Block and Vaaler (2004)- The Price of Democracy-Sovereign Risk Ratings, Bond Spreads, and Political

Block and Vaaler (2004)- The Price of Democracy-Sovereign Risk Ratings, Bond Spreads, and Political

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The Price of Democracy: Sovereign Risk Ratings, Bond Spreads, and Political Business Cycles in Developing Countries By: Steven A Block and Paul M. Vaaler (2004) Block, Steven A., and Paul M. Vaaler. 2004. “The Price of Democracy: Sovereign Risk Ratings, Bond Spreads, and Political Business Cycles in Developing Countries.” Journal of International Money and Finance. 23: 917-946. Abstract: This study examines the proposition that political business cycle theory is relevant to private foreign lenders to developing countries. We find that: credit rating agencies downgrade developing country ratings more often in election years, and do so by approximately one rating level; bond spreads are higher in the 60 days before an election compared to spreads in the 60 days after an election; spreads trend significantly downward in the 60 days before an election, but then flatten out in the 60 days after an election. Agencies and bondholders view elections negatively increasing the cost of capital to developing democracies. 1. Question: a. Are credit-rating assessment affected by occurrence of elections? b. If so, how? 2. Novel Approach: a. Use PBC to determine how elections affect the ratings of bond companies (instead of how elections and incumbents affect choices used to boost domestic support) 3. Theoretical Foundations: a. Political Business Cycle (PBC) 4. Theory: a. Political Business Cycle Theory (PBC): a.i. INCUMBENTS (there is no talk of opponents) manipulate the monetary and fiscal policies of a country (presidential only) right before elections and then readjust them afterwards in order to gain political support / this makes investors place a risk premium on ratings and on bond spreads a.ii. I have a shitload of problems with this theory, see below (and basically, the entire conclusion says it could definitely be a potential 5. Methods: a. “We examine empirical support for this proposition with data on long-term foreign currency denominated sovereign ratings from agencies, and with data on market determined credit spreads for representative dollar
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denominated sovereign bonds from developing countries holding presidential elections between 1987 and 1999.” 919 b. Ordered-Probit (for 16 pt-ratings score) test 1 b.i. Dynamic Generalized Method of Moments Model (GMM) to deal with lagged variables in fixed-effects model 6. Findings: a. Developing country elections affect their agency credit ratings (reduce rating by 1 on 17-pt scale) b. Developing country elections affect “Bond Spreads” b.i. Bond spreads are at their highest 120 days pre-election and decline “monotonically as election approaches”
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This note was uploaded on 02/03/2012 for the course POLS 5308 taught by Professor Biglaiser during the Spring '11 term at Texas Tech.

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Block and Vaaler (2004)- The Price of Democracy-Sovereign Risk Ratings, Bond Spreads, and Political

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