Credit Ratings and Sovereign Default

We use a small open economy with heterogeneous borrowers, non-enforceable debt contracts and incomplete information to investigate the role played by credit agency ratings in explaining sovereign debt and spreads. We find... [ view full abstract ]

We use a small open economy with heterogeneous borrowers, non-enforceable debt contracts and incomplete information to investigate the role played by credit agency ratings in explaining sovereign debt and spreads. We find that credit ratings have an active role in shaping market’s beliefs in settings of incomplete information by allowing for conditional pricing on the level of patience of the sovereign. This mechanism prevents defaults by producing higher spreads during output downturns, so the borrowing level that triggers the default is never reached. In addition, it is essential to generate the debt crisis observed in Greek data and to explain the low spread-output correlation in emerging and industrialised economies.