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On Spreads, Ratings and Liquidity

On Spreads, Ratings and Liquidity. Andrew Powell Research Department Inter-American Development Bank Chief Economists Meeting May 17th and 18 th 2007 Washington DC. Plan of the Presentation. Motivation Modeling Ratings Modeling Spreads What Explains Today’s Low Spreads

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On Spreads, Ratings and Liquidity

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  1. On Spreads, Ratings andLiquidity Andrew Powell Research Department Inter-American Development Bank Chief Economists MeetingMay 17th and 18th 2007Washington DC

  2. Plan of the Presentation • Motivation • Modeling Ratings • Modeling Spreads • What Explains Today’s Low Spreads • Do Ratings Matter?

  3. Ratings and Spreads

  4. Modeling Ratings • Several recent papers model ratings and obtain very high R-Squared’s. • But Current Account has the wrong sign and some models include Government Effectiveness… • Debt statistics come in different measures, we prefer: • Tax revenue to total debt (IPES) • Foreign debt to exports • We include OSIN3, and Foreign Currency Debt as % of Total Debt - from Jeanne and Guiscina (2006) and real exchange rate volatility.

  5. Over-rated?Circularity in Explaining Ratings

  6. Over-rated

  7. Some Predictions from the ModelFor end of 2006

  8. Global FactorsThree factors explain 80%of Ratings and Economic Fundamentals

  9. Modeling Spreads • Ratings are a convenient summary for fundamentals • Log Spreads & ratings, a reasonable approximation • We run models with fixed effects, with and without global financial variables: • US Treasury • US High Yield • VIX

  10. Average errors… • The average error across all emerging economies for the final observation is: • 153 (S&P) and 176 (Moody’s) basis points • If we include the financial variables this is reduced to • 22 (S&P) or 41 (Moody’s) basis points

  11. How much do Global Financial Variables Explain: A Variance Decomposition

  12. What Matters: Liquidity or Risk Aversion?

  13. Its Risk Aversion?

  14. EMBI and VIX: High Frequency Data

  15. Opinions Differ

  16. Explaining Rating Differences

  17. Do these opinions matter? • We regress spreads on economic fundamentals and the residuals of the rating regression • The residuals are highly significant • We run a system of spreads and ratings • Ratings are highly significant even with significant fundamentals present in the regression for spreads • But these methods have their limitations • As do “event studies”. • We exploit the differences in opinions…

  18. Difference in Difference Technique

  19. Conclusions • There has been a marked improvement in country fundamentals largely explained by (real) Global Factors • This explains some part of the compression in spreads but we need financial variables to explain the full extent of the fall in spreads • Ratings do appear to matter over and above fundamentals

  20. Thank You!

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