Impact of credit ratings on European Debt crisis

A new paper from IMF economists look at the impact of credit rating calls on European economies:

 This paper examines the spillover effects of sovereign rating news on European financial markets during the period 2007-2010. Our main finding is that sovereign rating downgrades have statistically and economically significant spillover effects both across countries and financial markets. The sign and magnitude of the spillover effects depend both on the type of announcements, the source country experiencing the downgrade and the rating agency from which the announcements originates. However, we also find evidence that downgrades to near speculative grade ratings for relatively large economies such as Greece have a systematic spillover effects across Euro zone countries. Rating-based triggers used in banking regulation, CDS contracts, and investment mandates may help explain these results. 

There are two channels through which ratings could lead to spillover to other economies:

One example is the holding of fo reign sovereign debt by domestic banks. A sovereign rating downgrade in a given country is thus likely to affect the profitability of banks in other countries where banks are holding this debt. This is the case of Europe where banks hold at times substantial amount of sovereign debt in both their trading and banking books (see Blundell-Wignall and Slovik, 2010).

Another example of channels through which sovereign rating news may spill over across countries and markets is when banks across countries hold claims on banks in other countries and are thus exposed to one another. This cross-holding feature is at the core of the European financial market convergence process in Europe.2 Sy (2010) provides a comprehensive discussion of the channels through which sovereign credit rating announcements may spillover to other markets including as a result of rating-based triggers such as those in banking regulation, ECB collateral rules, CDS contracts or investment mandates.

The results are no real surprises. Apart from this, the paper has some nice facts on the ratings goven to the nations: 

There were 71 rating announcements between October 2006 and April 2010 which constitutes the period of analysis for this paper. An exhaustive list of these news together with the countries subject to the rating announcement and the dates of occurrence is provided in Table 1.

Table 2 summarizes the volume and type of rating announcements broken down by credit rating agencies. It shows that out of the 71 announcements there were 29 rating changes mostly downgrades, 25 outlook revisions, 16 combined announcements and one review for future downgrade. S&P is the most frequent announcer (32 announcements), followed by Moody’s (29 announcements) and Fitch (10 announcements). There were 71 rating announcements between October 2006 and April 2010 which constitutes the period of analysis for this paper. An exhaustive list of these news together with the countries subject to the rating announcement and the dates of occurrence is provided in Table 1.

Figure 1 describes the number of rating announcements simply distinguishing between positive and negative announcements. It shows that there were very few announcements before July 2008. This observation suggests that rating agencies have not anticipated the macroeconomic weaknesses of European economies consecutive to the financial crisis.The pick of negative announcements has been reached in January 2009. The number of negative rating announcements has since then decreased but remains relatively large. This certainly reflects the unresolved nature of the European debt crisis. The number of positive credit rating announcements (mostly positive revisions of outlook) has also increased since October 2008. This could also suggest that credit rating agencies anticipate that those rating downgrades are temporary and that in the future European countries would recover their pre-crisis grade.

Credit rating announcements are not only concentrated over time but are also concentrated spatially. Table 3 describes the number of rating announcements by regions and for a selected number of European countries. It indicates that Eastern Europe with 30 announcements has concentrated most of the announcements. We observe that 8 rating announcement were issued for Baltic States and 2 for Central Asia. Among individual countries, Greece followed by Ireland has concentrated the highest number of rating downgrades. Iceland has the highest number of rating announcements in Continental and Western Europe but has been subject to relatively fewer rating downgrades than revisions of outlook.

There is a nice table which sums up the various rating announcements since 2006. Useful for presentations etc..

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