In any country, election year is a time when incumbents and hopefuls steeped in the rough and tumble of vote-getting are in urgent need of sporting some successes. Economists often talk of ‘political budget cycles,’ where governments borrow to temporarily gain votes. Needless to say, expenditure stemming from this type of borrowing, more commonly known as ‘pork’, is typically inefficient. In a recent paper, we demonstrate that governments are less likely to borrow in election years if and when major credit rating agencies put them on ‘watch’.
Our findings stem from analyses of credit ratings and government borrowing in 63 developing and developed countries between 2002 and 2011 (building on an earlier paper). We argue that credit ratings discipline fiscal policy in two ways. First, as is well known, credit ratings affect the cost of borrowing. Governments are loath to be downgraded because it will increase the cost of financing new projects or rolling over existing public debt. Second, credit rating downgrades have a signaling character. They are reported widely in the media.
In our sample, rating downgrades in election years are rare. Yet, when they do occur, incumbent governments are 27 percentage points more likely to lose the election. This effect is independent of the actual size of the fiscal deficit or public debt. Credit raters thus do something of a public service for citizens, although perhaps inadvertently: Credit ratings are easily understood expert opinions on a country’s fiscal policy stance—expressed in letter grades. A rating downgrade suggests that a country is less capable of servicing its financial obligations. This is a powerful verdict on the government’s competence. And when that verdict is rendered in an election year, citizens may well use it as a basis for voting the incumbent government out of office.
Before credit rating agencies change their assessment of national solvency conditions, they often provide a public warning by giving the rating a positive or negative watch or outlook. We demonstrate that governments with ratings having a negative outlook are less likely to borrow in election years than those that have stable or positive outlooks. We propose that this is due to governments’ fear of facing higher borrowing costs or having their reputation of economic competence tarnished by an actual downgrade, especially in election years. Our findings are especially strong in poorer countries with weaker credit ratings. Those countries also tend to have more pronounced ‘political budget cycles.’ Our research suggests that these countries may gain particularly from credit ratings, strengthening fiscal responsibility—which in turn creates an enabling environment for reducing poverty and boosting shared prosperity.
However, the reputation of the major for-profit credit agencies has been deeply tarnished following the global financial crisis, wherein they allegedly played a role in the subprime mortgage crisis. Therefore, we believe a strong case can be made for non-profit credit rating agencies. If credit ratings share characteristics of a public good, public institutions may be particularly suited to issuing them. Against this backdrop, the Bertelsmann Foundation recently proposed to set up a non-profit credit rating agency (Incra).
The International Financial Institutions in Washington, the World Bank and the IMF, both already analyze their member countries’ debt sustainability. Turning these assessment into easily understood letter-grade credit ratings—comparable to the AAA & co. ratings we are so familiar with—would not be a big leap.
So, we’re proposing an alternative: what if the World Bank issued credit ratings for government bonds? Perhaps a novel idea, but one worth considering.
Our findings stem from analyses of credit ratings and government borrowing in 63 developing and developed countries between 2002 and 2011 (building on an earlier paper). We argue that credit ratings discipline fiscal policy in two ways. First, as is well known, credit ratings affect the cost of borrowing. Governments are loath to be downgraded because it will increase the cost of financing new projects or rolling over existing public debt. Second, credit rating downgrades have a signaling character. They are reported widely in the media.
In our sample, rating downgrades in election years are rare. Yet, when they do occur, incumbent governments are 27 percentage points more likely to lose the election. This effect is independent of the actual size of the fiscal deficit or public debt. Credit raters thus do something of a public service for citizens, although perhaps inadvertently: Credit ratings are easily understood expert opinions on a country’s fiscal policy stance—expressed in letter grades. A rating downgrade suggests that a country is less capable of servicing its financial obligations. This is a powerful verdict on the government’s competence. And when that verdict is rendered in an election year, citizens may well use it as a basis for voting the incumbent government out of office.
Before credit rating agencies change their assessment of national solvency conditions, they often provide a public warning by giving the rating a positive or negative watch or outlook. We demonstrate that governments with ratings having a negative outlook are less likely to borrow in election years than those that have stable or positive outlooks. We propose that this is due to governments’ fear of facing higher borrowing costs or having their reputation of economic competence tarnished by an actual downgrade, especially in election years. Our findings are especially strong in poorer countries with weaker credit ratings. Those countries also tend to have more pronounced ‘political budget cycles.’ Our research suggests that these countries may gain particularly from credit ratings, strengthening fiscal responsibility—which in turn creates an enabling environment for reducing poverty and boosting shared prosperity.
However, the reputation of the major for-profit credit agencies has been deeply tarnished following the global financial crisis, wherein they allegedly played a role in the subprime mortgage crisis. Therefore, we believe a strong case can be made for non-profit credit rating agencies. If credit ratings share characteristics of a public good, public institutions may be particularly suited to issuing them. Against this backdrop, the Bertelsmann Foundation recently proposed to set up a non-profit credit rating agency (Incra).
The International Financial Institutions in Washington, the World Bank and the IMF, both already analyze their member countries’ debt sustainability. Turning these assessment into easily understood letter-grade credit ratings—comparable to the AAA & co. ratings we are so familiar with—would not be a big leap.
So, we’re proposing an alternative: what if the World Bank issued credit ratings for government bonds? Perhaps a novel idea, but one worth considering.
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