The Impact of Sovereign Credit Rating on International Capital Investment

The three standalone empirical studies that comprise this thesis examine the relationship between sovereign credit ratings and international capital movements. The first two studies (Chapters 2 and 3) focus on foreign direct investments (FDIs), whilst the third study (Chapter 4) examines the use of sovereign credit ratings in global banking regulation and their impact on international capital flows. Study one explores how sovereign credit ratings affect FDIs from developed countries. Study two analyses the impact of sovereign credit ratings as determinants of FDIs from emerging market countries, to both emerging and developed countries. Study three explores the particular impact of Basel II implementation on the relationship between sovereign credit ratings and international capital flows. This thesis identified a number of important findings. First, the key drivers of bilateral FDI flows are the sovereign credit ratings of both donor and recipient countries. In turn, the impact of these ratings on FDIs depends on the market development status (developed or emerging) of both donor and recipients. FDIs generally flow to recipients with high ratings. Specifically, less creditworthy developed countries and high-rated emerging market countries are more likely to invest abroad via FDIs. When distinguishing recipients as developed and emerging market countries, it is evident that high-rated developed countries and low-rated emerging market countries attract more FDIs from developed countries. In contrast, low-rated developed countries and high-rated emerging market countries attract more FDIs from emerging market countries. The second finding to emerge is that sovereign credit ratings have a significant spillover effect on FDI flows, thereby creating a strong neighbourhood effect. Recipient countries tend to receive more FDI inflows if their neighboring countries’ average ratings are high and when other competing regions’ average ratings are low. Thirdly, the use of credit ratings in banking regulation in Basel II reinforces the influence of sovereign credit ratings on international capital flows. In particular, changes in sovereign rating that lead to risk-weight changes discourage all forms of international capital flows after creditor countries adopted the Basel II capital framework. Fourthly, sovereign credit ratings is an important determinant of the composition of international capital investments. In the period since Basel II, risk weight changes prompted by rating upgrades or downgrades have had a beneficial impact. This provides valuable information to investors who can now adjust the composition of their international capital investments to meet the regulatory capital requirements, especially for investment flows to OECD countries. What, then, are the wider implications of the finding of this thesis? First, macroeconomic policies are an important determinant of FDI inflows, especially for emerging market countries. Thus, such policies should be consistent with the aim of achieving and maintaining high sovereign credit ratings. Second, in linking sovereign credit ratings to the literature on the determinants of FDIs, the thesis provides comprehensive empirical investigations to demonstrate that sovereign credit ratings affect corporate investors FDI strategies in developed and emerging market countries. The third study provides guidance to policy makers and regulators on how global banking regulation affects international capital mobility, and can improve our understanding of the unintended consequences of ratings-contingent capital rules on global financial stability