market countries, in bad times. Using a newly compiled dataset of quarterly sovereign bond ratings from 1990 until 2012, we find some evidence that EMU countries received a rating bonus on euro-denominated debt before the global financial crisis and a large penalty after 2007.