PIGS or Lambs? the European Sovereign Debt Crisis and the Role of Rating Agencies

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Abstract This paper asks whether rating agencies played a passive role or were an active driving force during Europe's sovereign debt crisis. We address this by estimating relationships between sovereign debt ratings and macroeconomic and structural variables. We then use these equations to decompose actual ratings into systematic and arbitrary components that are not explained by previously observed procedures of rating agencies. Finally we check whether systematic, as well as arbitrary, parts of credit ratings affect credit spreads. We find that both do affect credit spreads, which opens the possibility that arbitrary rating downgrades trigger processes of self-fulfilling prophecies that may drive even relatively healthy countries towards default.

Keywords Rating agencies * Sovereign debt * Credit risk * Eurozone * Panel data-Debt crisis

JEL G24 * H63 * F34

Introduction

Important lessons learned from the recent global financial crisis are that the judgment of private rating agencies can have a huge impact on macroeconomic outcomes--and that it can be utterly mistaken. (1) Given these past failings concerning structured products on US mortgage loans, it would be surprising if market participants again rely on the same rating agencies when assessing the default risks of governments in the current European sovereign debt crisis. It could even be cataclysmic if these sovereign debt ratings were driving government bond yields irrespective of the development of the underlying economic fundamentals. This would put the fate of entire nations into the hands of private agencies because bad ratings, which are not in line with economic fundamentals, could be justified ex post via self-fulfilling prophecies. Then, even innocent lambs could be turned into, and treated like, pigs.

Given the importance of these issues for the stability of the European Monetary Union (EMU) we elaborate on the role of rating agencies in the current sovereign debt crisis, focusing on the so-called PIGS countries, i.e., Portugal, Ireland, Greece and Spain. The question whether rating agencies played a passive role or were an active driving force during Europe's debt crisis is addressed in three steps. First, we try to develop an understanding of how sovereign debt ratings are formed. We do this by estimating relationships between ratings and macroeconomic and structural variables. Second, we use these equations to decompose actual ratings into a systematic and an arbitrary part, the latter being defined as what is left unexplained by previously observed procedures of rating agencies. Finally, we quantify the effect of the systematic and the arbitrary part of a country's sovereign debt rating on its government bond yields to assess the endogenous and the discretionary impact of rating agencies on market outcomes during the European debt crisis with special concern for the PIGS countries. As our results suggest, the PIGS countries were not only rated worse during the crisis than all other countries in our sample of 26 OECD countries, but this markdown also resulted in significantly higher interest rates on government bonds, which themselves aggravated the European debt crisis.

Our paper contributes to several strands in the literature. First, it adds to the broad literature following Cantor and Packer (1996) that tries to explain sovereign debt ratings, which is summarized by Mellios and Paget-Blanc (2006). Most closely related to our study is the work of Ferri et al. (1999), Mulder and Perrelli (2001) and El-Shagi (2010) who discuss the role of rating agencies during the Asian Crisis at the end of the 1990s. By employing ordered regressions to explain sovereign debt ratings, our analysis is also related to Hu et al. (2002), Block and \fealer (2004) and Afonso et al (2007, 2009). It seems that no study exists which analyzes the role of rating agencies during the current European sovereign debt crisis using such methods. …