Rating Agencies, Self-Fulfilling Prophecy and Multiple Equilibria? An Empirical Model of the European Sovereign Debt Crisis 2009-2011

Abstract

We explore whether governments may have faced scenarios of self-fulfilling prophecy and multiple equilibria during Europe"s sovereign debt crisis. To this end, we estimate the effect of interest rates and other macroeconomic variables on sovereign debt ratings, and of ratings on interest rates. We detect a nonlinear effect of ratings on interest rates which is strong enough to permit multiple equilibria. The good equilibrium is stable, ratings are excellent and interest rates are low. A second unstable equilibrium marks a threshold beyond which the country slides towards an insolvency trap. Coefficient estimates suggest that countries should stay well within the A segment of the rating scale in order to remain safe from being driven towards default.

The Damaging Bias of Sovereign Ratings

“…The authors suggest that the agencies did this in order to rebuild their reputation after they failed to predict the onset of the crisis—but ended up aggravating it. It has been well‐documented that ratings tend to lag markets: economic or political changes are spotted early by ‘fast money’, the rating agencies then follow spread‐widening with downgrades, which can trigger a vicious circle (Reisen and von Maltzan, 1999; Gartner and Griesbach, ; Kiff et al ., ). So the rating agencies end up overreacting in an attempt to repair the reputational damage suffered from not foreseeing the crisis and reacting late.…”

“…The first branch examines whether a ratings action (ratings changes, reviews, watches and outlooks) has an effect on sovereign yield spreads. A number of papers find that spreads actually lead ratings actions (see, for example, Reisen and von Maltzan, 1999; Kiff et al ., ; Gartner and Griesbach, ), suggesting that the CRAs are merely market followers, which means that they—via their legislated and generally guiding role for investors—make matters worse when markets get nervous about a given sovereign credit. The other branch assesses whether readily available fundamentals can explain the variation in ratings.…”

How Do Credit Rating Agencies Rate? An Implementation Perspective on the Assessment of Austerity Programs during the European Debt Crisis

“…Since the outbreak of the European debt crisis, CRAs have been increasingly accused of triggering self‐fulfilling prophecies through their severe downgrades, which let refinancing costs rise and a state's ability to service its debt decline (Carruthers and Kim ; Ferri, Liu, and Stieglitz ; Gärtner and Griesbach ; Kerwer ). This leads to a new downgrade and powers a self‐perpetuating process that, in the absence of possibilities to externally devaluate, forces countries to adopt ever stricter austerity measures (Eijffinger ).…”

“…The cognitive authority of sovereign ratings, which manifests itself in the influence of ratings on refinancing costs, has important implications for states and their scope of policy making (Afonso, Furceri, and Gomes ; Paudyn ; Scott ). Through a downgrade, CRAs can trigger self‐fulfilling prophecies (Ferri, Liu, and Stiglitz ; Gärtner and Griesbach ). In the event of a negative rating, refinancing costs rise and the state's ability to service its debt declines.…”

A hard nut to crack: Regulatory failure shows how rating really works

“…The 'Big Three' have given European states excessively severe sovereign ratings compared to the U.S. sovereign rating. Similarly, Gärtner and Griesbach (2012) suggest that ratings have a nonlinear effect on interest rates, facilitating self-fulfilling prophecy scenarios in sovereign debt markets. 3 In another study, Gärtner et al (2011) find that economic fundamentals cannot explain sovereign ratings during the European sovereign debt crisis.…”