Do Sovereign Credit Ratings Affect the Composition and Maturity of Sovereign Borrowing?

In this paper, I develop a theoretical model to analyze the optimal choice between bank loans and bond finance for a sovereign debtor. The model describes a market that is subject to moral hazard and adverse selection. I model the choice between the two debt instruments allowing for debt renegotiation in the event of financial distress, with the possibility of default. The model incorporates private monitoring by the banks and public monitoring by the credit rating agencies. I derive the choice of debt instruments with their associated maturity structures endogenously. I find that the reduced cost of information dissemination and large crisis costs of default have increased the willingness of the sovereigns to get themselves publicly monitored. This made it easier for the countries to participate in the bond market. The choice between bank loans and bond finance is thus determined endogenously by the trade-off between two deadweight costs: the crisis cost of a default and the cost of debtor moral hazard. In equilibrium, sovereigns use bank loans for financing short-term projects and issue long-term bonds for projects when crisis costs are large. The predictions of the theoretical model are tested using data from 48 emerging market economies and the rating agencies SP and Fitch Ratings. I find that there are additional informational contents in the sovereign credit ratings over and beyond the traditional macroeconomic factors. As credit ratings for a country improves, they are able to borrow more longterm bonds internationally. JEL Classification: F34; F37; F39; H63