Ordered Response Comparison Between Fitch, Standard & Poor, Moody Ratings

Anshul Kumar Singh (ansks@iitk.ac.in) and Prof. Somesh K. Mathur (skmathur@iitk.ac.in) Department of Humanities and Social science Indian Institute of Technology ,Kanpur ,India

This paper basically examined the relationship between the country debt ratings based on several basic factors like GDP per capita ,GDP growth, Inflation rate, external balance etc. which may affect the countrys ratings. I have used three companys debt ratings (Fitch ratings, Standard and Poor, Moodys ratings) as my dependent variable and tried to see which company gives the closest results towards the actual ratings. I have used the Ordered Logit /Probit model to estimate the parameters .For the Regression I have taken the 79 countrys data including Developed, Developing and Under Developing countries. I have used cross-sectional data for the year 2011 to find the results. We will also see how any countrys ratings can be improved in future.

Keywords: Credit Ratings, Ordered Logit, Ordered Probit

1. Introduction:
A countrys sovereign credit ratin g is a key indicator of its financial system development and reflects that countrys perceived willingness and ability to repay its sovereign debts. Sovereign credit ratings impact the economic environment of countries in a number of ways. The primary importance of ratings is the fact that they influence the interest rates at which countries can obtain credit on the international financial markets. Second, sovereign ratings also influence credit ratings of national banks and companies and affect their attractiveness to foreign investors by directly impacting the ability of firms in that country to access global capital markets. Third, institutional investors may be contractually restricted on the degree of risk they can presume which in turn implies that they cannot invest in debt rated below an agreed level. The sovereign credit rating of an economy is a measure of the solvency to pay back its loan. It also provides an outlook into the economic, political and the Ongoing situation for a nations inhabitants. Therefore, various quantitative and qualitative factors are used in rating methodologies. On the website of Moodys as of September 2005, they stated that they determ ined credit ratings after examining creditworthiness of bond issuers qualitatively and quantitatively. Specically, evaluation of qualitative aspects of credit ratings was said to be done in the form of

Electronic copy available at: http://ssrn.com/abstract=2253659

interview with top executives and divisional chiefs of bond issuers. Also, that of quantitative aspects was said to be done by analyses using nancial data.According to the website of S&P, the agency said that the credit ratings were based on the information offered by bond issuers and on other information sources which they deemed reliable to use. However the agencies have never revealed entire mechanisms of how they decided credit ratings. In other words, we cannot know how many contributions qualitative factors make in determining credit ratings but can research to what extent publicly available nancial data contributes in determining credit ratings. Thus, there have been many studies aimed at exploring quantitatively the determinant factors of credit ratings. Credit ratings are ordinal measures of through-the-cycle expected loss. As such, while they are certainly based on the current financial strength of the issuer, they incorporate expectations of future performance as well - not just issuer performance, but the industry and overall economy. Ratings also measure the relative permanence or stability of the issuer's financial position: fleeting or noisy disturbances, even those which might be reflected in bond spreads, do not impact credit ratings. Consequently, while we can hope to construct a "good" and "useful" mapping between conventional financial metrics and ratings, we know from the outset that we can never construct a perfect map, since we simply cannot include all the factors which determine ratings. This has not prevented the development of a variety of rating prediction models, both by academics and industry practitioners. They generally fall into two types: linear regression and ordered probit/Logit . Basic linear regression projects ratings (usually measured in linear or notch space, for instance with Aaa = 1 and C = 21) on various financial metrics.The result is a linear index with fixed coefficients which maps directly to rating space. The ordered probit (or logit) relaxes the assumption of a linear rating scale by adding endogenously determined "break points" against which a similar fixed coefficient linear index is measured.In this paper I have focused on Ordered response Functions only . A public finance credit risk rating is an opinion about a local governments ability and willingness to pay. With no credit rating these two attributes would be difficult to evaluate in Mexico due to the lack of timely and reliable information about public finances. As the events in the ongoing worldwide crisis have revealed, failing to assess credit quality based on quality information can lead to financial bankruptcy, default, crisis and contagion. Despite the heavy criticism to rating agencies, credit risk ratingswith all their imperfectionsare tools still widely considered by analysts and are among the very few parameters available to monitor the health and soundness of local government's public finances.Commercial banks and financial creditors for in stance use risk ratings as a benchmark to calculate capital reserves and to manage default risk. The bigger the gap between the State credit risk rate and the sovereign risk rate, the bigger will be the required reserve capital and, therefore, a higher interest rate the local government will be charged for such credit. Credit rating agencies such as Fitch, Moody's and Standard & Poors have been issuing ratings for corporate debt since the first half of the 20th century. Today, the majority of large companies in developed markets possess a credit rating. Over time, the rating process has not undergone major changes. Rating agencies combine quantitative information such as accounting ratios with qualitative assessments of management quality and other factors. The final rating decision

Electronic copy available at: http://ssrn.com/abstract=2253659

is made by a rating committee. According to rating agencies, it does not rest on a fixed weighting algorithm (Standard and Poors (2008)). In this paper i have tried to see the results from all three approach and determined what are the factors which relates to this significantly. In my results I have seen that in some of the factors affects one rating significantly but not the others.

Objectives:
1.Does the parameters using all three different companys ratings make sig nificant difference on the explanatory variables? 2. Which one is closely related to the actual rating of the country in their domain?

2. Literature Review:
There have been done so many studies related to defining the Debt /Credit ratings of a country. I have studied some of the studied related to this and found some interesting results . Determinants and impact of sovereign credit ratings by Cantor, R., Packer, F. (1996) . In this paper they may be regarded as an earlier study in this area, analyzing the determinants and impact of sovereign credit ratings using a cross-section of 49 countries by applying OLS methodology. In their analysis, six factors appear to play an important role in determining a countrys rating: per capita income, GDP growth, inflation, external debt, level of economic development, and default history. Their findings do not support a statistically significant relationship between ratings and either fiscal or current account deficits. In fact, the empirical literature on sovereign ratings only extends in a few strands. The study of Afonso (2003) Understanding the determinants of sovereign debt ratings: Evidence for the two leading agencies examines possible determinants of sovereign credit ratings assigned by Moodys and the S&P for a sample of 81 countries consisting of 29 developed and 52 developing countries for the year 2001 by using the OLS method. Rating scales are transformed by using linear, logistic and exponential transformations. The variables that have statistically significant explanatory power for the rating levels are GDP per capita, external debt as a percentage of exports, the level of economic development, default history, real growth rate, and the inflation rate. The results of the logistic transformation estimations appear to be better for the overall sample s, especially for the countries located at the top end of the rating scale. Butler and Fauver (2006) Institutional environment and sovereign credit ratings examine the cross-sectional determinants of sovereign credit ratings by using a sample of 86 countries as of March 2004. The main findings of the study display that the quality of a countrys legal and

political institutions, which are measured by its rule of law, political stability, voice of the people, corruption control, government effectiveness, or regulatory quality, has a vital role in determining these ratings. Strikingly, credit ratings are found to be over three times as sensitive to a change in the legal environment composite as they are to GDP per capita, inflation, foreign debt per GDP, and overall economic development. Linear panel models generalizing a cross section specification to panel data are also used by Monfort and Mulder (2000) Using Credit Ratings for Capital Requirements on Lending to Emerging Market Economies: Possible Impact of a New Basel Accord, Eliasson (2002) Sovereign credit ratings. Deutche Bank Research, and Canuto et al. (2012) Macroeconomics and sovereign risk ratings in their papers . PROVINCIAL CREDIT RATINGS IN CANADA: An Ordered Probit Analysis by Stella Cheung In this paper they have tried to see the effect of variables on rating using some independent variables like debt to GDP ratio ,last year employment ratio ,federal transfer as proportion of total provincial revenues provincial GDP as a share of total Canadian GDP.They have used the 25 years data from 1970 to 1995.They found that a number of other variables are significant such as the employment ratio, the relative size of the provincial economy, the governments dependence on federal transfers, and the relative importance of UI benefits. Determinants and Impact of Sovereign Credit Ratings by Richard Cantor and Frank Packer.In this paper they tried to focus on basic variables (GDP per capita,GDP growth ,Inflation, Fiscal Balance,External balance )that affects the credit ratings and also compared the moodys and S&P ratings.They found all the variables significant in 10% significant level.They have used 79 observations.There was not that huge difference between these two ratings results. As we can see that there has been done enough work using panel data ,cross sectional data ,time series data with different estimation method like OLS and etc. There have been also done many similar kind of studies using different sample size so. it can be easily said that Sample size is the important factor to obtain realistic Credit ratings.

3. ESTIMATED MODEL & METHODOLOGY and DATA Sources: Model: I am using the model which is given below for determining the relationship between independent and dependent variables. Latent Variable (unobserved)Y* = a0+a2*GDPG +a3*Infl +a4*Fisbal+a5*Extbal +a6*Extdebt+a7*Ecodvlpmt +a8*Deflthist+ a9*EU +error Initially I also took GDP per capita in my model but because of collinearity in GDP per capita and GDP growth I dropped GDP per Capita. So finally I have taken few variables (GDP growth,Inflation rate ,External balance,Fiscal balance,External debt,dummies for European countries, Economic development or Industrialized country and Default history) for the

regression as my independent variables which comes from literature for the 79 countries sample size . I have taken different Ratings as my dependent variables using ordinal function.

4. Defining the Variables:

To estimate the relationship between different ratings and independent variables I am using Maximum likelihood estimation with cross sectional data in ordered logit /Probit Models.

Basic Ordered Logit/Probit Models:

I have shown only Moodys ratings in form of ordered logit /Probit but we can also define the other Ratings models like Standard & Poor, Fitch in the same way. The only difference that we will see is the

particular rank associated with particular rating and the cut off points which basically defines as the total no of rank defined less than one.

Aaa (best rating) Aa1 Aa2 Aa3 A1 Yi *= . . . . . Ca C (poorest rating)

Y*<c1

---- defined as 0 1 2 . . . .

c1<Y*<c2 c2<Y*<c3 . . . . . . . . c>c18

Define for the model Aaa -0 , Aa1-1 ,Aa2-2 ..for more see data table.Same Kinds models I applied for Fitch and Standard and Poors Ratings where c1,c2,c3..c18 are the cutting points

5. Results: In my first result I have regressed Moodys ratings on host of dependent variables which are defined earlier. for this i have used both the results from Ordered Logit/Probit to check the difference. From the figure 1&2 similar kind of things I have performed for S&P,Fitch regression results can be seen in the appendix.I have used robust standard error for the heteroscedasticity. In Moodys result I have found 5 variables (Inflation rate,External balance,Fiscal balance ,Economic development and EU dummy) with 95 % significance level. As GDP growth ,Fiscal balance ,External balance ,External debt,Economic development increases it also increases the probability of any country getting good Credit ratings.In this case I have found 18 cut off point through which probability can be calculated .While in the other hand increment in Inflation rate ,Default history and EU dummies decreases the probabilty of getting the good ratings. In S&P ratings results are totally similar but the significant variable changed .In this case GDP growth, inflation rate, external balance and economic development are highly significant while others not. In Fitch ratings results and significant variables are same so these two approaches are gives quite close ratings of the countries rather than the S&P. to check the results see the appendix. I have also calculated the variance and covariance matrix to see the correlation among the variables.

From the graph It can be clearly seen that GDP growth has mild ve correlation with external balance ,Economic development, Economic debt and EU dummy GDP growth is +vely correlated to

Inflation rate ,Fiscal balance and Default history

From the graph we can see that our fitted values are quite close to actual values. Residual values are higher for under Developed countries may be because of because of data. For Developed/Developing countries residual values are close zero .

6. Conclusions:For the regression I have taken the 2011 data for 79 countries including Developed, Developing / Under Developing countries. In Moodys RatingCountry rating will improve as GDP growth, Fiscal Bal, External balance, External debt increase and it declines in increment inflation rate In Fitch RatingsCountry rating will improve as GDP growth, External balance, External debt and Fiscal balance increase and it declines in increment inflation rate In Standard & Poor RatingsCountry rating will improve as GDP growth, External balance, Fiscal Balance increase and it declines in increment inflation rate Major finding is that in all three approaches External balance, Inflation rate, External Debt and EU dummy has most significant (5% probability) impact on Country credit ratings.

References: Afonso, A. (2003), Understanding the determinants of sovereign debt ratings: Evidence for the two leading agencies. Journal of Economics and Finance, 27(1), 56 74. Antonio Afonso & Pedro Gomes & Philipp Rother, 2009. "Ordered response models for sovereign debt ratings," Applied Economics Letters, Taylor and Francis Journals, vol. 16(8), pages 769-773. Bissoondoyal-Bheenick, E. (2005). An analysis of the determinants of sovereign ratings. Global Finance Journal 15 (3), 251-280. Cantor, R., Packer, F. (1996), Determinants and impact of sovereign credit ratings. Economic Policy Review, 2(2), 37-54. Canuto, O., Dos Santos, P.F.P., Porto, P.C.D.S. (2012), Macroeconomics and sovereign risk ratings. Journal of International Commerce, Economics and Policy (JICEP), 3(2), 1250011-25. Richard Cantor & Frank Packer, 1996. "Determinants and impacts of sovereign credit ratings," Research Paper 9608, Federal Reserve Bank of New York . Cheung, Stella, Provincial Credit Ratings in Canada: An Ordered Probit Analysis (April 1996). Working Paper 96-6 Wooldridge, J. (2002). Econometric Analysis of Cross Section and Panel Data. MIT Press.

Appendix : Regression results : Moodys Ratings:

Fig.1 Ordered Logit Result for Moodys rating

Fig.2 Ordered Probit Result for Moodys ratings

Standard and Poors Ratings

Fig.3 Ordered Logit Result for S&P s ratings

Fig.4 Ordered Probit Result for S&Ps ratings

Fitch Ratings

Fig.5 Ordered Logit Result for Fitchs ratings

Fig.6 Ordered Probit Result for Fitchs ratings