Privilege or burden? A study on the long-term impact of public debt on sovereign ratings

The escalation of the sovereign debt crisis in Europe has brought up the question whether the declined creditworthiness of advanced countries can be explained by economic fundamentals or if the recent downgrades are rather driven by fading market sentiment. This question is closely related to the issue of debt sustainability: In the past thirty years, industrialized economies were able to run fiscal deficits for a long time-span absent visible changes of creditworthiness. However, with sharp increases in public debt, some countries have recently experienced sudden downgrades of their ratings, first of all in Southern Europe. Thus, it seems worth to explore whether markets consider some debt ratios as unsustainable or if the downgrades are rather the consequence of pro-cyclical behavior in times of financial turmoil. One option to answer this question is a comparison of the long-term credit risk across countries with different paths of public debt.

In this paper, we contribute to the literature by addressing three important questions: First, can we identify a "debt privilege" in industrialized countries over emerging markets and if yes, is it possible to measure the size of this advantage given that the rating difference may also be the result of a "debt burden" for emerging markets (default history, original sin)? Second, has the "privilege" disappeared or even changed into a burden for countries with large ratios of general government debt to GDP? And third, how do banking crises affect sovereign creditworthiness across the two country groups? The latter question addresses the consequences of sudden public debt surges due to national bailouts of financial institutions.

Our preliminary findings suggest that in the case of industrialized countries public debt ratios did not have a significant effect on ratings until recently. However, the correlation has become negative since the early 2000s, particularly in member countries of the Euro area. We also observe that emerging markets have experienced a decreasing debt burden in recent years, which can be largely explained by better access to foreign capital markets. In contrast to previous studies, we find that banking crises in emerging markets led to a strong negative effect on ratings and debt ratios in the short run, followed by a relatively quick recovery compared to industrialized countries. The latter are less affected by severe downgrades in the first year after the crisis but experience further adjustments in subsequent quarters.

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