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In Rememberance: World Trade Center (WTC)

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Determinants and Impact of Sovereign Credit Ratings

by Richard Cantor of the Federal Reserve of New York, and
Frank Packer of the Federal Reserve of New York

October 1996

Abstract: In this article, we present the first systematic analysis of the sovereign credit ratings of the two leading agencies, Moody's and Standard & Poor's (S&P).  We find that the ordering of risks they imply is broadly consistent with macroeconomic fundamentals.  While the agencies cite a large number of criteria in their assignment of sovereign ratings, six factors explain more than 90 percent of the cross-sectional variation in the ratings.  In particular, a country's rating appears largely determined by its per capita income, external debt burden, inflation experience, default history and level of economic development.  We do not, however, find any systematic relationship between ratings and either fiscal or current deficits, perhaps because of the endogeneity of fiscal policy and international capital flows.  Sovereign ratings are also closely related to market-determined credit spreads, effectively summarizing and supplementing the information content of macroeconomic indicators in the pricing of sovereign risk.  Cross-sectional results suggest that the rating agencies' opinions have independent effects on market spreads.  Event study analysis broadly confirms this qualitative conclusion, for the reaction of bond yields to the announcements of changes in the agencies' sovereign risk opinions are statistically significant with respect to both their sign and magnitude.

Published in: FRBoNY Economic Policy Review, Vol. 2, No. 2, (October 1996), pp. 33-52.

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