Rating sovereign debt in a monetary union – original sin by transnational governance

Finn Marten Körner (FSI Assurance Department, Deloitte, Düsseldorf, Germany)
Hans-Michael Trautwein (Department of Economics, University of Oldenburg, Oldenburg, Germany)

Journal of Risk Finance

ISSN: 1526-5943

Publication date: 18 May 2015

Abstract

Purpose

The purpose of this paper is to test the hypothesis that major credit rating agencies (CRAs) have been inconsistent in assessing the implications of monetary union membership for sovereign risks. It is frequently argued that CRAs have acted procyclically in their rating of sovereign debt in the European Monetary Union (EMU), underestimating sovereign risk in the early years and over-rating the lack of national monetary sovereignty since the onset of the Eurozone debt crisis. Yet, there is little direct evidence for this so far. While CRAs are quite explicit about their risk assessments concerning public debt that is denominated in foreign currency, the same cannot be said about their treatment of sovereign debt issued in the currency of a monetary union.

Design/methodology/approach

While CRAs are quite explicit about their risk assessments concerning public debt that is denominated in foreign currency, the same cannot be said about their treatment of sovereign debt issued in the currency of a monetary union. This paper examines the major CRAs’ methodologies for rating sovereign debt and test their sovereign credit ratings for a monetary union bonus in good times and a malus, akin to the “original sin” problem of emerging market countries, in bad times.

Findings

Using a newly compiled dataset of quarterly sovereign bond ratings from 1990 until 2012, the panel regression estimation results find strong evidence that EMU countries received a rating bonus on euro-denominated debt before the European debt crisis and a large penalty after 2010.

Practical implications

The crisis has brought to light that EMU countries’ euro-denominated debt may not be considered as local currency debt from a rating perspective after all.

Originality/value

In addition to quantifying the local currency bonus and malus, this paper shows the fundamental problem of rating sovereign debt of monetary union members and provide approaches to estimating it over time.

Keywords

Acknowledgements

The authors thank Wiebke Mai for excellent research assistance. Both authors gratefully acknowledge financial support from Stiftung Bremer Wertpapierbörse and VolkswagenStiftung. The authors are grateful for the helpful comments from participants of the conference on “Coping with Risk on Transnational Financial Markets”. All remaining errors are their own.

Citation

Körner, F.M. and Trautwein, H.-M. (2015), "Rating sovereign debt in a monetary union – original sin by transnational governance", Journal of Risk Finance, Vol. 16 No. 3, pp. 253-283. https://doi.org/10.1108/JRF-11-2014-0171

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Publisher

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Emerald Group Publishing Limited

Copyright © 2015, Emerald Group Publishing Limited

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