This paper presents empirical evidence on the effects of achieving investment grade on borrowing costs for the sovereign and the private sector. This study provides background information on sovereign credit ratings and compares Panama’s key macroeconomic and institutional characteristics with those of other emerging markets. Statistical evidence on the reduction in sovereign spreads associated with obtaining investment grade status and the impact of the sovereign’s upgrade on corporate financing costs were also discussed. The model is estimated using a variety of panel regression techniques.

Abstract

This paper presents empirical evidence on the effects of achieving investment grade on borrowing costs for the sovereign and the private sector. This study provides background information on sovereign credit ratings and compares Panama’s key macroeconomic and institutional characteristics with those of other emerging markets. Statistical evidence on the reduction in sovereign spreads associated with obtaining investment grade status and the impact of the sovereign’s upgrade on corporate financing costs were also discussed. The model is estimated using a variety of panel regression techniques.

I. Benefits from Attaining Investment Grade Status And Implications for Panama1

A. Introduction

1. Achieving investment grade status is an aim shared by many emerging market economies. Among the benefits often associated with having investment grade status are lower financing costs for both the sovereign and the private sector; increased financing options in international capital markets, including from institutional investors; higher private capital inflows; and rapid financial development. Panama’s sovereign credit rating was raised to investment grade by the three major rating agencies in the first half of 2010. There is the expectation that the upgrade will bring benefits to the Panamanian economy and ultimately help increase economic growth.

2. This paper presents empirical evidence on the effects of achieving investment grade on borrowing costs for the sovereign and the private sector. Evidence consists of statistical analysis and model-based estimates. The latter build on a modeling framework developed by Jaramillo (2010). The paper uses a panel data framework for a sample of emerging market economies for 1995-2010. Econometric results indicate that reaching investment grade lowers sovereign debt spreads by over 140 basis points. At the same time, a five-notch upgrade of the sovereign to investment grade is found to reduce borrowing costs for the private sector by about 180 basis points.

3. The rest of the paper is organized as follows. Section B presents background information on sovereign credit ratings and compares Panama’s key macroeconomic and institutional characteristics with those of other emerging markets. Sections C and D present statistical evidence on (a) the reduction in sovereign spreads associated with obtaining investment grade status, and (b) the impact of the sovereign’s upgrade on corporate financing costs. Section E concludes.

B. Background

4. Sovereign credit ratings provide summary measures of a government’s ability and willingness to repay its debts on time. As such, sovereign ratings are forward-looking indicators of the probability of default as perceived by the rating agencies. Sovereign ratings condensate a vast amount of information and provide important signals to market participants. A move from speculative grade to investment grade can have important implications for borrowing costs to the extent that investment grade is assigned to high-quality credit risks (“safer” investments).

5. Empirical studies have shown that country ratings depend on a relatively small set of economic and institutional variables. The three major credit agencies (Fitch Ratings (Fitch), Moody’s Services (Moody’s), and Standard and Poor’s (S & P)) provide credit ratings summarizing those variables, without being explicit about the specific weights attached to them. Building on the existing literature, Jaramillo (2010) identifies a parsimonious set of economic and institutional variables as determinants of investment grade status. The set includes domestic macroeconomic variables (GDP per capita, real GDP growth, potential GDP growth, inflation, unemployment), external sector variables (exports to GDP, current account balance to GDP, private external debt to GDP, international reserves to GDP), fiscal variables (primary balance, external and domestic public debt to GDP), financial depth variables, and a political risk index.

6. Panama’s key indicators were comparable to those of emerging markets with investment grade status a couple of years ago. Table 1 groups emerging markets into those with investment grade status and those with a speculative grade rating. The table shows that investment grade countries tend to outperform speculative grade countries on most economic and institutional variables. Panama’s indicators were generally aligned with those of investment-grade countries, while surpassing the mean and median of that group in a few areas, including economic growth, financial depth, and political risk. This helps explain why Panama’s upgrade to investment grade by the three main credit rating agencies in March-June 2010 had been widely expected by market participants.2 The upgrade was also consistent with the behavior of EMBI spreads, which placed Panama alongside other investment grade countries in the region, such as Peru and Brazil (Figure 1).

Table 1.

Country Characteristics by Investment Grade Rating

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Sources: Authors’ calculations based on data from IMF, World Bank, and International Country Risk Guide.

C. Investment Grade Status and Sovereign Borrowing Costs

7. Countries benefit when the sovereign receives a higher credit rating. Kim and Wu (2008) argue that improvements in sovereign credit ratings encourage inter alia financial development and capital inflows. Three main specific reasons are frequently stated for why sovereign credit ratings are important. First, they are identified as a key determinant of a country’s borrowing costs in international capital markets. Second, the sovereign rating sets a key benchmark for the ratings assigned to domestic firms and therefore affects private financing costs. And third, some institutional investors have lower bounds for the risk they can assume in their investments and will choose their portfolio composition taking into account the country risk signaled by the rating notations.

8. Sovereigns with better credit ratings have tended to enjoy lower spreads. Figure 2 depicts the (non linear) relationship between sovereign ratings and spreads in selected years since 1999. The figure shows that sovereign credit ratings are a key determinant of a country’s borrowing costs in international capital markets. The slope of the curves in Figure 2 suggests that a rating upgrade (a movement to the left on the horizontal axis) may result in a substantial reduction in borrowing costs for the sovereign. Figure 3 provides an alternative graphical representation of the differences in spreads between investment grade and speculative rating countries.3

Figure 2.
Figure 2.

Sovereign Spreads and Ratings

(Selected years, basis points)

Citation: IMF Staff Country Reports 2010, 315; 10.5089/9781455208647.002.A001

Source: Bloomberg; and authors’ calculations.
Figure 3.
Figure 3.

Sovereign Spreads, Median

(Basis points)

Citation: IMF Staff Country Reports 2010, 315; 10.5089/9781455208647.002.A001

Source: Bloomberg.

9. However, the economic fundamentals summarized in sovereign credit ratings are not the only factors determining borrowing costs. In particular, factors linked to global liquidity also affect the behavior of sovereign spreads (Gonzalez Rosada and Yeyati (2006), Hartelius et al. (2008)). Two variables that have been found to summarize well these conditions are the Federal Funds futures rate and the Chicago Board Options Exchange Volatility Index (VIX) (a proxy for risk appetite).

10. The two questions addressed in this section to analyze the benefits of attaining investment grade are:

  • Do investment grade countries have lower borrowing costs relative to speculative grade countries after controlling for the global environment?

  • Does investment grade reduce sovereign spreads by more than justified by the macroeconomic determinants?

11. The model used to investigate these questions is the following:4

Spdembiit=α+βIGt+γvixt+δffft+ηepdyit+θdpdyit+λyit+Φresyit+μt(1)

Where Spd_embiit denotes sovereign spreads; α is a constant, IGt is a binary variable that takes the value of 1 for countries with investment status, and zero otherwise; vix is the Chicago Board Options exchange volatility index; fff is the U.S. Fed Funds futures rate; epd_y is the external debt-to-GDP ratio; dpd_jy is the domestic debt-to-GDP ratio; y is the growth rate of real GDP; res_y is the ratio of international reserves to GDP; and μrepresents disturbances that are assumed to be independent across countries.

12. The model is estimated using a variety of panel regression techniques.5 These include fixed-effects (FE) two-stage least squares (2SLS), which is the preferred technique. This approach helps overcome the problem of heterogeneity bias, and also the possible endogeneity of credit ratings. The instruments used in the estimation are the exports-to-GDP ratio, the ratio of broad money to GDP, and a political risk index. The choice of FE is based on Haussmann tests that reject random effects (RE). Tests for panel-based co-integration (as some variables are non-stationary) find that the variables are co-integrated.6

13. All the estimated coefficients obtained with the preferred technique are significant and have the expected sign (Table 2, column 3). The results suggest that attaining investment grade status decreases sovereign spreads by 143 basis points, after controlling for other macro variables. The reduction in spreads using the FE OLS model is only 55 basis points, but this estimate may be subject to a downward bias due to the possible endogeneity of the ratings. The average spread for speculative-rated countries was 505 basis points during the sample period, which suggests that moving to investment grade tends to make a substantial difference for debt spreads.

Table 2.

Regression Results on the Benefits of an Investment Grade Status

article image
Standard errors in parentheses. Fixed effect coefficients are not shown. *** p<0.01, ** p<0.05, * p<0.1

14. External factors seem to be more important than domestic macroeconomic variables to explain changes in spreads. Only between 10-20 percent of the changes in spreads is explained by domestic macroeconomic variables. At the same time, the estimates suggest that a one standard deviation increase in: (i) vix raises spreads by 116 bps; (ii) fff increases spreads by 50 bps; (iii) epd_y the external debt-to-GDP ratio raises spreads by 30 bps. Changes in international reserves to GDP do not appear to have a large effect on sovereign spreads.

15. Fiscal consolidation in non investment grade countries explains the narrowing of spreads between investment grade and speculative credits in recent years. Since 2004, the difference in spreads between investment grade and speculative grade sovereigns has declined by about 70 basis points. The regression results suggest that some 31 basis points of this decline is accounted for by a reduction in debt levels (mostly external debt) in non investment grade countries.

D. Sovereign Ratings and Corporate Financing Costs

16 Corporates based in emerging market economies issued a growing amount of bonds in international financial markets in the last decade. Sovereign risk plays a critical role in allowing corporates of developing countries to borrow from international capital markets at favorable terms (Reinhart and Rogoff, 2004). In particular, lower sovereign risk improves access to the deep and liquid financial resources of the major financial centers and offers opportunities to emerging market corporations to reduce their cost of capital by diversifying their funding and lengthening maturities.

Figure 4.
Figure 4.

Corporate Bond Issuance from Emerging Markets

(Number)

Citation: IMF Staff Country Reports 2010, 315; 10.5089/9781455208647.002.A001

Source: Dealogic Analytics.Note: Data until March 2010.

17. Sound macroeconomic policies tend to reduce the cost of capital for corporations. International investors care about the macroeconomic conditions and the institutional setting in which corporations seeking to issue international bonds operate (World Bank, 2007). In this context, the improvements in country performance reflected in sovereign credit ratings are interpreted as proxies of an improved business environment (Das et. al, 2010). At the same time, domestic growth performance affects corporate profitability and cash flows.

18. Sovereign creditworthiness interacts with corporate creditworthiness through several channels.7 The first channel is the common macroeconomic environment shaped by country economic policies and country-specific macroeconomic vulnerabilities, such as exposure to large term-of-trade shocks. Major events such as large currency depreciation could often imply difficulties for both companies and the sovereign to meet foreign currency liabilities. A second channel is the “spillover”/externality effect from the solvency of the sovereign to private debtors. A sovereign default may be followed by policies that have an adverse impact on the corporates’ ability to service their debts, such as inflationary financing or tax increases. The third channel is the potential closure of the capital account or foreign exchange markets in times of sovereign default, a possibility that underpinned the pre-1997 credit rating agencies’ policy of “sovereign ceiling”, whereby no private company was rated above the sovereign.

19. Corporate spreads in investment grade countries tend to be lower than those in speculative grade countries (Figure 5). This suggests that improvements in sovereign creditworthiness may benefit domestic companies. Corporate bond spreads are higher than sovereign spreads in investment grade rated countries, suggesting the existence of an implicit sovereign ceiling. However, the evidence suggests that the difference between sovereign spreads and corporate spreads in non investment grade countries is much smaller.

20. Corporate characteristics will also affect the benefits from an improvement in a country’s rating. Studies reporting corporate bonds trading at a lower risk premium than sovereign debt suggest that the sovereign ceiling may be inappropriate, for example, for firms generating foreign exchange through exports, affiliates of foreign companies, or firms with strong ties to the government (Durbin and Ng, 2005). Thus, the sovereign rating appears to have become a benchmark rather than an effective limit.8

21. The following model is estimated to assess the benefit to domestic corporates from an upgrade in the sovereign credit rating status :

Corpspdit=α+βratingcorpit+γvixt+δffft+Icountry26t+θdurationit+λdealvalit+μt(2)

Where Corp_spd is the corporate spread; α is a constant, rating_corp is the corporate rating; vix is the Chicago Board Options exchange volatility index, fff is the U.S. Fed Funds futures rate; _Icountry_26 is a dummy to adjust for the observations corresponding to Russia (which is an outlier); duration corresponds to the length of time before the bond matures; deal_val is the amount of the corporate issuance; and µ represents disturbances that are independent across countries.

Table 3.

Regression Results on the Determinants of Corporate Spreads

article image

22. Results suggest that upgrades to investment grade status reduce corporate debt spreads substantially. The estimated size of the contribution from a rating change of one notch (36 bps) is similar to that obtained in World Bank (2007). Moving from the average in the speculative grade rating to the lowest investment grade category (BBB-)—a five-notch upgrade—tends to reduce corporate spreads by about 180 basis points.

E. Final Remarks and Implications for Panama

23. Panama’s sound macroeconomic policies in recent years were key to attaining investment grade status in early 2010. The improved rating had been validated by the spreads on sovereign bonds observed prior to the upgrade. These placed Panama alongside other investment grade countries, such as Brazil, Peru, and South Africa, and well below the Latin American average dominated by the speculative grade countries.

24. Empirical evidence suggests that the recent rating upgrade may lead to a substantial reduction in borrowing costs. The econometric estimates reported in the paper indicate a reduction of 55 to 210 basis points, with the preferred estimate suggesting a reduction of 140 basis points. This is a sizeable decline compared to the average spread for speculative grade countries during the sample period, which was 505 basis points.

25. Improved creditworthiness of the sovereign tends to lower financing costs for domestic corporations. Estimates suggest that a five-notch upgrade (to the lowest investment grade category) lowered domestic corporate spreads by about 180 basis points over the sample period. As the sovereign rating improves, corporate spreads will tend to experience a substantial decline.

26. Panama’s sovereign credit upgrade to investment grade should lower borrowing costs in the country and help boost economic growth. The upgrade also provides strong incentive to maintain prudent fiscal management, a strong fiscal framework, and sound financial sector policies.

Appendix: Data Sources and Country Sample

Data Sources

The source for the data on corporate bonds is Dealogic Analytics (Emerging Market –Corporate External Issuance), which provides information on the date of issuance, industry, issuer type, and spreads. The EMBI spread (from Bloomberg) and the other variables are matched with the day the corporate bond was issued. The sample period covers January 1995-March 2010; monthly data is used.

Sample of Emerging Market Countries

  • Argentina

  • Brazil

  • Bulgaria

  • Chile

  • China

  • Colombia

  • Croatia

  • Dominican Republic

  • Ecuador

  • Egypt

  • EI Salvador

  • Hungary

  • Indonesia

  • Jamaica

  • Kazakhstan

  • Korea

  • Lebanon

  • Lithuania

  • Malaysia

  • Mexico

  • Morocco

  • Pakistan

  • Panama

  • Peru

  • Poland

  • Russia

  • Serbia

  • South Africa

  • Sri Lanka

  • Thailand

  • Tunisia

  • Turkey

  • Ukraine

  • Uruguay

  • Venezuela

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1

Prepared by Mario Dehesa, Laura Jaramillo, and Michelle Tejada.

2

The agencies indicated that the upgrade reflected the strengthening of the public finances in recent years, prospects for further declines in public debt, and a very favorable growth outlook.

3

A Wilcoxon test indicates a significant difference between the average spreads for investment grade countries (189 basis points) and speculative grade countries (505 basis points). A Welch test of medians also finds significant differences between the spreads of investment grade and speculative grade countries (with medians of 159 and 409 basis points respectively).

4

The specification builds on Jaramillo (2010).

5

The sample period is January 1995- March 2010; and the data is monthly. The list of countries included in the sample is provided in the Appendix.

6

The Kao and Johansen Fisher panel co-integration tests were used.

8

The country ceiling concept replaced sovereign ceilings in Fitch Ratings and other credit risk assessments (Fitch Ratings, 2008).

Appendix

Figure A1.
Figure A1.

Impulse Responses

Citation: IMF Staff Country Reports 2010, 315; 10.5089/9781455208647.002.A001

Figure A2.
Figure A2.

Variance Decompositions

Citation: IMF Staff Country Reports 2010, 315; 10.5089/9781455208647.002.A001

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1

Prepared by Juliana Araujo and Kristin Magnusson.

2

Panama has no national currency or central bank and has the U.S. dollar as its only legal tender. This means that neither money supply nor credit are buffered or amplified by domestic monetary policy considerations.

3

Previous work (Swiston, 2010) has found trade in goods and services to be an important transmission channel of shocks from the United States to Panama, but we chose not to include it given the presence of U.S. GDP growth in the model and the paper’s focus on financial and domestic factors. Panama’s large off-shore financial center is also excluded from the model because the segment is largely de-linked from the rest of the economy.

4

For the first subperiod the prior on US GDP growth was between 1 and 3 percent and for the latter subperiod was -1 and 2 percent. The prior on Panama’s GDP growth rate was between 2 and 8 percent and 6 and 10 percent, respectively.

5

For the priors governing the dynamics of the model, we follow Litterman, 1986, in using a modified version of the Minnesota prior. If a variable is modified in levels, the prior mean on its first own lag is set to 0.9; if in growth rates, it is set to 0. The reason for modifying the traditional Minnesota prior in this fashion is that a prior mean on the first own lag equal to 1 is theoretically inconsistent with a mean-adjusted model, since a random walk does not have a well-specified mean.

6

One standard deviations shocks correspond to the following magnitudes for the included variables: 6.6 percent for PAN credit growth, 1.5 percent for PAN government spending, 4 percent for PAN FDI, 4 percent for PAN GDP, and 2 percent for U.S. growth.

Panama: Selected Issues Paper
Author: International Monetary Fund