The Credit Rating Agencies and the Sovereign Ceiling

Once again, during an episode of financial turmoil, the credit rating agencies have become the target of criticism, this time on account of apparently lenient ratings granted to complex financial instruments backed by “subprime” mortgages.

Whether the charges are justified or not, part of the problem lies on the narrow opinion that the ratings convey. This shortcoming also affects Latin American corporates and banks that issue debt in global financial markets on account of a practice known as the “sovereign ceiling.”Although the sovereign ceiling policy─meaning that no private firm in a particular country can receive a rating higher than that of the sovereign─is not strictly applied by the credit rating agencies any more, sovereign ratings still exert visible pressure on the ratings that private borrowers obtain. The figure below displays the frequency distribution of the difference between the ratings obtained by private firms in emerging markets and those of the governments, where the usual ratings are mapped into a numerical scale between 1 and 21.

The large spike at zero indicates a bunching of corporate ratings at the same level as the sovereign. Few firms have pierced the sovereign ceiling; these are represented by the short bars to the right of the spike at zero. Thus, the sovereign rating is not an absolute constraint on private ratings but it still is a sort of “lite” ceiling.

In a recent joint paper with Kevin Cowan (IMF Working Paper WP/07/75) we conduct an econometric analysis on the ratings received by 509 non-financial corporations from 30 countries, six of them from Latin America. We control for other factors that determine credit ratings, both firm-specific indicators of creditworthiness and macroeconomic variables that proxy for the robustness of the government’s financial position. We find that sovereign ratings have a significant direct effect on private ratings. On average, a sovereign rating that is two notches lower implies a one private firms’ rating that is one notch lower. This “sovereign ceiling lite” can be onerous. At current levels of sovereign ratings and spreads, an average Latin American firm may be facing a cost of borrowing that is 100 to 200 basis points higher than what would be commensurate with its financial strength.

Why consider a sovereign ceiling at all? The view is that if a government defaults on its debt, it would impose capital controls that could also force private firms to miss payments on their obligations. But if the firms are economically sound, any such situation would be temporary and fully reversed. Although technically a “default,” creditors would actually come out basically whole. The ratings, however, only measure the probability of a “credit event” regardless of its seriousness. A more elaborate risk measure for emerging market economies could get around the sovereign ceiling problem and be more informative at the same time. And, in addition, the credit rating agencies could avoid being in the dock in the next credit crisis.