Institutional Environment and Sovereign Credit Ratings

Abstract

Using a sample of 86 counties, we examine the cross-sectional determinants of sovereign credit ratings around the world. We find that the quality of legal and political institutions of a country plays a vital role in determining sovereign credit ratings. A one standard deviation increase in our legal environment index results in an average credit rating increase of 0.466 standard deviations, even when controlling for obvious factors such as GDP per capita, inflation, foreign debt per GDP, previous defaults, and general development. Indeed, the economic magnitude of a change in each of those variables is less than one-third of that for legal environment. Although part of this effect is due to legal environment's endogeneity, the relative importance of legal environment is robust to endogeneity concerns.

Keywords: Sovereign credit ratings, legal environment, law and finance

JEL Classification: G1, G30