Findings suggest that poor public debt management leads to large adverse effects for the private sector.
Researcher: Miguel Ferreira | Igor Cunha
The effect of sovereign credit rating downgrades on firm investment and financial policy is the focus of the research paper by Miguel Ferreira and Igor Cunha (both from Nova SBE), Heitor Almeida (Univ. of Illinois at Urbana Champaign) and Felipe Restrepo (Boston College). The authors explore sovereign ceiling policies followed by rating agencies to precisely measure the effects on corporate policy. Results show that sovereign downgrades lead to an increase in corporate bond yields and large decreases in investment and leverage. Findings suggest that poor public debt management leads to large adverse effects for the private sector.
Sovereign downgrade – does it take a toll on the private sector?
In the aftermath of the 2007-2009 global financial crisis and the Eurozone sovereign debt crisis, sovereign credit rating downgrades have become a significant problem for developed countries. France and the United States were downgraded from AAA for the first time in history, and other developed countries also experienced downgrades. The authors investigate how the sovereign downgrades affect corporate outcomes.
They explore sovereign ceiling policies followed by rating agencies in order to separate the effects of sovereign downgrades, from the other factors happening simultaneously in the economy. The ceiling policy implies that the sovereign rating is the maximum attainable rating for a corporate bond. Because of this rule, firms that are at the ceiling will be downgraded after a sovereign downgrade not because of a deterioration of their fundamentals or worst economic outlook, but simply because the sovereign ceiling was lowered.
Effects of sovereign downgrades on corporate outcomes:
As a consequence of sovereign downgrades, firms that have ratings equal to the sovereign (i.e., the firms with higher credit quality in the country):
- Cut investment by 25%.
- Decrease long-term leverage by 15%.
- See bond yields increase by 34 basis points.
These findings are a consequence of a number of facts that can hinder the firm's ability to access bond and commercial paper markets, such as:
- Rating levels determine whether some institutional investors are allowed to invest in a firm's securities.
- Ratings affect banks and insurance companies capital requirements (Basel).
- Rating downgrades can trigger bond covenant violations, increase bond coupons or loan interest rates and force bond repurchases.
In addition, downgrades can directly impact business operations such as the ability to enter a long-term supply or a financial contract.
Contrary to conventional wisdom, we show that the better quality firms in the country are heavily affected and cut investment in a significant way after a sovereign downgrade. Governments need to be aware of these unintended effects of sovereign downgrades on the private sector, which exacerbate the consequences of public debt crises on real economic activity.
This article is based on the working paper accessible here http://ssrn.com/abstract=2349051
Know more about Miguel Ferreira, Professor at Nova SBE and Igor Cunha, Assistant Professor at Nova SBE.
Date posted: February 2014