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1 May 2017 CFA Institute Journal Review

Sovereign Debt Ratings and Stock Liquidity around the World (Digest Summary)

  1. Derek W. Johnson, CFA

The authors examine the effects of sovereign bond rating changes on the liquidity of stocks in 40 countries. They find a strong relationship between stock liquidity and negative rating changes. They also find that positive rating changes have no significant effect on liquidity.

How Is This Research Useful to Practitioners?

Much research exists on the effects of sovereign debt downgrades and upgrades on stock movements globally. The authors look at the effects of rating changes on overall stock liquidity. Liquidity can affect not only trading in financial assets but also money flows throughout the general economy. Lending as well as trade is affected. If the sovereign debt acts as a ceiling on all other debt in a country, companies may find it harder to borrow.
The authors examine both credit downgrades and credit upgrades, finding that downgrades affect liquidity much more than upgrades. They note that rating changes can affect stock liquidity through three channels. As financial assets decline after a downgrade, market makers, although providing liquidity, will endure losses in collateral and will eventually reach margin limits. This loss of liquidity can then spread to other firms, inducing liquidity spirals. A second channel occurs when investors rebalance between countries after a rating change, moving liquidity from the downgraded country into a higher-rated country. A third channel is an information link. A downgrade of sovereign debt makes a statement about the economy and government of the country affected. Because downgrades are much less common than upgrades, the authors surmise that the information is asymmetrical, meaning that a downgrade supplies more information about the country’s creditworthiness than an upgrade. Nevertheless, the authors’ research provides support for only the first channel in the relationship between sovereign debt ratings and stock liquidity: Funding constraints of market makers can create a liquidity spiral that spreads to other firms.
At the firm level, the authors find that companies with a higher concentration of ownership or lower liquidity tend to experience negative effects of greater magnitude, whereas firms with higher turnover or a higher return on assets tend to experience smaller decreases in stock liquidity. At the country level, higher stock market capitalization relative to GDP, higher credibility of financial disclosures, and lower risk of outright confiscation or forced nationalization lessen the effects of a downgrade. But the authors also find that civil law origin and higher non-domestic institutional ownership can exacerbate the decline in stock liquidity after a rating change.

How Did the Authors Conduct This Research?

The authors study the effects of sovereign credit rating changes on daily stock liquidity at the firm level for 40 developed and emerging markets from January 1990 through December 2009. They identify key firm-specific and country-level determinants of corporate stock liquidity changes during sovereign credit events. They use rating changes from Standard & Poor’s (S&P), because S&P has been more active than other rating agencies in making rating changes and its changes tend to be unanticipated by the market, usually preceding changes made by other rating agencies. The authors assign different values to various rating events. They assign a zero value to Stable and Watch Developing Outlook because Watch Developing implies only that a change might occur and does not indicate directionality. They assign a value of –0.3 to Outlook Negative and a value of –0.6 to Watch Negative. They assign a zero value to Watch Positive but assign a value of 0.6 to Outlook Positive. The authors find that the rating changes for emerging economies account for 79% of their sample, with the rating changes for developed countries accounting for 21%.

Abstractor’s Viewpoint

Liquidity in the stock market can affect all facets of a country’s economy, from trade to lending to general commerce. Liquidity can also affect a country’s currency if money is rebalanced from a downgraded country to a country with higher ratings. Investors can be better informed about the general outlook of a country’s financial markets, economy, and currency by paying close attention to sovereign rating changes.

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