Sovereign Credit Ratings and the Transnationalization of Finance - Evidence from a Gravity Model of Portfolio Investment

It is a matter of debate in how far credit ratings contribute to allocative efficiency or to excessive volatility of asset prices and cross-border capital flows. Yet it is generally taken for granted that ratings play a significant role in the transnationalization of financial relations. That hypothesis is tested in this paper with regard to data on sovereign credit ratings and foreign portfolio investment. A rating-related gravity model of finance is derived from the choice-theoretical framework of Okawa and van Wincoop (2012) and estimated in three stages, based on the IMF's Coordinated Portfolio Investment Survey (CPIS) for the 2000s and unilateral datasets going back to the 1970s. At the first stage, it is explored to which extent the introduction and evolution of sovereign ratings has affected inward portfolio investment stocks and flows in the host countries. At the second stage, it is examined to which extent sovereign ratings predict levels of investors' home bias, as measured by the share of outward portfolio investment holdings in the home countries' portfolios. At the third stage, the focus is set more specifically on rating determinants of the size of bilateral portfolio investment. Evidence for a significant role of credit ratings in the transnationalization of finance is found at all three stages.