How do sovereign credit ratings help to financially develop low-developed countries?

Abstract:

This paper investigates the importance of having a sovereign credit rating for a country’s financial development. After controlling for endogeneity and selection bias, we compare different aspects of the financial sector and the capital markets of recently rated countries with otherwise similar, but unrated countries. We find that obtaining a sovereign credit rating changes the composition of the assets of domestic banks and leads to a growth in bank assets. With a sovereign rating, the government is less dependent on bank financing and it can tap international bond markets. Banks subsequently provide more credit to the private sector, which translates into riskier debt holdings, resulting in an increase in the banks’ risk-weighted assets. We also show that an initial sovereign credit rating attracts foreign investors, both FDI and portfolio investments. Hence, we conclude that a sovereign credit provision plays a crucial role in enabling the financial development in a country.

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