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We study the effect of a sovereign credit rating change of one country on the sovereign credit spreads of other countries from 1991 to 2000. We find evidence of spillover effects; that is, a ratings change in one country has a significant effect on sovereign credit spreads of other countries. This effect is asymmetric: positive ratings events abroad have no discernable impact on sovereign spreads, whereas negative ratings events are associated with an increase in spreads. On average, a one-notch downgrade of a sovereign bond is associated with a 12 basis point increase in spreads of sovereign bonds of other countries. The magnitude of the spillover effect following a negative ratings change is amplified by recent ratings changes in other countries. We distinguish between common information and differential components of spillovers. While common information spillovers imply that sovereign spreads move in tandem, differential spillovers are expected to result in opposite effects of ratings events across countries. Despite the predominance of common information spillovers, we also find evidence of differential spillovers among countries with highly negatively correlated capital flows or trade flows vis-á-vis the United States. That is, spreads in these countries generally fall in response to a downgrade of a country with highly negatively correlated capital or trade flows. Variables proxying for cultural or institutional linkages (e.g., common language, formal trade blocs, common law legal systems), physical proximity, and rule of law traditions across countries do not seem to affect estimated spillover effects.

During the 1990s a fundamental shift occurred in the nature of cross-country economic linkages. While the trend toward trade liberalization continued, many observers note that financial flows are now the dominant vehicle of interdependence. Capital flows have been central in the crises of the exchange rate mechanism (ERM) in 1992, the Tequila crisis in 1994–1995, and the Asian and the Ruble crises of the latter half of the 1990s. Moreover, at least during crisis periods, cross-country transmission contributes to financial market turmoil beyond individual country borders. In part, because of readily available high frequency data from organized exchanges, studies of financial market spillovers frequently examine co-movements of stock market returns. In the context of contagion, these studies test whether stock market correlations increase during contagious episodes.1 In contrast, this paper contributes to a more recent literature on bond market contagion and spillovers. Empirically, we focus on the transmission of news concerning sovereign credit ratings, to sovereign bonds issued by other countries. As these rating changes occur sporadically throughout our sample period, we can examine the nature of cross-border financial market linkages in both crisis and noncrisis periods. The study of the sovereign bond market offers some obvious advantages. First, sovereign debt serves as the benchmark for all other interest rates in the local economy, e.g., the cost of corporate borrowings, thus developments in this market have wider implications for credit conditions in general. Second, sovereign spreads reflect the default risk of borrowing countries (in addition to other risks, such as liquidity risks). Thus, conceptually, sovereign debt affords a primary channel for the transmission of spillovers of ratings. Our particular focus is on the cross-market spillovers of sovereign credit rating changes. We concentrate on the spillover of a change in the sovereign debt rating or the credit outlook of one country (labeled as the event country) to interest rate spreads (vis-á-vis the interest rate of a U.S. Treasury bond of comparable maturity) on sovereign debt for all other countries (labeled as home countries). Using a daily data set consisting of all publicly traded U.S. dollar denominated sovereign debt, we ask several related questions about observed cross-border spillovers. First, how much do sovereign spreads react to announcements concerning other sovereigns? Second, are the announcement effects asymmetric? Do negative announcements have a quantitatively different impact than positive announcements? Third, do these spillovers have an economic basis? In particular, do historical financial and trade linkages increase or reduce the size of the spillovers? Are spillovers greater between similar countries? Fourth, we explicitly study the impact of cultural or institutional linkages (e.g., common language, formal trade blocs, common law legal systems), physical proximity (distance or adjacency), and rule of law traditions across countries. Finally, we examine whether a sequence of events in separate countries reinforce each other. We make a conceptual distinction between differential versus common information spillovers.2In principle, spillovers between two countries could be either positive or negative. For example, a positive ratings event, such as an explicit upgrade of the credit rating or an improvement in the credit outlook of a country, could signal a widespread common trend, thus leading to a general lowering of interest rate spreads for all other countries. We refer to this as the common information effect. Alternatively, such good news could reveal that the event country has enhanced its attractiveness at the cost of all other countries, resulting in an increase in interest rate spreads in other countries.3We refer to this as the differential effect. Moreover, any given rating event could contain both common information and differential effects. In these cases, we refer to the net impact. Finally, a given ratings change could have differential effects only for a subset of countries. We explicitly test for these cross-sectional effects in our empirical analysis. More formally, we hypothesize that positive (negative) events decrease (increase) sovereign spreads abroad, if the common information effect dominates the differential effect and vice versa. We reach five primary findings. First, we find evidence of spillover effects; that is, a ratings change in one country has a significant effect on sovereign credit spreads of other countries. Second, this effect is asymmetric: positive ratings events abroad have no discernable impact on sovereign spreads, whereas negative ratings events are associated with an increase in spreads. On average, a one-notch downgrade of a sovereign bond is associated with a 12 basis point increase in spreads of sovereign bonds of other countries, assuming a 6% yield on a U.S. Treasury of comparable maturity. Third, despite the predominance of common information spillovers, we find evidence of differential spillovers for countries with highly negatively correlated trade or capital flows (vis-á-vis the United States). Our evidence also suggests that the transmission channel for spillovers is stronger through capital than through trade flow linkages. Fourth, variables proxying for cultural or institutional linkages (e.g., common language, formal trade blocs, common law legal systems), physical proximity, and rule of law traditions across countries do not seem to systematically affect observed spillovers. Fifth, our results support the Kaminsky and Reinhart (2000) assertion that susceptibility to crises is highly nonlinear more generally. In particular, we find that negative spillovers are amplified by recent ratings change activity. Several related lines of research are reviewed in Section 2. We describe our data set in Section 3. In Section 4 we discuss our framework for analyzing spillovers in terms of common versus differential information effects. Section 4 also outlines the testable hypotheses and presents our empirical results. Section 5 concludes.

This paper examines the extent of cross-border financial market linkages by focusing on the transmission of news events (specifically sovereign credit rating changes) concerning one country to sovereign bond spreads in other countries. We show the existence of asymmetric spillovers: positive ratings events abroad have no discernable impact on the sovereign spreads, whereas negative ratings events are associated with an economically meaningful and statistically significant increase in spreads. We present a framework characterizing these spillovers in terms of common information and differential information effects associated with a ratings change. While common information events imply that sovereign spreads move in tandem, differential spillovers are expected to result in opposite effects of ratings events across countries. We find that differential spillovers exist among countries with highly negatively correlated capital flows or trade flows (vis-á-vis the United States). Interest rate spreads in these countries generally fall (relative to other countries) in response to a downgrade of a country with highly negatively correlated capital or trade flows. Our evidence also suggests that the transmission channel for spillovers is stronger through capital than through trade flow linkages. We also confirm the importance of cumulative events, as posited by Kaminsky and Reinhart (2000). In other words, ratings changes should not be viewed as isolated events, and it is appropriate to ask the context in which the change was announced: have there been other similar ratings changes in the past few days? Finally, we explicitly test whether our results stem from time-invariant historical, economic, institutional, cultural, or location-specific factors, or from time-dependent crisis-specific factors. Our conclusions with regard to spillovers remain unaffected. Our paper has numerous implications for future research. For example, the existence of asymmetric spillovers is consistent with a view that rating agencies could be biased in evaluating sovereigns, e.g., through their reluctance to issue low credit ratings (at initiation) or to lower a credit rating in a timely manner. To explore this issue further, one must examine the incentives of the rating agencies in divulging ratings changes in a timely manner. In addition to the extent that large spillovers can be viewed as a precursor to a financial contagion, one can characterize (and possibly forecast) the vulnerability of an economic system to a financial contagion in terms of the aggregate spillovers.