Credit Ratings in the Presence of Bailout: The Case of Mexican Subnational Government Debt

Bond ratings have existed for nearly a century, and they have become a matter of public policy concern (Cavallo, Powell and Rigobón 2008). Debt issued by firms, sovereign countries, and subnational governments (SNGs) are regularly rated in industrial countries (Cantor and Packer 1995, 1996).¹ The rating history for less developed countries (LDCs) is shorter. International raters turned their attention to LDCs in the 1980s when agencies started rating LDC sovereign bonds in reaction to several international debt crises. As a result, literature on grading SNGs and sovereign bonds in industrial countries abounds, while for LDCs it is scarce.

Rating agencies have come under scrutiny in regard to their grading of industrial countries and LDCs. For example, the Wall Street Journal (2004) reported that credit ratings in China could be merely guesswork. In the case of sovereign credit ratings, there is a growing body of literature that casts doubt on their role (see, for example, Reinhart 2001 and 2002), especially after the Asian and Argentinean crises of 1997-98 and 2001, respectively. Others have attempted to refine the measurement of risk (Remolona, Scatigna, and Wu 2008; Alfonso 2003). More recently, the credibility of rating agencies has been challenged due to the role of their evaluations in losses associated with the U.S. mortgage crisis.

In this paper, we target the rating technology used by agencies to grade SNGs in LDCs. By using data from the SNG bond market of Mexico, a country with a tradition of bailouts, we analyze how political and financial factors are weighted in the construction of ratings. This case exemplifies the situation in most Latin American countries.

Latin American governments have a long tradition of bailing out SNGs; Bevilaqua and Garcia (2002) document this phenomenon in Brazil, and Sanguinetti and others (2002) do likewise for Argentina. A high bailout probability raises at least two issues: the adequacy of the bond rating process and its purpose. Rating principles should take into account the many differences between industrial and LDC countries (Laulajainen 1999). Typically, developing countries have serious institutional and legal shortcomings (see Inter-American Development Bank 1997). Most relevant, they are very centralized, law enforcement is deficient (La Porta and others 1998), and most of them have just started fiscal decentralization reform, which in many cases has responded more to political pressure than to efficiency-enhancing purposes (see Díaz 2006; Giugalle, Korobow, and Webb 2001). These characteristics are important when rating bonds in their local currencies. For instance, Mexican SNGs are not allowed to issue debt denominated in foreign currency. Such differences call for different rating technologies than those used when rating entities within industrial countries, where many of the aforementioned shortcomings are not present.

Surprisingly, one of the largest states in Mexico, the State of Mexico, has been continuously bailed out since 1995; though this SNG is virtually bankrupt, it still has been assigned an investment grade.² Likewise, Sanguinetti and others (2002) report that the provincial government of La Rioja, Argentina, was bailed out several times previous to the 2001 crisis, and it still continues to receive an investment grading.³ Bond ratings are meant to indicate the likelihood of default (Bhatia 2002).⁴ If SNGs are to be bailed out anytime they face financial problems, then their risk is passed on to the federal government. Thus SNG rates eventually would become similar to those of sovereign debt.⁵ Is this happening in LDCs? If so, then the purpose of rating SNG debt may be arguable.

Rating agency results are puzzling in LDCs since, as pointed out before, they often give high rates to financially bankrupt SNGs. What, then, are agencies actually rating? Are they rating financial soundness or just probability of bailout? Do rating agencies foster market discipline in the presence of implicit guarantees, or do they tend to exacerbate moral hazard problems?⁶ In this article, we try to answer these questions. Bailout events are most frequently the result of political negotiations. Therefore, we focus our analysis on the relevance...