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Courage to Capital? A Model of the Effects of Rating Agencies on Sovereign Debt Roll–over

  • Galina Hale

With the rise of international bond markets in the 1990s, the role of sovereign credit ratings has become increasingly important. In the aftermath of Asian Crises a series of empirical studies on the effects of sovereign ratings appeared. The theoretical literature on the topic, however, remains rather scarce. We propose a model of rating agencies that is an application of global game theory in which heterogeneous investors act strategically. The model is consistent with the main findings of the empirical literature. In particular, it is able to explain the independent effect of sovereign ratings on the cost of debt. Our model also predicts that, in addition to affecting the level of debt roll–over, the mere existence of the rating agency's announcement can increase the magnitude of the response of capital flows to changes in fundamentals. In addition, introducing a rating agency to a market that otherwise would have the unique equilibrium can bring multiple equilibria. The model also allows us to explore the reasons why agencies may over–react to crises, how they can spread financial contagion, and the failure of rating agencies to predict crises. Classification-F34, G14, G15

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Paper provided by IIIS in its series The Institute for International Integration Studies Discussion Paper Series with number iiisdp062.

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Date of creation: 20 Apr 2005
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Handle: RePEc:iis:dispap:iiisdp062
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  1. Roman Kraeussl, 2003. "Sovereign Credit Ratings and Their Impact on Recent Financial Crises," International Finance 0311013, EconWPA.
  2. Jeremy I. Bulow & Kenneth Rogoff, 1988. "Sovereign Debt: Is To Forgive To Forget?," NBER Working Papers 2623, National Bureau of Economic Research, Inc.
  3. Bulow, Jeremy & Rogoff, Kenneth S., 1989. "A Constant Recontracting Model of Sovereign Debt," Scholarly Articles 12491028, Harvard University Department of Economics.
  4. Metz, Christina E., 2000. "Private and public information in self-fulfilling currency crises," Research Notes 00-7, Deutsche Bank Research.
  5. Reuven Glick & Andrew K. Rose, 1998. "Contagion and trade: why are currency crises regional?," Pacific Basin Working Paper Series 98-03, Federal Reserve Bank of San Francisco.
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  7. Carmen M. Reinhart, 2002. "Default, Currency Crises, and Sovereign Credit Ratings," World Bank Economic Review, World Bank Group, vol. 16(2), pages 151-170, August.
  8. Allan Drazen, 1999. "Political Contagion in Currency Crises," NBER Working Papers 7211, National Bureau of Economic Research, Inc.
  9. Seth B. Carpenter & William Whitesell & Egon Zakrajsek, 2001. "Capital requirements, business loans, and business cycles: an empirical analysis of the standardized approach in the new Basel Capital Accord," Finance and Economics Discussion Series 2001-48, Board of Governors of the Federal Reserve System (U.S.).
  10. Giancarlo Corsetti & Amil Dasgupta & Stephen Morris & Hyun Song Shin, 2001. "Does one Soros make a difference?: a theory of currency crises with large and small traders," LSE Research Online Documents on Economics 25045, London School of Economics and Political Science, LSE Library.
  11. Reisen, Helmut & von Maltzan, Julia, 1998. "Sovereign credit ratings, emerging market risk and financial market volatility," HWWA Discussion Papers 55, Hamburg Institute of International Economics (HWWA).
  12. G. Ferri & L.-G. Liu & J. E. Stiglitz, 1999. "The Procyclical Role of Rating Agencies: Evidence from the East Asian Crisis," Economic Notes, Banca Monte dei Paschi di Siena SpA, vol. 28(3), pages 335-355, November.
  13. Arnoud W. A. Boot & Todd T. Milbourn & Anjolein Schmeits, 2006. "Credit Ratings as Coordination Mechanisms," Review of Financial Studies, Society for Financial Studies, vol. 19(1), pages 81-118.
  14. Giancarlo Corsetti & Amil Dasgupta & Stephen Morris & Shin, Hyun, 2000. "Does One Soros Make a Difference? A Theory of Currency Crises with Large and Small Traders," Cowles Foundation Discussion Papers 1273, Cowles Foundation for Research in Economics, Yale University.
  15. George-Marios Angeletos & Christian Hellwig & Alessandro Pavan, 2004. "Coordination and Policy Traps," Levine's Bibliography 122247000000000294, UCLA Department of Economics.
  16. Kaminsky, Graciela & Schmukler, Sergio, 2001. "Emerging markets instability: do sovereign ratings affect country risk and stock returns?," Policy Research Working Paper Series 2678, The World Bank.
  17. Chang, Roberto, 2007. "Financial crises and political crises," Journal of Monetary Economics, Elsevier, vol. 54(8), pages 2409-2420, November.
  18. Richard Cantor & Frank Packer, 1996. "Determinants and impacts of sovereign credit ratings," Research Paper 9608, Federal Reserve Bank of New York.
  19. Mora, Nada, 2006. "Sovereign credit ratings: Guilty beyond reasonable doubt?," Journal of Banking & Finance, Elsevier, vol. 30(7), pages 2041-2062, July.
  20. Allen, Franklin, 1990. "The market for information and the origin of financial intermediation," Journal of Financial Intermediation, Elsevier, vol. 1(1), pages 3-30, March.
  21. Blum, Jurg & Hellwig, Martin, 1995. "The macroeconomic implications of capital adequacy requirements for banks," European Economic Review, Elsevier, vol. 39(3-4), pages 739-749, April.
  22. Con Keating & Hyun Song Shin & Charles Goodhart & Jon Danielsson, 2001. "An Academic Response to Basel II," FMG Special Papers sp130, Financial Markets Group.
  23. Amar Gande & David Parsley, 2003. "News Spillovers in the Sovereign Debt Market," Working Papers 062003, Hong Kong Institute for Monetary Research.
  24. Stephen Morris & Hyun Song Shin, 2002. "Social Value of Public Information," American Economic Review, American Economic Association, vol. 92(5), pages 1521-1534, December.
  25. Ferri, Giovanni & Li-Gang Liu & Majnoni, Giovanni, 2000. "How the proposd Basel Guidelines on rating-agency assessments would affect developing countries," Policy Research Working Paper Series 2369, The World Bank.
  26. Guillermo Larraín & Helmut Reisen & Julia von Maltzan, 1997. "Emerging Market Risk and Sovereign Credit Ratings," OECD Development Centre Working Papers 124, OECD Publishing.
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