11/3/201511/3/2015 1IPES Annual Meeting, November 13-14, 2015

Credit Rating Agencies and Political Budget Cycle Dynamics Around the World

Paul M. VaalerLaw School & Dept of Strategic Mgmt & Entrepreneurship

University of Minnesota

11:10-11:40amSaturday, November 14, 2015Room 2Arrillaga Alumni CenterStanford UniversityPalo Alto, CA, USA

Marek HanuschGlobal Practice for Macroeconomics and Fiscal Mgmt

World Bank

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Research In a Nutshell Fiscal Policy (Government Taxing, Borrowing and Spending) Policies Let Sovereign Governments

Finance “Good” Spending for Long-Term Economic Growth and Development, and “Bad” Spending in Election Periods to Maintain Office. Political Budget Cycle (PBC) Theory Predicts More (Less) Bad Spending in Election (Non-Election) Periods.

Major Credit Rating Agencies (CRAs) Summarize Overall Sovereign Creditworthiness Affected by Both Spending Types with Ratings (e.g., AAA) and Associated Watches (Negative, Positive, Stable).

Previous Work Has Demonstrated That CRA Ratings May Moderate Such Election-Year Spending Sprees (Hanusch and Vaaler, 2013), But Has a Limited Empirical Domain and Has Not Analyzed Underlying Mechanisms for CRA Moderation of Election-Period Spending: Election-Period Downgrades Undermine Incumbent Claims of Economic Stewardship, Increase Likelihood of Incumbent Turnover. Election-Period Ratings with Negative Watch Indicate Greater Likelihood of Downgrade and Diminish Incumbent Spending.

We Find Support for These Two Predictions in CRA Ratings and Watches, Budget Balances, and Electoral Outcomes in 63 Countries Holding 111 Elections from 2002-2011: Downgrade in Year of or Before Election Increases Likelihood of Incumbent Turnover by 27 Percentage Points. Incumbent Ratings with Negative Watch Do Not Run Larger Budget Deficits in Election Years. Incumbents in Least Developed Countries With Low Ratings Borrow Progressively Less With Positive, Stable and Negative Watches.

Private, For-Profit CRAs “Regulate” National Politicians in a Transnational Regime That Might Increase Fiscal Discipline and Government Accountability, Particularly in Less-Developed Democracies.

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Research Background and Motivation I

How Do We Jumpstart Economic Growth and Poverty Reduction in Less-Developed Democracies? Do So With More Private-Sector Investors…But Without Domestic Institutional Safeguards Private-Sector Investors

Desire: Migrants and Remittances Do So With More Local Government Accountability…But Without Domestic Institutional Safeguards Voters

Desire: CRAs and Sovereign Ratings

Part of Aid and Policy Reform PackagesFor Democratizing IDA Countries of West Africa (e.g., Guinea-Bissau)

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Research Background and Motivation IIIf you think deficit-reduction is being driven by John Boehner or Harry Reid, think again. The biggest driver right now is Standard & Poor’s.

Robert Reich (2011) There are two superpowers in the world today in my opinion. There's the United States and there's Moody's Bond Rating Service. The United States can destroy you by dropping bombs, and Moody's can destroy you by downgrading your bonds. And believe me, it's not clear sometimes who's more powerful.

Tom Friedman(1996)

The New Masters of Capital: American Bond Rating Agenciesand the Politics of Creditworthiness

Timothy Sinclair (2005)

Love them or loath them. If they did not exist we would have to invent them.

Gary Jenkins(2003)

AAA……………..Most CreditworthyAA+AAAA-A+AA-BBB+BBBBBB-…………..Lowest Investment GradeBB+…………….”Junk” (Non-Investment Grade)Lower

•The Increasing Importance of Sovereign Ratings and Rating Agencies (“Agencies”) Since the 1980s

•Their Spotty Record

•The Curious (Private) Status

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Average Annual CRA Rating and Yield on 1-Year Sovereign Bonds, 2001-2011

Research Background and Motivation III

Why Incumbent GovernmentsCare About CRAs: Ratings Affect Cost and Availability of Credit

AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B- CCC and Below Prime Investment Grade Invest/Junk Default

There are two superpowers in the world today in my opinion. There's the United States and there's Moody's Bond Rating Service. The United States can destroy you by dropping bombs, and Moody's can destroy you by downgrading your bonds. And believe me, it's not clear sometimes who's more powerful.

Tom Friedman(1996)

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Moody's downgrades Minneapolis' credit rating (Star Tribune, July 30, 2013)

“Moody's Investors Service downgraded Minneapolis's credit rating Monday night, delivering a blow to one of Mayor R.T. Rybak's signature achievements.”http://www.startribune.com/local/blogs/217580141.html S&P Downgrade: Ex-

Obama Adviser Christina Romer Says U.S. 'Pretty Darn F**ked‘ (Huffington Post,August 6, 2011)http://www.huffingtonpost.com/2011/08/06/christina-romer-downgrade-standard-and-poors-bill-maher_n_920152.html

"If France loses its AAA, I'm dead…“Le Canard Enchainé, October 21, 2011

Research Background and Motivation IVIf you think deficit-reduction is being driven by John Boehner or Harry Reid, think again. The biggest driver right now is Standard & Poor’s.

Robert Reich (2011)

Why Incumbent GovernmentsCare About CRAs: Ratings Affect Incumbent Government ReputationAs a Good Economic Steward

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Research Background and Motivation VA Government is not supported a hundreth part so much by the constant, uniform, quiet prosperity of the country as by those damned spurts which [British Prime Minister William] Pitt used to have just in the nick of time.

Henry Brougham on Pitt the Younger (1814)

The “all-time hero of political business cycles…”

Ken Rogoff on Richard Nixon (1988)

Political Budget Cycles (“PBCs”)

Fiscal Policies Follow the Electoral Calendar

Opportunistic (Expansionary) PBCs Partisan (Left-Right) PBCs Models and Evidence To Date

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Research Questions to Be Addressed

How Do CRAs and Ratings Matter for PBCs? Do CRAs Care About PBC Behaviors in Democracies? If So, Do CRAs Influence Those Same Behaviors? If So, How?

Why These Questions Matter…For Academic Research, Policy/Practice For Policy Research, Help Understand Importance of “Transnational Regimes” Providing Global (Financial) Governance Without

Governments. For Business Research, Help Understand Novel Application of Regulatory Theory: How Multinational Firms (Not Governments)

Regulate National Governments. For Policy Practice, Help Understand Potential of CRAs to Provide Auxiliary (to Domestic Institutional) Oversight of Incumbent

Government Fiscal Policy Quality When That Quality Is Threatened.

Goals for the Study Understand the Interplay of Privately-Administered International Financial Regimes and Electorally-Influenced Fiscal Policy

Trends. Ground That Understanding in an Integrative (Regime Theory and PBC Theory) Framework. Document Evidence Related to Framework in Broad-Sample (Multi-Country, Year) Study.

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Why Incumbent GovernmentsCare About CRAs in Election Years:CRAs Undermine Claims of GoodEconomic Stewardship and AffectCost of Capital.

Theory and Predictions

Moody’s S&P and Fitch Grade

Numerical Equivalent on 0-16 Scale Common Interpretation

Aaa AAA Investment 16 Extremely strong capacity to meet its financial obligations. Aa1 Aa2 Aa3

AA+ AA AA-

Investment 15 14 13

Very strong capacity to meet its financial obligations.

A1 A2 A3

A+ A A-

Investment 12 11 10

Adequate capacity to meet its financial obligations.

Baa1 Baa2 Baa3

BBB+ BBB BBB-

Investment 9 8 7

Less vulnerable than lower rated obligors but facing adverse conditions which could lead to obligor’s inadequate capacity to meet its financial obligations.

Ba1 Ba2 Ba3

BB+ BB BB-

Speculative (Junk)

6 5 4

More vulnerable than the obligors rated above. Obligor currently has the capacity to meet its financial obligations but adverse conditions will likely impair this capacity.

B1 B2 B3 C

B+ B B- C

Speculative (Junk)

3 2 1 0

Currently vulnerable and dependent on favorable conditions to meet its financial obligations.

Positive Outlook: Potential upgrade in next two years Stable Outlook: Neither potential upgrade nor downgrade in next two years Negative Outlook: Potential downgrade in next two years

Research Proposition: How CRAs Moderate Incumbent Governments and Election-Period PBCs Regime Theory: Behavior Among States Governed by Universally-Accepted Norms, Not Just National Self Interest. CRAs Lead a

Transnational (Non-Governmental) Regime Setting and Enforcing Norms Regarding How Much and for What Reasons States Borrow.

(Opportunistic) PBC Theory: During Election Periods, Incumbent Governments Have Incentives to Run Larger Budget Deficits to Fund Spending Sprees That Promote Short-Term Economic Growth (and Re-Election) But May Be Inconsistent With Long-Term Economic Growth and Poverty Reduction Aims.

Regime and PBC Theoretical Framework Hypotheses: 1) Election-Period Downgrade Increases Likelihood of Incumbent Turnover; 2) Election-Period Negative CRA Outlook Indicates Higher Likelihood of Downgrade And Diminishes Bad Election-Period Spending Sprees.

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(1) (2) (3) (4)Probit Marginal

(5) (6)

Estimator Probit Probit Probit Effects (Model 3)

Probit Probit

Dependent VariableIndependent Variable

Incumbent Turnover

Incumbent Turnover

Incumbent Turnover

IncumbentTurnover

IncumbentTurnover

Incumbent Turnover

Control VariablesConstant () 2.708† 3.147† 3.158* 3.050* 2.510

(1.595) (1.554) (1.585) (1.554) (1.621)GDP Growth (1) 0.042 0.065 0.060 0.023 0.050 0.028

(0.048) (0.055) (0.055) (0.019) (0.046) (0.050)Ln GDP Per Capital (2) -0.360* -0.429** -0.429** -0.151** -0.400** -0.349*

(0.164) (0.161) (0.164) (0.052) (0.159) (0.166)Public Debt (3) 0.007† 0.009* 0.007† 0.003** 0.008* 0.007†

(0.004) (0.004) (0.004) (0.001) (0.004) (0.004)Primary Budget Balance (4A)

-0.052† -0.050† -0.018† -0.055† -0.059†

(0.029) (0.030) (0.010) (0.031) (0.032)Overall Budget Balance (4B)

-0.035

(0.029)Unified Government (5) -0.511* -0.531* -0.519* -0.186* -0.514* -0.542*

(0.252) (0.258) (0.258) (0.087) (0.249) (0.253)Parliamentary System (6)

0.624* 0.735** 0.790** 0.258** 0.822** 0.662*

(0.273) (0.274) (0.270) (0.093) (0.270) (0.277)Main Variables

Downgrade (1) 0.767† 0.817† 0.270†(0.438) (0.439) (0.150)

Downgradeit-1 (2) -0.549 -0.547 -0.193(0.433) (0.433) (0.149)

Stable (1A) -0.465†(0.259)

Stableit-1 (2A) 0.237(0.276)

Upgrade (1B) 0.282(0.283)

Upgradeit-1 (2B) 0.143(0.334)

Results I: Is Election-Year Incumbent Turnover More Likely After Recent CRA Downgrade?

Sample of 109 National Election Country-YearObservations from53 Countries,2002-2011

Controls Enter Largely As Predicted

Recent CRA DowngradeIncreases TurnoverLikelihood by27 Percentage Points.

Stable CRA RatingOutlook Decreases Turnover Likelihood

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- 1- .5

0. 5

1

Non‐NegativeOutlook:StableorPositive

NegativeOutlook

MeanDifferenceinAnnualPrimaryBudgetBalance

as%ofGDP

Annual (January 1) Rating Outlook Published by CRAs in Election Year

Sample of 440 Country-Year Observations From 63 Countries Holding 111 National Executive Elections, 2002-2011

Incumbents Borrow More InElection Years (111) WhenThey Have Stable or PositiveCRA Rating Outlook

Results II: Does Election-Year Incumbent Borrowing Decrease With Greater CRA Downgrade Likelihood?

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Results II: Does Election-Year Incumbent Borrowing Decrease With Greater CRA Downgrade Likelihood?

(1)Panel

(2)Panel

(3)Panel

(4)Panel

(5)Panel

(6)Panel

Estimator Fixed Effects Sys-Diff-GMM Sys-Diff-GMM Sys-Diff-GMM Sys-Diff-GMM Sys-Diff-GMMDependent Variable

Variables

Primary Budget Balance

Primary Budget Balance

Primary Budget Balance

Primary BudgetBalance

Overall Budget Balance

Overall Budget Balance

Main VariablesRating (1) -0.557† -0.986 -0.739 -0.615 -0.811 -0.592

(0.287) (0.656) (0.473) (0.408) (0.517) (0.426)Election Year (2) -0.392* -0.366†

(0.201) (0.202)Election Positive (2A)

-0.495 -2.416** -0.638 -2.435**

(0.443) (0.834) (0.436) (0.790)Election Stable (3A) -0.524* -1.893† -0.560* -1,941†

(0.244) (1.088) (0.249) (1.106)Election Negative (4A)

0.201 1.290 0.286 2.297

(0.847) (1.080) (0.897) (2.049)Election Positive 0.253** 0.250*** Rating (5A) (0.095) (0.088)Election Stable 0.112 0.114* Rating (6A) (0.079) (0.075)Election Negative -0.138 -0.246* Rating (7A) (0.098) (0.172)

Sample of 440 Country-Year Observations From 63 Countries Holding 111 National Executive Elections, 2002-2011

(Stable-Rated) Election Years See More Negative Budget Balances (PBC Effect)

At Low Rating LevelsThere’s a Clear HierarchyOf Borrowing That Decreases As CRA Rating Outlook Shifts from Positive to Stable to Negative

That Hierarchy DiminishesWhen CRA Ratings ReachInvestment Grade

Heightened LikelihoodOf CRA Downgrade in Election Years DecreasesBorrowing for Lower-Rated(Mostly IDA) Countries

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Implications and Next Steps

Previous Work Has Demonstrated That CRA Ratings May Moderate Such Election-Year Spending Sprees (Hanusch and Vaaler, 2013), But Has a Limited Empirical Domain and Has Not Analyzed Underlying Mechanisms for CRA Moderation of Election-Period Spending: Election-Period Downgrades Undermine Incumbent Claims of Economic Stewardship, Increase Likelihood of Incumbent Turnover. Election-Period Ratings with Negative Watch Indicate Greater Likelihood of Downgrade and Diminish Incumbent Spending.

We Find Support for These Two Predictions in CRA Ratings and Watches, Budget Balances, and Electoral Outcomes in 63 Countries Holding 111 Elections from 2002-2011: Downgrade in Year of or Before Election Increases Likelihood of Incumbent Turnover by 27 Percentage Points. Incumbent Ratings with Negative Watch Do Not Run Larger Budget Deficits in Election Years. Incumbents in Least Developed Countries With Low Ratings Borrow Progressively Less With Positive, Stable and Negative Watches.

Private, For-Profit CRAs “Regulate” National Politicians in a Transnational Regime That Might Increase Fiscal Discipline and Government Accountability, Particularly in Less-Developed Democracies.

What Next: Dealing with Various Methodological Issues and Re-Framing for Business and Policy Audiences Paying for CRA Ratings for IDA Countries in West Africa Developing and Publicizing Proprietary World Bank (MIGA) Ratings for Same Countries to Tie to Aid and Reform Packages.

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Thanks

IPES Annual Meeting, November 13-14, 2015

Credit Rating Agencies and Political Budget Cycle Dynamics Around the World

Paul M. VaalerLaw School & Dept of Strategic Mgmt & Entrepreneurship

University of Minnesota

Marek HanuschGlobal Practice for Macroeconomics and Fiscal Mgmt

World Bank

11:10-11:40amSaturday, November 14, 2015Room 2Arrillaga Alumni CenterStanford UniversityPalo Alto, CA, USA