Promotion and relegation between country risk classes

This paper has as its starting point the fact that the association between the quality of policy outcomes reported by countries and the ratings outcomes published by credit rating agencies is weak at best, and entirely absent at worst. Strong market incentives preclude the likelihood that this absence of an association is simply a reflection of market failure, or of information asymmetries. Instead, we present a model in which policy makers respond endogenously to ratings, and in which the rating agency changes ratings in response to policy changes. We show that for rational, social welfare maximizing policy makers, the quality of policy outcomes comes to be conditional on the probability of receiving a high or low rating outcome, as well as the responsiveness of ratings agencies to changes in policy. It is important to note that the consequence is that poor policy can occur under high ratings (where the rating agency shows slow response to policy changes, policy makers have constrained incentives to maintain good policy), but that good policy can also occur under poor ratings (where ratings agencies show high responsiveness to improvements in policy, policy makers have an incentive to respond by better policy choices). Modelling is both under a rational choice framework, and in terms of strategic interaction betrween the policy maker and the rating agency. We examine panel evidence for 60 countries for which there are 5 or more Moody rating data points, over the 1980-2013 time period. Our evidence confirms the prediction of the model: better policy is observable where Moody’s is more responsive to changes in policy.