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Sovereign Rating Model: Greek Sovereign Rating Worse Than We Deserve

One of the main factors exerting –one could even argue excessive- influence on the decisions and considerations of both policy makers and market participants is the sovereign rating assigned by the main rating agencies to each economy. The significance of sovereign ratings stems from the influence they exert on the ability of each government to issue debt on local and global bond markets as well as on the pricing of this debt. Furthermore, sovereign ratings in most cases impose a ceiling on the ratings of all financial and non-financial corporates, thus affecting both the cost of funding and the cost of capital of the entire economy.

The profound effect of sovereign credit ratings on economic activity is all too well known in the case of Greece, where the downgrade of the Hellenic Republic to below investment grade led to the “financial isolation” of the Greek state from the global financial system. Yet, given that the Greek economy stands once again on the cusp of recovery and the Greek banking system is confident and robust enough to start planning forward for the upcoming three to five years, the rating outlook of the Greek sovereign debt is coming back to the fore with a vengeance. For that reason, we have developed a sovereign rating model that allows us to examine and forecast the credit ratings of the Hellenic Republic – as well as the sovereign rating of a large number of other economies - under various macroeconomic scenarios in an objective and transparent way.

As we have already stated, the ultimate objective of this study is to explain and forecast the credit rating of the Greek Sovereign. To accomplish the above objective we needed to develop a fully-fledged sovereign rating model able to describe the sovereign ratings of more than 120 countries. The main features of our model are:

  • Objectivity: contrary to most rating agencies that base their ratings on both quantitative and qualitative criteria (and delegate the final ratings decision to “Rating Committees”), we used only publicly available data and indicators as inputs to our model.
  • Sensitivity: most agencies pride themselves on the “stability” of their ratings. Instead, we believe that ratings should change when data change. For that reason, we used cross-sectional data (instead of pooled panel data) to allow our ratings to vary at each particular point in time.
  • Non-recursiveness: one way to improve the in-sample performance of the model is to include a lagged dependent variable (in our case past credit ratings) as an explanatory factor. We chose not to go down this road since we desired to identify a pure relationship between macro-factors and ratings.

The main conclusion of our research is that Greece’s actual rating was out of step with macroeconomic fundamentals throughout the period we examine. In the pre-crisis period, rating agencies over-rated Greece perhaps taking into consideration an implicit “positive” premium from Greece’s participation in a strong monetary union such as the EuroArea, its robust banking systems and a history of a strong economic performance. This translated into a rating in the Single-A rating band as opposed to our fundamentals-based rating assessment in the Baa rating band. This “premium” turned negative as the crisis broke out. As a result, Greece is now being penalised for its fundamentals. This penalty is carried over into the future depriving Greece of a rating upgrade into the single-B rating band.

Finally, we run a sensitivity analysis where we examined the evolution of Greece’s sovereign rating under both an adverse and a positive macro scenario for 2016 – 2017. The findings revealed that the size of the “negative premium” currently embedded in Greece’s rating is of such a magnitude that Greece deserves an upgrade to the single-B band even under the pessimist's assumption incorporated in the adverse scenario.