Sovereign Credit Ratings, Transparency and International Portfolio Flows

Abstract:     
We examine the response of equity mutual fund flows to sovereign rating changes in 85 countries from 1996-2002. We find that the response is asymmetric: Sovereign downgrades are strongly associated with outflows of capital from the downgraded country while improvements in a country's sovereign rating are not associated with discernable changes in equity flows. Greater transparency moderates the response, i.e., highly transparent countries experience smaller outflows around downgrades. Moreover, flows around downgrades are consistent with a flight to quality phenomenon. That is, highly transparent non-event countries are net recipients of capital inflows, and these inflows increase with the severity of the cumulative downgrade abroad. The results remain after controlling for country size, legal traditions, market liquidity, crisis versus non-crisis periods, and are invariant to different assumptions regarding the within-month distribution of equity flows, monthly predicted benchmark flows, and persistence of equity flows. Taken together, the results suggest that improving transparency could mitigate some of the perceived negative effects associated with global capital flows.

Keywords: Asymmetric effects, portfolio flows, sovereign rating agencies

JEL Classification: G15, F36, G14

working papers series