Foreign banks and sovereign credit ratings: Reputational capital in sovereign debt markets
| Published date | 01 March 2020 |
| Author | Jana Grittersová |
| Date | 01 March 2020 |
| DOI | 10.1177/1354066119846267 |
https://doi.org/10.1177/1354066119846267
European Journal of
International Relations
2020, Vol. 26(1) 33 –61
© The Author(s) 2019
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DOI: 10.1177/1354066119846267
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E
JR
I
Foreign banks and sovereign
credit ratings: Reputational
capital in sovereign debt
markets
Jana Grittersová
University of California Riverside, USA
Abstract
Sovereign credit ratings importantly influence the borrowing costs of governments in
international capital markets. Yet, there is limited understanding of how credit-rating
agencies determine sovereign bond ratings. I provide theoretical justification and
empirical evidence to support the proposition that a substantial presence of established
global banks, acting as foreign direct investors, enhances the perceived creditworthiness
of the host countries that have weak domestic institutions. Foreign banks can render
the host countries’ commitments to make good on their debt obligations more credible
by encouraging the transparency in the financial system, disciplining their fiscal policies,
and mitigating the incentives for and impact of bank bailouts. Statistical evidence from
countries in emerging Europe shows that countries with high levels of foreign bank
ownership tend to be assigned better sovereign credit ratings and find it easier to
obtain credit at lower interest rates in sovereign bond markets. My findings are robust
to various estimation techniques, to extensive controls for alternative determinants
of credit ratings, for the endogeneity of foreign bank entry, and for sample-selection
bias. Interviews with bankers and senior analysts at credit-rating agencies were used
to complement quantitative analyses. This article is the first attempt in the literature
on sovereign borrowing and debt to examine whether private market agents, such as
global banks, can enhance the government’s international creditworthiness.
Keywords
Crisis, international finance, global governance, globalization, economic
interdependence, political economy
Corresponding author:
Jana Grittersová, University of California, Riverside, 900 University Avenue, 2230 Watkins Hall, Riverside,
California, USA.
Email: janag@ucr.edu
846267EJT0010.1177/1354066119846267European Journal of International RelationsGrittersová
research-article2019
Article
34 European Journal of International Relations 26(1)
Introduction
Sovereign credit ratings are assessments of a government’s willingness and ability to
repay its sovereign debt. They are estimates of the probability of default. Ratings are a
key determinant of the cost of government borrowing: the higher the perceived sovereign
credit risk, the higher the risk premium in the form of higher interest rates a government
faces in international credit markets. Why do some countries receive more favorable
sovereign credit ratings than others? How can a government convince credit-rating agen-
cies (CRAs) of its intentions to pay the obligations it assumes? In this article, I test the
proposition that multinational banks, acting as foreign direct investors, positively influ-
ence the perceptions of the credit quality of the host country’s sovereign debt by CRAs.
I argue that foreign banks may serve as credibility-building mechanisms. These banks
can render the host country’s commitments to make good on its debt obligations more
credible by disciplining its fiscal policies and mitigating the incentives for and impact of
bank bailouts. Their presence thus creates the perception that the host country will honor
its debt obligations. However, foreign banks can also generate pressures on the host
country’s government to change its behavior by threatening to exit.
Less developed countries, in particular, face a serious challenge in signaling to sover-
eign bond markets that they are creditworthy borrowers (Mosley, 2003). Many of them
have legacies of wars and conflicts, new or weak domestic institutions, and no credit
history; hence, they are unable to signal a credible commitment of their intent and ability
to repay sovereign debt. As these countries have a poor endogenously created reputation
for honoring their promises, they face difficulties in raising money in sovereign bond
markets. Furthermore, when a government lacks credibility in international financial
markets, it will be charged a risk premium in the form of high interest rates to compen-
sate for the risk of default (Gros, 2003: 2).1 The costs of borrowing in sovereign bond
markets matter a lot for capital-scarce transition and developing countries that rely on
foreign funds to finance their general expenses and development projects.
This article contributes to several strands of the International Relations literature.
First, it provides a significant extension of the literature on how countries accumulate
reputational capital in international relations. Reputation is particularly important in sov-
ereign borrowing, in which an enforcement mechanism is limited because collateral in
the sense used in domestic contracts is “irrelevant” (Bulow and Rogoff, 1989).2 In his
influential study, Tomz (2007: 14) argues that reputational concerns in international
lending “motivate countries to repay and inspire investors to lend”; hence, countries
repay their debt to accumulate reputational capital. He develops a dynamic theory of
reputation in which investors continually update their beliefs about the type of govern-
ment they are dealing with. The prior literature has focused predominantly on the repu-
tational costs of sovereign defaults, however. Furthermore, it has ignored the role of
private market agents. Tomz (2007), for instance, sees lenders in sovereign debt markets
as “atomized” actors. This article examines how governments can use foreign private
banks to build their reputation in sovereign bond markets.3
Second, this article also fills the gap in the literature on financial globalization. One of
the liveliest debates in this literature involves the implications of the growing foreign bank
presence for less-developed countries. Before the 2008 global financial crisis, the general
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