Inflation Volatility, Financial Institutions and Sovereign Debt Rating

This study analyzes the impact of reducing inflation volatility versus the impact of improving financial institutions with regard to the country’s sovereign debt rating. An empirical analysis of the impact of inflation, inflation volatility and financial institutions on a country’s sovereign debt rating is undertaken using a sample of 37 developed and developing countries over the period 1989–2006. The study estimates a non-linear rating regression that interacts inflation volatility with an index for financial institutions developed in this paper using the principal component analysis. The results suggest that reducing inflation volatility can have a statistically and economically significant positive effect on a country’s sovereign debt rating as compared to the level of inflation. The results also show that improving financial institutions has a statistically and economically significant positive direct and indirect effect on a country’s sovereign debt rating. A decrease of one standard deviation in inflation volatility leads to an increase of about two classifications in a country’s sovereign debt rating. The increase in sovereign debt rating leads to a reduction in the average annual long-term bond yield by about 4.4%. On the other hand, an increase of one standard deviation in the financial institutions’ index leads to an increase in the ratings class of about one class, which in turn reduces the average annual long-term bond yield by about 4.27%