Good Credit Ratios, Bad Credit Ratings: The Role of Debt Structure

Abstract

Why do developing countries have low credit ratings and high risk premia while exhibiting credit ratios that are often much stronger than highly rated developed countries? This paper argues that the inability to borrow internationally in domestic currency and the inability to borrow even at home at long maturities and fixed rates in domestic currency – the so-called original sin – forces countries to opt for dollar debts or short-term domestic currency debts. This makes debt service vulnerable to shocks to the short-term real interest rate and the real exchange rate. The volatility and co-movement of these prices makes debt service volatile and anti-cyclical, increasing drastically at the worst times, thus increasing the probability that a country will not be able to make good on its debt service commitments. The paper presents a theoretical model of risk premia to illustrate the role played by debt structure and shows empirically that credit ratings are robustly related to measures of original sin while they are weakly linked to standard debt ratios. This implies that only lowering debt levels may not be the most effective way of lowering fiscal risk. Debt denomination may be an effective complement. The paper derives some implications for the debate on budget institutions and fiscal rules and proposes a system that targets a risk-adjusted level of debt.