## 5. Sovereign Spread Minus Cross-Country Median

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### Introduction and research question
- Objective: measure the impact of investment grade status on sovereign borrowing costs and whether an upgrade to investment grade differs from other upward rating movements.
- Dataset: panel of 35 emerging market economies, December 1997 to February 2010.
- Key methodological features:
  - Fixed effects panel regression with robust standard errors; standard errors clustered by country.
  - Rating dummies for each grade between A+ and CC- (18 dummies), lagged one period.
  - Controls: global variables (VIX, Fed Funds futures rate), macro fundamentals (external public debt to GDP, domestic public debt to GDP, reserves to GDP, real GDP growth), year dummies, and interaction terms of global and macro variables with investment grade status.
  - Dependent variable: log of sovereign spreads (EMBI Global spreads, end-of-period monthly observations).

### Main empirical findings
- Investment grade status effect:
  - Reaching investment grade lowers sovereign spreads by 36 percent, above and beyond macroeconomic fundamentals.
  - A one-notch upgrade within the investment grade asset class reduces spreads by 5–10 percent.
  - Movements within the speculative grade asset class have no estimated impact on spreads, ceteris paribus.
  - Example: if a BB+ rated country has a spread of 440 basis points (average for speculative grade countries during 2010 Q1), a BBB- country would have a spread of 279 basis points, ceteris paribus (difference ≈ 160 basis points).
- Rating-grade coefficients:
  - Coefficients on all investment grade rating dummies (A+ to BBB-) are significant and negative; these sovereigns enjoy spreads between 35–60 percent lower than the omitted group.
  - BB and B rating dummies are not significant.
  - CCC rating coefficients are significant and positive; spreads about 65–70 percent higher on average than the omitted group.
- Global conditions and external shocks:
  - VIX is significant and positive. A one standard deviation increase in VIX (9 points) would raise spreads by 27 percent.
  - Fed Funds futures rate coefficient is not significant in the full sample.
- External public debt:
  - External public debt to GDP is significant and positive; impact is smaller for investment grade countries.
  - If external debt to GDP increases by 7 percentage points (one standard deviation), spreads would increase by 17 percent for speculative grade countries and 7 percent for investment grade countries.
  - Evaluated at the median, a one standard deviation increase in external debt to GDP would raise spreads by 59 basis points for countries at BBB and by 16 basis points for countries at BB.
- Reserves and growth:
  - Reserves to GDP: significant and negative for speculative grade countries; no impact for investment grade countries once the interaction is included.
    - A reserves to GDP increase of 4 percentage points (one standard deviation) would lower spreads by 4 percent, implying a 14 basis point reduction if evaluated at the median of BBB rated countries.
  - Real GDP growth: significant and negative, more so for investment grade countries.
    - A real GDP growth improvement of 2 percentage points (one standard deviation) would reduce spreads by 4 percent for speculative grade countries and 10 percent for investment grade countries.
    - Evaluated at the median, a one standard deviation increase in real GDP growth would reduce spreads by 13 basis points for countries at BBB and by 24 basis points for countries at BB.

### Model performance and robustness
- Explanatory power:
  - Model explains about 80 percent of the variation in spreads (R-squared = 0.787 in the main specification).
  - Global financial conditions explain about 47 percent of the variation; rating dummies and domestic macroeconomic variables explain 32 percent.
- Robustness checks:
  - Results robust to shortening time period to 2005-2010 and to narrowing sample to countries at BBB or BB.
  - Similar findings when using 5 year or 10 year sovereign CDS spreads as dependent variable (results available from authors).
- Sample and observations:
  - Observations: 3,636 (main sample).
  - Number of countries: 35.

### Interpretation and policy implications
- Investment grade status delivers a substantial market “seal of approval,” lowering financing costs materially and broadening investor base (institutional inflows).
- Speculative grade countries: external public debt levels matter most; debt reduction efforts are especially important to lower borrowing costs.
- Investment grade countries: enjoy some flexibility but remain subject to market discipline if external debt increases abruptly.
- Policy focus:
  - For speculative grade countries: prioritize external debt reduction and reserve accumulation to lower spreads.
  - For all countries: promote stronger real GDP growth to reduce borrowing costs; investment grade countries gain larger spread reductions from growth improvements.

*Source: IMF Working Paper (section 5, “Sovereign Spread Minus Cross-Country Median”), based on a panel of 35 emerging market economies, Dec. 1997–Feb. 2010.*

### References .............................................................................................................

### _wp1144 - References .............................................................................................................

### References and Appendix
- References ....................................................................................................................15 
- Appendix ......................................................................................................................17 

### Tables
- 1. Sovereign Credit Ratings by Agency  ................................................................................. 4
- 2. Data Description ................................................................................................................. 9
- 3. Regression Results: Sovereign Spreads .............................................................................10 

### Figures
- 1. EMBI Spreads and Global Conditions  ............................................................................... 5
- 2. Emerging Markets: Sovereign Credit Ratings and Spreads by Year ..................................6
- 3. Median Spreads: Fitted Values .........................................................................................12
- 4. Spreads Implied by Rating Dummy Coefficients, All Else Equal .................................... 12

*Source: _wp1144 - References .............................................................................................................*

### 5. Sovereign Spread Minus Cross-Country Median .............................................................12

### 5. Sovereign Spread Minus Cross-Country Median

### Introduction and research question
- Objective: measure the impact of investment grade status on sovereign borrowing costs and whether an upgrade to investment grade differs from other upward rating movements.
- Dataset: panel of 35 emerging market economies, December 1997 to February 2010.
- Key methodological features:
  - Fixed effects panel regression with robust standard errors; standard errors clustered by country.
  - Rating dummies for each grade between A+ and CC- (18 dummies), lagged one period.
  - Controls: global variables (VIX, Fed Funds futures rate), macro fundamentals (external public debt to GDP, domestic public debt to GDP, reserves to GDP, real GDP growth), year dummies, and interaction terms of global and macro variables with investment grade status.
  - Dependent variable: log of sovereign spreads (EMBI Global spreads, end-of-period monthly observations).

### Main empirical findings
- Investment grade status effect:
  - Reaching investment grade lowers sovereign spreads by 36 percent, above and beyond macroeconomic fundamentals.
  - A one-notch upgrade within the investment grade asset class reduces spreads by 5–10 percent.
  - Movements within the speculative grade asset class have no estimated impact on spreads, ceteris paribus.
  - Example: if a BB+ rated country has a spread of 440 basis points (average for speculative grade countries during 2010 Q1), a BBB- country would have a spread of 279 basis points, ceteris paribus (difference ≈ 160 basis points).
- Rating-grade coefficients:
  - Coefficients on all investment grade rating dummies (A+ to BBB-) are significant and negative; these sovereigns enjoy spreads between 35–60 percent lower than the omitted group.
  - BB and B rating dummies are not significant.
  - CCC rating coefficients are significant and positive; spreads about 65–70 percent higher on average than the omitted group.
- Global conditions and external shocks:
  - VIX is significant and positive. A one standard deviation increase in VIX (9 points) would raise spreads by 27 percent.
  - Fed Funds futures rate coefficient is not significant in the full sample.
- External public debt:
  - External public debt to GDP is significant and positive; impact is smaller for investment grade countries.
  - If external debt to GDP increases by 7 percentage points (one standard deviation), spreads would increase by 17 percent for speculative grade countries and 7 percent for investment grade countries.
  - Evaluated at the median, a one standard deviation increase in external debt to GDP would raise spreads by 59 basis points for countries at BBB and by 16 basis points for countries at BB.
- Reserves and growth:
  - Reserves to GDP: significant and negative for speculative grade countries; no impact for investment grade countries once the interaction is included.
    - A reserves to GDP increase of 4 percentage points (one standard deviation) would lower spreads by 4 percent, implying a 14 basis point reduction if evaluated at the median of BBB rated countries.
  - Real GDP growth: significant and negative, more so for investment grade countries.
    - A real GDP growth improvement of 2 percentage points (one standard deviation) would reduce spreads by 4 percent for speculative grade countries and 10 percent for investment grade countries.
    - Evaluated at the median, a one standard deviation increase in real GDP growth would reduce spreads by 13 basis points for countries at BBB and by 24 basis points for countries at BB.

### Model performance and robustness
- Explanatory power:
  - Model explains about 80 percent of the variation in spreads (R-squared = 0.787 in the main specification).
  - Global financial conditions explain about 47 percent of the variation; rating dummies and domestic macroeconomic variables explain 32 percent.
- Robustness checks:
  - Results robust to shortening time period to 2005-2010 and to narrowing sample to countries at BBB or BB.
  - Similar findings when using 5 year or 10 year sovereign CDS spreads as dependent variable (results available from authors).
- Sample and observations:
  - Observations: 3,636 (main sample).
  - Number of countries: 35.

### Interpretation and policy implications
- Investment grade status delivers a substantial market “seal of approval,” lowering financing costs materially and broadening investor base (institutional inflows).
- Speculative grade countries: external public debt levels matter most; debt reduction efforts are especially important to lower borrowing costs.
- Investment grade countries: enjoy some flexibility but remain subject to market discipline if external debt increases abruptly.
- Policy focus:
  - For speculative grade countries: prioritize external debt reduction and reserve accumulation to lower spreads.
  - For all countries: promote stronger real GDP growth to reduce borrowing costs; investment grade countries gain larger spread reductions from growth improvements.

*Source: IMF Working Paper (section 5, “Sovereign Spread Minus Cross-Country Median”), based on a panel of 35 emerging market economies, Dec. 1997–Feb. 2010.*

### REFERENCES

### _wp1144 - REFERENCES

### References
- Akitoby, B. and T. Stratmann (2008), “Fiscal Policy and Financial Markets,” The Economic Journal, 118, November.
- Arora, V. and M. Cerisola (2000), “How Does U.S. Monetary Policy Influence Economic Conditions in Emergin Markets?” IMF Working Paper No. 00/148.
- Baldacci, E., G. Sanjeev, and A. Mati (2008), “Is It (Still) Mostly Fiscal? Determinants of Sovereign Spreads in Emerging Markets”, IMF Working Paper 08/259.
- Cantor, R. and F. Packer (1996), “Determinants and Impact of Sovereign Credit Ratings,” Federal Reserve Bank of New York Economic Policy Review, September.
- Cavallo, E. A. Powell, and R. Rigobon (2008), “Do Credit Rating Agencies Add Value? Evidence from the Sovereign Rating Business Institutions,” IADB Research Department Working Papers 647, November.
- Edwards, S. (1984), “LDC’s foreign borrowing and default risk: an empirical investigation,” American Economic Review, vol. 74(4), pp. 726–34.
- Edwards, S. (1986), “The Pricing of Bonds and Bank Loans in International Markets: An Empirical Analysis of Developing Countries’ Foreign Borrowing,” European Economic Review, vol. 30(3), pp. 565–89.
- Eichengreeen, B. and A. Mody (1998), “What Explains Changing Spreads on Emerging-Market Debt: Fundamentals or Market Sentiment?”, NBER Working Paper 6408.
- Gonzalez-Rozada, M. and E. Levy Yeyati (2008), “Global Factors and Emerging Market Spreads”, The Economic Journal, 118.
- Hartelius, K., K. Kashiwase, and L.E. Kodres (2008), “Emerging Market Spread Compression: Is it Real or is it Liquidity?” IMF Working Paper 08/10.
- International Monetary Fund (2010), Global Financial Stability Report, October 2010: Sovereigns, Funding, and Systemic Liquidity.
- Jaramillo, L. (2010), “Determinants of Investment Grade status in Emerging Markets” IMF Working Paper 10/117.
- Kamin, S. and K. von Kleist (1999), “The Evolution and Determinants of Emerging Market Credit Spreads in the 1990s’” BIS Working Paper 68, May.
- Kaminsky, G. and S. Schmukler (2002), “Emerging market Instability: Do Sovereign Ratings Affect Country Risk and Stock Returns?” The World Bank Economic Review, Vol. 16, No. 2, pp. 171–195.
- McGuire, P. and M. Schrijvers (2003), “Common Factors in Emerging Market Spreads,” BIS Quarterly Review.
- Rigobon, R. (2002), “The Curse of Non-investment Grade Countries,” Journal of Development Economics 69, pp. 423–449.
- Sløk, T. and M. Kennedy (2004), “Factors Driving Risk Premia” OECD Working Paper No. 385.
- Sy, A. (2002), “Emerging Market Bond Spreads and Sovereign Credit Ratings: Reconciling Market Views with Economic Fundamentals,” Emerging Markets Review 3, pp. 380‒408.
- Uribe, M., and V.Z. Yue (2006), “Country Spreads and Emerging Countries: Who drives Whom?” Journal of International Economics 69, pp. 6–36.

### Appendix: Derivation of the spread equation
- Context: Derivation uses the model developed by Edwards (1984, 1986) and applied by Akitoby and Stratmann (2008). A risk-neutral investor lends to a given country that is a price-taker in the world capital market.

- Equilibrium condition for the optimal allocation of the investor’s portfolio (equation A.1):
  )1)(1()1( *L rr

  Where:
  - *r is the risk-free world interest rate;
  -  is the probability of default;
  -  is the payment made by the borrower to the lender in the default state; and
  - Lr is the lending rate.

- Spread over the risk-free rate (s = Lr − *r) derived from (A.1) (equation A.2):
  )1( 1 *       r s

- Logistic specification for the probability of default (equation A.3):
   n k kk n k kk Z Z 1 1 exp1 exp   

  Where:
  - kZ are determinants of the probability of default; and
  - k are the corresponding coefficients.

- Combining (A.2) and (A.3), taking natural logarithms, and setting  to zero yields (equation A.4):
   n k kk Z rs 1 * )1(lnln 

- Stochastic model with country and time dimensions and fixed effects to be estimated (equation A.5):
  itiitit Z rs )1(lnln *

  Where:
  - its is the secondary market spread over the risk-free world interest rate in country i at time t;
  - i is a country fixed effect; and
  - it is a Gaussian error term.

*Source: _wp1144 - REFERENCES*

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