Market Segmentation Effects in Corporate Credit RatingChanges: The Case of Emerging Markets

Seung Hun Han & Yoon S. Shin & Walter Reinhart &William T. Moore

Received: 20 May 2008 /Revised: 15 October 2008 /Accepted: 12 November 2008 /Published online: 1 December 2008# Springer Science + Business Media, LLC 2008

Abstract We examine stock market reactions to corporate credit rating changes in 26emerging market countries included in the Morgan Stanley Capital International (MSCI)Emerging Market Index. We hypothesize and test the notion that emerging market firms inthe American Depository Receipts (ADRs) markets are more likely to purchase ratings fromthe Big Two (Moody’s and S&P), and that they react more strongly to the announcementsof corporate rating changes by Moody’s or S&P than to those of raters in local markets. Wecompare the effect of credit rating changes of the Big Two in two emerging stock markets:local markets (local currencies) and ADR markets (U.S. dollars). We find significant pricereactions in the ADR markets, and insignificant reactions in local markets, and concludethat there is capital market segmentation in ADR markets for credit rating changes ofemerging market firms. We find evidence that investors react more strongly in the ADRmarkets than local markets because they require higher costs of capital for firms cross-listedboth in the ADR markets and local markets due to greater expected bankruptcy costs andforeign exchange risks of those firms. We also report that stock markets react significantly,not only to rating downgrades, but also to upgrades in the ADR markets.

Keywords Credit ratings . Market segmentation . Emergingmarkets

JEL classification G14 . G15 . G20

J Financ Serv Res (2009) 35:141–166DOI 10.1007/s10693-008-0049-0

S. H. HanInformation & Communications University, Daejeon, Korea

Y. S. Shin :W. ReinhartLoyola College in Maryland, Baltimore, MD, USA

W. T. Moore (*)University of South Carolina, Columbia, SC, USAe-mail: wtmoore@mailbox.sc.edu

1 Introduction

Investment in emerging market1 corporate bonds as well as the issuance of credit ratings byMoody’s and S&P has increased dramatically because of low interest rates in developedcountries, credit quality improvement in emerging market firms, and an apparent decline inrisk aversion of global investors. According to the Wall Street Journal (2007a), emergingmarket corporate debt denominated in foreign currency in 2006 totaled about $110 billion,which is a 20% increase from 2005 and more than two times the amount of emergingmarket government debt issued in foreign currency in 2006. The Wall Street Journal reportsthat corporate bonds in emerging markets provide higher returns compared with the samecredit-quality bonds in developed countries. The Economist( 2007) also reports that afterthe financial crisis in Argentina in 2001, corporate bonds in emerging markets recoveredmore quickly than sovereign ones.

Smith and Walter (2001) argue that credit ratings issued by the Big Two global ratingagencies (Moody’s and S&P2) are critical to global investors in emerging market corporatedebt because (1) financial information in emerging markets is much less transparent than indeveloped markets; (2) there are no reliable financial organizations in emerging marketsthat can certify the eligibility of a particular debt issue for global investors; (3) manyinstitutional investors in the U.S. are not allowed to invest in speculative grade debt3 inemerging markets; and (4) banking regulators use credit ratings for financial regulation andsupervision such as capital adequacy rules (BIS 2000).

Earlier research on credit ratings addresses the question of whether credit rating changesdeliver new information to capital markets in developed countries such as the U.S. andJapan. Using U.S. corporate bond ratings, Hand et al. (1992) find that bond downgradingannouncements by S&P and Moody’s result in a mean 1.12% reduction in firm value. Li etal. (2006) find evidence of a home bias in Japan between global rating agencies (Moody’sand S&P) and local (Japanese) raters (R&I and JCR), and the global raters are moreinfluential than Japanese rating agencies in the Japanese market.

In the present study we examine corporate credit rating changes of the Big Two inemerging markets, whereas previous studies address only the effects of sovereign creditrating changes on stock markets in emerging countries. We also investigate the effect ofcredit rating changes for emerging market firms on two different markets, local markets andADRs, and examine whether there is segmentation between the two markets. We find thatcorporate credit rating changes in emerging markets affect the value of firms only in ADRmarkets, not local markets, thus there is capital market segmentation for the credit ratingchanges of emerging market firms.

1 According to the definition of Pacific Investment Management Company LLC (PIMCO 2004), “theemerging markets comprise those nations whose economies are considered to be developing or emergingfrom underdevelopment, and usually include most or all of Africa, Eastern Europe, Latin America, Russia,the Middle East and Asia excluding Japan. Emerging market debt includes sovereign bonds issued bygovernments as well as fixed income securities issued by public and private companies in emerging marketnations.” This study examines the corporate bonds of the countries included in the Morgan Stanley CapitalInternational (MSCI) Emerging Markets Index. As of December 2006 the MSCI Emerging Markets Indexconsisted of the following 26 emerging market country indices: Argentina, Brazil, Chile, China, Colombia,Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco,Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, Turkey and Venezuela.2 According to the Wall Street Journal( 2003), S&P and Moody’s dominate the world credit services marketwith 79% of combined market share in 2001, followed by Fitch (14%) and other rating agencies (6%).3 According to S&P (Moody’s), investment grade ratings are AAA (Aaa), AA (Aa), A (A), and BBB (Baa),and speculative grade ratings are ratings below BBB (Baa).

142 J Financ Serv Res (2009) 35:141–166

Investors who rely on the credit ratings of Moody’s and S&P in emerging corporate debtmarkets include foreign investors who purchase bonds issued in foreign currencies, inparticular, U.S. dollars, and local investors who buy bonds issued in local currencies. It isreasonable that foreign investors purchase bonds issued by emerging market firms that arewell-known in international capital markets, or firms with less information asymmetrybecause firms in emerging markets have higher risks than those in developed markets.Therefore, foreign investors are more likely to depend on ratings information supplied bythe Big Two, whereas local investors are less likely to rely on global rating agencies. Unlikefirms in the U.S., where money market mutual funds must buy investment-grade debt ratedby at least two of the Nationally Recognized Statistical Rating Organizations (NRSRO),4

firms in emerging markets are not covered by this rule.Emerging market firms with ADRs are more likely to issue foreign currency debt and

obtain ratings from the Big Two because it is more likely that foreign investors are willingto buy bonds issued by firms with ADRs than those without. The Economist (2007) reportsthat the average size of emerging market firms that issue debt in the international capitalmarkets is ten times that of domestic firms that do not issue foreign currency debt.However, we argue that the more international activities emerging market firms with ADRshave, the greater the expected agency costs and bankruptcy costs. It is difficult for U.S.shareholders of ADRs to monitor the managers of emerging market firms, and bankruptcycosts should be high if those firms experience financial distress. Therefore, ADR investorsdemand higher standards for emerging market firms whose shares are trading in the U.S.We also hypothesize that emerging market firms in ADR markets are more likely topurchase ratings from the Big Two, and their values react more strongly to theannouncements of corporate rating changes by Moody’s or S&P than to those in localmarkets.

2 Background and hypotheses

2.1 Credit ratings changes

Evidence regarding corporate credit rating changes shows that rating downgrades affectstock and bond prices negatively, presumably because investors believe that rating agenciesare information specialists capable of assessing the default risks of corporations (see Handet al. (1992), Zaima and McCarthy (1988), Hite and Warga (1997), and Richards andDeddouche (1999)). However, this finding has not yet been found to extend to ratingupgrades, which have benign effects on security prices. Dichev and Piotroski (2001) alsofind negative long-run abnormal stock performance following rating downgrades, but nosignificant abnormal performance following upgrades. Byoun and Shin (2002) examineunsolicited credit rating changes, and find they are more likely to induce significantannouncement period abnormal returns for downgrades but not for upgrades.

4 The designation of NRSRO by the U.S. Securities and Exchange Commission (SEC) enables the ratings ofNRSRO agencies to be used as credible investment guidance by investors such as bond and money-marketmutual fund managers, as well as a crucial financing benchmark by issuers. Only Moody’s, S&P, Fitch,Dominion Bond Rating Service (DBRS), and A.M. Best Co. have NRSRO status as of 2006. The Big Twoand Fitch received NRSRO status in 1975, DBRS obtained the recognition in February 2003, and A.M. Bestin March 2005. Most debt issuers in the U.S. obtain ratings from Moody’s and S&P.

J Financ Serv Res (2009) 35:141–166 143

Shin and Moore (2008) compare Dominion Bond Rating Service (DBRS)5 ratings beforeand after Nationally Recognized Statistical Rating Organizations (NRSRO) designation bythe U.S. Securities & Exchanges Commission (SEC) in February 2003, and investigatewhether there are differences in ratings and valuation effects following designation.6 Theyfind that while stock prices react significantly to rating downgrades of Canadian firms inboth periods, there are no significant stock price reactions for those of non-Canadian firmsfor either period. The results are consistent with the notion that investors react to opinionsof DBRS when the agency changes ratings of Canadian firms because they may believe thatDBRS possesses specialized skills at assessing credit worthiness and default risks for thosefirms, and not because of NRSRO designation per se.

2.2 Capital market segmentation

Capital markets may be segmented due to information asymmetry between local andforeign investors, high transaction costs, foreign exchange risks, political risks, differencesin corporate governance, lack of transparency, regulatory barriers, and governmentconstraints. In segmented capital markets, assets with comparable expected return and riskmay have different required rates of return between local markets and foreign markets evenafter adjusting for foreign exchange risk and political risk (Eiteman et al. 2005).

There are two arguments on the costs of capital associated with the globalization of afirm and capital market segmentation. The first argument is that globalization reduces thecosts of capital. Hughes et al. (1975), Shapiro (1978), and Fatemi (1984) report that U.S.multinational firms face lower costs of equity capital than local firms because theirdiversified international operations reduce systematic risks. Stulz (1999) also argues thatglobalization of a firm lowers the cost of equity capital through diversification ininvestment and financing, improved corporate governance, reduced agency problembetween shareholders and managers due to increased monitoring and lower transactioncosts. Errunza and Miller (2000) document that non-U.S. firms cross-listing their shares inthe U.S. in the form of ADRs reduce the cost of equity capital. In addition, Reeb et al.(2001) find that globalization of U.S. firms reduces the costs of debt financing.

On the other hand, there is an argument that international firms will have higher costs ofcapital due to greater bankruptcy costs, agency costs, political risks, and foreign exchangerisks. Lee and Kwok (1988) and Burgman (1996) argue that U.S. multinational firms havehigher agency costs of debt and lower debt ratios than local firms because of greaterdifficulties in monitoring managers. Reeb et al. (1998) and He and Ng (1998) provideevidence that internationalization increases the cost of equity capital owing to greaterforeign exchange risks, more acute agency problems, and information asymmetry facinginternational firms. Armstrong and Riddick (2000) also suggest that globalization willincreases the cost of equity capital because different bankruptcy laws in each country mayboost the costs of financial distress.

5 Dominion Bond Rating Service, founded in 1976, is a privately owned Canadian credit rating agency.6 Several scholars such as Partnoy (1999, 2001, and 2006) and White (2002), argue that the designation ofNRSRO grants rating agencies monopolistic power, and the influence of raters stems from the designation,not from their specialized skills or knowledge at assessing credit risk. They insist that the SEC providesrating agencies with reputational capital by giving them “regulatory licenses,” i.e. NRSRO designation, andthey contend that the SEC should eliminate NRSRO designation and replace credit ratings with creditspreads.

144 J Financ Serv Res (2009) 35:141–166

Most previous studies compare U.S.-based multinational firms with U.S.-based localfirms. However, when emerging market firms globalize their activities by cross-listing theirshares in the U.S., we expect higher costs of equity capital for those firms. The secondargument implies that, as emerging market firms with ADRs have greater internationalactivities, the greater expected agency costs and bankruptcy costs they face relative to localfirms. It is difficult for U.S. shareholders of ADRs to monitor managers of emerging marketfirms, and bankruptcy costs may be high if those firms experience financial distress.Therefore, ADR investors demand higher standards for emerging market firms whoseshares are trading in the U.S. For example, emerging market firms with ADRs should carrylower debt ratios and higher market capitalization. When credit ratings of emerging marketfirms are changed, we expect greater stock market reactions for firms cross-listed in the U.S. than local firms because the required rates of return of the cross-listed firms should behigher than those of local firms.

2.3 Role of foreign currency ratings and sovereign ratings

Rating agencies assign either local or foreign currency ratings to non-U.S. firms. Whilefirms with bonds denominated in local currencies pay coupons and principal in localcurrencies, firms with bonds denominated in foreign currencies must purchase the foreigncurrencies even when those currencies have high values. There have been more defaults onbonds denominated in foreign currencies than those in local currencies. According to S&P’ssurvey of 113 countries, since 1970 there have been 69 defaults on sovereign debt withforeign currency ratings compared with only 8 defaults for sovereign debt with localcurrency ratings (Fabozzi 2004). We expect stock markets to react more strongly to ratingchange announcements for firms with foreign currency ratings than to those with localcurrency ratings.

More importantly, we argue that small or unknown firms in international capital marketsare more likely to issue debt in local currencies, so they do not need to purchase ratingsfrom the Big Two. On the other hand, firms that issue debt in foreign currencies arebelieved to be large or well-known firms and are more likely to obtain ratings fromMoody’s or S&P to market the debt securities to international investors. Moreover, Ferriand Liu (2002) argue that the information content of corporate credit ratings in emergingmarket countries is much weaker than that in developed countries because of the sovereigncredit rating ceiling effect.7 Hooper et al. (2005) also find that sovereign credit ratingchanges significantly affect equity market indices in both developed and emerging markets,and the impact is much stronger for downgrades, foreign currency debt, emerging markets,and financial crisis periods.

2.4 Hypothesis development

We assume that firms that issue ADRs to raise equity capital in the U.S. are more likely toissue debt in foreign currencies. As a result, we hypothesize that ADR markets react morestrongly than local markets to the announcements of rating changes of emerging market

7 Sovereign ceiling effect is that corporate credit ratings are bound not to exceed their sovereign ratings.Under sovereign credit rating ceiling, the private information of firms is less important because sovereignratings have significant effect on corporate ratings.

J Financ Serv Res (2009) 35:141–166 145

firms by S&P and Moody’s. We also hypothesize greater sensitivity of stock returns for U.S. investors compared to local investors due to the existence of capital market segmentationin ADR markets with regard to rating changes of emerging market firms. It is more likelythat firms with ADRs are large or well-known, issue debt in foreign currencies, and obtainratings from the Big Two. Most importantly, they are more likely to default than firms withlocal currency debt because the former need to purchase foreign currencies to pay backforeign currency-denominated debt, and cross-listed firms should experience higherexpected bankruptcy costs, agency costs, and foreign exchange risks.

We examine other arguments discussed in previous studies as well. Erb et al. (1999)argue that country risk affects bond prices in emerging markets and show that country riskis reflected in yields and bond returns. We argue that country risk also affects stock returnsof firms in emerging markets; i.e., stock markets react more strongly to rating changeannouncements for firms located in high-risk countries than to those in low-risk countries.Hooper et al. (2005) find that sovereign credit rating changes more strongly affect equitymarket indices in emerging markets during financial crises. Therefore, we argue thatsovereign credit rating changes that are contemporaneous to corporate rating changes affectstock returns of emerging market firms.

According to Moody’s (2007), banks employ different ratings methodologycompared with non-financial firms because banks enjoy government support duringfinancial crises. In addition, in their study of banking and currency crises, Kaminsky andReinhart (1999) and Staikouras (2004) argue that a banking crisis usually precedes acurrency crisis and the currency crisis aggravates the banking crisis, resulting in aferocious spiral of financial crises. Hutchison and Noy (2005) report that a banking crisisreduces Gross Domestic Products (GDP) by about 10% over 2–4 year crisis periods.Because most of downgrades in our study occur during financial crises, we investigatethe market segmentation hypothesis for both all firms and non-financial firms, sep-arately. We expect that stock markets react more strongly to rating change announce-ments of financial firms than of non-financial firms due to more volatility of financialfirms in the crisis periods.

Furthermore, consistent with results documented in earlier studies, we hypothesizethat stock markets react more strongly to rating change announcements of firms withspeculative grade, than to those with investment grade. In addition, based on theargument of Smith and Walter (2001) and BIS (2000), we hypothesize that Moody’s ismore influential in Asia, and that S&P is more influential in Latin America. By dividing26 countries included in the MSCI Emerging Markets Index into four regions, weinvestigate the influence of the Big Two in Asia and Latin America. Asia is composed ofeight countries (China, India, Indonesia, Korea, Malaysia, Philippines, Taiwan, andThailand); Latin America, seven (Argentina, Brazil, Chile, Colombia, Mexico, Peru, andVenezuela); Eastern Europe, four (Czech Republic, Hungary, Poland, and Russia); andthe Middle East and Africa, 7 (Egypt, Israel, Jordan, Morocco, Pakistan, South Africa,and Turkey).

3 Our data

Credit rating changes of emerging market corporate bonds are obtained fromBloomberg. These are long-term credit ratings of public corporations in local or foreigncurrencies from 1990 to 2006. Municipal credit ratings, ratings of private corporations,and short-term ratings are excluded from the sample. Both the MSCI Emerging Markets

146 J Financ Serv Res (2009) 35:141–166

Index and respective local stock market indices is used as the market portfolio,8 and themarket indices and daily stock return data in emerging market countries are obtainedfrom Datastream. We collect daily ADR prices and firm characteristics data for eachrated company from the Center for Research in Securities (CRSP) database andWorldscope, respectively.

Table 1 describes the number of firms rated by Moody’s and S&P for each countryincluded in the MSCI Emerging Markets Index and the year that the Big Two startedsovereign or corporate ratings. Moody’s rated 589 firms and S&P 632 as of 2006, while321 firms have ratings in both agencies (Panel A). More than 50% of emerging marketfirms have dual ratings from the Big Two. Moody’s assigned more firms in Latin America(Moody’s 246 vs. S&P 243), but S&P assigned more in Asia (Moody’s 199 vs. S&P 239),in Eastern Europe (88 vs. 92), and Middle East and Africa (56 vs. 58). In Asia, bothagencies assigned the largest number of corporate ratings to Korean firms (44 vs. 43), inLatin America to Brazilian firms (88 vs. 62), in Eastern Europe to Russian firms (50 vs.61), and Middle East and Africa to Turkish firms (21 vs. 19).

Panel B shows the year that the Big Two began assigning ratings in emerging markets. Itis interesting that Moody’s began assigning corporate ratings in seven countries includingIndia, Philippines, Taiwan, and Mexico, and S&P began in five countries. The majority ofratings were initiated during the 1980s and 1990s except for the Philippines (1977) andVenezuela (1977). The Big Two entered Asian and Latin American markets first, and thenexpanded to other regions.

Table 2 illustrates the downgrades (Panel A) and upgrades (Panel B) of emerging marketfirms from 1990 to 2006. There are very few rating changes until 1994 because the BigTwo did not penetrate most emerging corporate debt markets even after 1990. For ratingdowngrades of Asian firms, 71% of downgrades (567) occurred during the period of theAsian financial crisis (1997 and 1998). Regarding downgrades of Latin American firms,Moody’s and S&P announced 62% of downgrades (694) during the period of the Argentinefinancial crisis (2001 and 2002). Out of 145 downgrades in Eastern Europe, 59% (86)centered on the Russian financial crisis of 1998. The data confirm that rating downgradesare linked noticeably to overall business and market conditions. In addition, the fact that theBig Two concentrated 88% of downgrades (1,924) out of 2,180 total downgrades on Asianand Latin American firms confirms that the two regions are important markets for Moody’sand S&P compared with other regions such as Eastern Europe and Middle East.

For rating upgrades in Panel B, the fact that 74% of upgrades (1,562) out of a total 2,106were clustered around Asian and Latin American firms bolsters the findings in Panel A.Moreover, the majority of rating upgrades in Asia (428) and Latin America (427) out of 746and 816 total upgrades in the regions, respectively, occurred after 2002, corresponding toeconomic recovery in the two regions beginning at that time. Even though S&P is moreactive than Moody’s in downgrades, the frequencies of rating upgrades for Moody’s andS&P are similar. For instance, for 2,180 total downgrades, the Moody’s was responsible for964 (44%), while S&P announced 1,216 (56%). However, for the 2,106 upgrades, Moody’sannounced 1,040 (49%) while S&P announced 1,066 (51%).

Table 3 reports the distribution of rating changes by rating scales. Out of 2,180 ratingdowngrades, 1,574 (72%) are downgrades within speculative grades. Credit ratings BBB-(Baa3) and above for S&P (Moody’s) are defined as investment grade, and those below

8 We use both the MSCI Emerging Markets Index and respective local stock market indices as the marketportfolio because several local stock market indices such as Egypt, Jordan and Morocco are not available inthe Datastream.

J Financ Serv Res (2009) 35:141–166 147

BBB- (Baa3) are speculative grade. Within speculative grade, S&P (882) has moreobservations than Moody’s (692), and Latin America has the largest number of downgrades(966). In addition, for rating upgrades in Panel B, observations within speculative grades(1,241) consist of the largest percentage (59%) out of 2,106 total upgrades. From the data inTable 3, we infer that emerging market firms have relatively high credit risks because theportion of rating changes within investment grade is very small (16% for downgrades and29% for upgrades, respectively).

Table 4 describes financial variables as of fiscal year 2006. The financial variables MC(Total Market Capitalization), Debt Ratio (Total Debt/Total Assets), Profitability (Net

Table 1 Number of firms rated by Moody’s and S&P for countries included in the MSCI emerging marketsindex and the year that the big two started credit ratings. The number of firms rated by Moody’s and S&Pand the year that the big two started credit ratings in the emerging markets come from Bloomberg database.Twenty-six countries in the table are included in the MSCI emerging markets index. aComposed of firmswhich issued long-term credit ratings of public corporations in local or foreign currencies from 1990 to 2006.bRepresents that Moody’s or S&P started assigning corporate credit ratings first rather than sovereign creditratings

Country Number of firms rateda Both Year started ratings

Moody’s S&P Moody’s S&P

Asia China 17 19 12 1988 1992

India 23 24 10 1982b 1992

Indonesia 33 40 21 1994 1992

Korea 44 43 32 1986 1988

Malaysia 20 18 11 1986 1990

Philippines 22 27 16 1982b 1977b

Taiwan 16 42 12 1987b 1992

Thailand 24 26 14 1989 1989

Subtotal 199 239 128

Latin America Argentina 48 61 28 1986 1993

Brazil 88 62 33 1986 1994

Chile 21 26 15 1993 1982b

Colombia 8 15 4 1993 1993b

Mexico 61 66 39 1982b 1992

Peru 6 7 3 1996 1997b

Venezuela 14 6 3 1987 1977

Subtotal 246 243 125

Eastern Europe Czech Republic 7 11 2 1993 1993

Hungary 12 6 3 1989 1992

Poland 19 14 10 1993b 1995

Russia 50 61 30 1996 1996

Subtotal 88 92 45

Middle East & Africa Israel 9 9 6 1986b 1992

Jordan 3 0 0 1995 1995

Pakistan 3 5 0 1994 1991b

Turkey 21 19 9 1992 1994

Egypt 7 9 2 1996 1997

Morocco 0 2 0 1998 1998

South Africa 13 14 6 1982b 1994

Subtotal 56 58 23

Total 589 632 321

148 J Financ Serv Res (2009) 35:141–166

Tab

le2

Descriptiv

estatisticsof

ratin

gdowngradesandupgrades

byyear

andregion.The

downgradesandupgrades

ofem

erging

marketfirm

sarecollected

from

Bloom

berg

database

from

1990

to20

06.T

here

are26

countriesin

Asia,Latin

America,Eastern

Europe,andMiddleEastandAfrica,andthey

areinclud

edin

theMSCIem

erging

markets

index.

Allratin

gchangesarethelong

-term

creditratin

gchangesof

public

corporations

inlocalor

foreigncurrencies

from

1990

to20

06

Region

Agency

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

Total

Ratingdowngrades

Asia

Moody

’s4

90

00

61

159

163

66

96

910

143

405

S&P

00

01

00

287

158

3212

3831

146

98

398

Subtotal

49

01

06

3246

321

3818

4737

2316

2311

803

Latin

America

Moody

’s0

00

12

78

567

458

150

9235

106

9445

S&P

00

00

416

26

2484

32276

176

383

69

676

Subtotal

00

01

623

1011

91129

40426

268

7313

1218

1,121

Eastern

Europe

Moody

’s0

00

00

00

043

31

41

03

55

65

S&P

00

00

00

01

437

07

35

72

580

Subtotal

00

00

00

01

8610

111

45

107

10145

MiddleEast&

Africa

Moody

’s0

00

02

03

138

00

142

11

41

49

S&P

00

00

00

14

73

129

75

12

262

Subtotal

00

00

20

417

153

143

96

26

3111

Total

49

02

829

17275

513

180

60527

318

107

4148

422,180

Ratingupgrades

Asia

Moody

’s0

00

23

60

132

4547

2238

5535

4158

367

S&P

10

00

23

110

1429

1522

4338

66108

27379

Subtotal

10

02

59

123

1674

6244

8193

101

149

85746

Latin

America

Moody

’s0

00

03

33

258

5655

3720

1845

8068

421

S&P

00

03

07

140

411

4834

3125

7158

62395

Subtotal

00

03

310

465

1267

103

7151

43116

138

130

816

Eastern

Europe

Moody

’s0

00

00

00

37

159

1916

2110

3926

165

S&P

00

00

01

13

29

1120

1730

1843

48203

Subtotal

00

00

00

06

924

2039

3351

2882

74368

MiddleEast&

Africa

Moody

’s0

00

00

00

70

06

127

813

277

87

S&P

00

00

01

01

95

171

120

1514

589

Subtotal

00

00

01

08

95

2313

828

2841

12176

Total

10

05

820

5102

46170

208

167

173

215

273

410

301

2,106

J Financ Serv Res (2009) 35:141–166 149

Income/Total Sales), and MB (Market-to-Book Ratio) are considered important variables indetermining credit ratings. We test the hypothesis that means of the variables are equal forMoody’s and S&P. Except for Debt Ratio (t=3.5381), the variables representing firmquality rated by Moody’s and S&P are similar. Differences in mean Debt Ratio for Asianfirms are significant at the 1% level (t=2.946), however, for the most part, the quality ofrated firms between the Big Two is similar. On average, the mean Debt Ratios of emergingmarket firms (0.76 for Moody’s and 0.68 for S&P) are higher than those of U.S. firms.

4 Empirical findings

To examine the influence of the Big Two on rating announcement effects on stock values inemerging markets, we estimate announcement period cumulative abnormal returns (CARs)following the method of Boehmer et al. (1991).9 Parameters of the market model or market-adjusted model in emerging market countries are estimated using Datastream daily pricedata for the estimation period (t=−255, −30) relative to the announcement date of ratingchanges (t=0). Parameters of the market or market-adjusted model for ADRs of emergingmarket firms are estimated using the Center for Research in Securities Prices (CRSP) dailystock prices and value-weighted market index for the same estimation period relative to theannouncement date (t=0). We calculate the CARs for 3-day window (t=−1, +1), 11-daywindow (−5, +5), and 21-day window (−10, +10) relative to the announcement date (t=0).

Table 3 Distribution of rating changes by rating scales. The rating changes of Moody’s and S&P are fromBloomberg database. Credit ratings BBB- (Baa3) and above for S&P (Moody’s) are defined as investmentgrade and those below BBB- (Baa3) speculative grade. There are 26 countries in Asia, Latin America,Eastern Europe, and Middle East and Africa, and they are included in the MSCI Emerging Markets Index.All rating changes are the long-term credit rating changes of public corporations in local or foreign currenciesfrom 1990 to 2006. For rating downgrades, S to S means downgrades from speculative to speculative; I to Sfrom investment grade to speculative grade; and I to I from investment grade to investment grade. For ratingupgrades, S to S means upgrades from speculative to speculative; S to I from speculative grade to investmentgrade; and I to I from investment grade to investment grade

Downgrades Upgrades

Region Agency S to S I to S I to I Total S to S S to I I to I Total

Asia Moody’s 200 86 119 405 166 62 139 367

S&P 206 79 113 398 158 47 174 379

Subtotal 406 165 232 803 324 109 313 746

Latin America Moody’s 392 22 31 445 319 31 71 421

S&P 574 53 49 676 282 53 60 395

Subtotal 966 75 80 1,121 601 84 131 816

Eastern Europe Moody’s 58 2 5 65 63 29 73 165

S&P 66 4 10 80 151 20 32 203

Subtotal 124 6 15 145 214 49 105 368

Middle East & Africa Moody’s 42 1 7 50 48 7 32 87

S&P 36 7 18 61 54 6 29 89

Subtotal 78 8 25 111 102 13 61 176

Total 1,574 254 352 2,180 1,241 255 610 2,106

9 The method of Brown and Warner (1980) provides the similar results.

150 J Financ Serv Res (2009) 35:141–166

In particular, we look at long event windows such as 11- and 21-day windows because thetime of stock market transactions differs between the ADR markets and most of the localmarkets due to different time zones. We eliminate observations with other informationreleases appearing in the Lexis-Nexis database within five trading days (t=−2, +2) aroundthe announcement date. This includes information on earnings or credit rating changes byother agencies.10 We look at mean cumulative abnormal returns (CARs) and their statisticsin the announcement period between local markets and ADR markets for emerging marketcorporations.

To examine the hypothesis of capital market segmentation, we estimate the followingregression model of announcement period abnormal returns for rating downgrades andupgrades separately. Employing Total Market Capitalization (MC) and Debt Ratio(DEBT) as control variables that affect stock returns, we specify the following regressionmodel:

CAR ¼ b1þ b2 MCþ b3 DEBTþ b4 MDþ b5 SOVþ b6 CONþ b7 SPECþ" ð1ÞIn Eq. 1, CAR=cumulative abnormal return for the 3-day window (−1, +1); MC=natural

log of total market capitalization; DEBT=Total Debt/Total Assets; MD=1 if a rating isassigned by Moody’s and 0 otherwise; SOV=sovereign credit rating on the date of

10 We report the results of only clean samples, not contaminated by other information releases within fivetrading days (t = −2, +2) around the announcement date. The empirical results of contaminated samples aresimilar to those of clean samples and are available upon request.

Table 4 Descriptive statistics of emerging market firms rated by Moody’s and S&P. The financial variablesare from data available from Worldscope as of 2006 fiscal year. There are 26 countries in Asia, LatinAmerica, and other regions, and they are included in the MSCI Emerging Markets Index. The financialvariables are MC (total market capitalization), debt ratio (total debt/total assets), profitability (net income/total sales), and MB (market-to-book ratio). Units for MC are in millions of US dollars. N number ofobservations, SD standard deviation. We use two sample t-tests assuming equal variances

Variables Moody’s S&P t-statistics

Mean SD N Mean SD N

All MC 5,351.62 10,392.37 154 5,132.99 9,713.60 208 0.2055

Debt ratio 0.76 0.24 184 0.68 0.25 244 3.5381***

Profitability 0.13 0.15 184 0.13 0.18 246 0.0008

MB 2.07 1.73 155 2.66 8.21 210 −0.8787Asia MC 6,466.29 12,727.25 88 5,835.91 11,422.06 126 0.3789

Debt ratio 0.80 0.24 99 0.71 0.25 140 2.946***

Profitability 0.13 0.16 99 0.13 0.17 141 0.019

MB 1.94 1.20 87 1.84 1.99 126 0.425

Latin America MC 3,454.77 5,669.46 50 3,769.22 6,512.80 58 −0.2655Debt ratio 0.72 0.22 59 0.66 0.23 69 1.6362

Profitability 0.12 0.14 59 0.13 0.24 70 −0.3742MB 1.89 1.56 52 4.45 14.95 60 −1.2249

Other regions MC 5,148.63 6,147.03 16 4,738.41 5,240.94 24 0.2263

Debt ratio 0.68 0.27 26 0.58 0.24 35 1.4847

Profitability 0.18 0.10 26 0.15 0.10 35 1.0745

MB 3.31 3.49 16 2.46 2.30 24 0.9321

*p=0.10; **p=0.05; ***p=0.01

J Financ Serv Res (2009) 35:141–166 151

corporate rating changes11; CON=1 if corporate rating changes occur concurrently withsovereign credit rating changes during the event window (−1, +1) and 0 otherwise; SPEC=1 if rating downgrade (upgrade) is from speculative grade to speculative or investment(speculative) grade to speculative (investment) grade, and 0 otherwise. We estimate Eq. 1separately for rating upgrades as well.

With the indicator variable MD, we test whether Moody’s is more influential than S&P.Since previous studies report that sovereign credit ratings at the time of corporate ratingchanges affect stock returns of emerging market firms, we investigate the relationshipbetween sovereign credit ratings and corporate ratings with indicator variables SOV andCON. SOV reflects the business cycle at the time of corporate rating changes while CONreveals the influence of sovereign rating changes on corporate rating changes.12 If thecoefficient for CON is significant, stock returns are influenced by sovereign rating changes,not corporate rating changes. SPEC is added to confirm previous findings that ratingchanges within speculative grades are more significant than those within investment grades.

Tables 5 and 6 contains the mean CARs and associated z-statistics for rating changes inADR markets (U.S dollars) and local markets (local currencies) for each window. Panel Areports local market reactions for all firms and non-financial firms and Panel B, ADRmarket reactions.13 In addition, the results of both local market indices and MSCI index aredocumented in Panel A. In the case of local market indices in Panel A, the 501 downgradesof all firms have mean CARs ranging from −1.16% for the 3-day window to −2.66% for the21-day window, and for all windows the returns are significant at the 1% and 5% levels,respectively. When we use MSCI index for all firms, although the 3-day window issignificant at the 1% level (z=−3.5711), longer windows are not significant at any level.For non-financial firms in local markets, no event window is significant at any level.

On the other hand, with regard to the downgrades of ADR markets in Panel B, all eventwindows are significant at the 1% level whether we separate non-financial firms from thefull sample or not. For instance, the downgrades of the Big Two have mean CARs rangingfrom −2.40% (z=−4.009) for event window (−1, +1) to −4.92% (z=−3.680) for eventwindow (−5, +5) and −11.07% (z=−5.676) for event window (−10, +10). We conclude thatmarket reactions in ADR markets for downgrades are much stronger than those in localmarkets, and the value of non-financial firms in local markets is not affected by ratingchanges except event window (−1, +1).

For upgrades in local markets, all event windows are not significant whether we uselocal market indices or MSCI index. The negative and significant results for upgradesduring the event windows of (−5, +5) and (−10, +10) with MSCI index are puzzle. In thecase of upgrades in ADR markets (Panel B), the 217 events for all firms have mean CARsof 0.29%, 0.80%, and 1.14% in each event window of (−1, +1), (−5, +5), and (−10, +10),and the values are significant at the 10% level (z=1.539) for the 3-day window and at the

12 CON demonstrates that a sovereign rating is changed at the event window (−1, +1) of corporate ratingchange announcement.

11 A sovereign credit rating is the credit rating of a specific country and it is converted into a numeric rating:AAA (Aaa) = 17, AA + (Aa1) = 16, AA (Aa2) = 15, AA- (Aa3) = 14, A + (A1) = 13, A (A2) = 12, A- (A3) =11, BBB + (Baa1) = 10, BBB (Baa2) = 9, BBB- (Baa3) = 8, BB + (Ba1) = 7, BB (Ba2) = 6, BB- (Ba3) = 5, B +(B1) = 4, B (B2) = 3, B- (B3) = 2, from CCC (Caa) to C = 1, and SD = 0.

13 For ADR markets, out of 2,106 (2,180) total upgrades (downgrades) in Table 2, stock prices for 271 (232)upgrades (downgrades) are available in the CRSP. Only clean samples of 217 (154) upgrades (downgrades)are adopted in Table 5. For local markets, out of 2,106 (2,180) total upgrades (downgrades) in Table 2, stockprices for 775 (716) upgrades (downgrades) are available in the Datastream. Only clean samples of 676(502) upgrades (downgrades) are adopted.

152 J Financ Serv Res (2009) 35:141–166

5% level for the 11- and 21-day windows (z=2.313 and 1.905). Moreover, upgrades fornon-financial firms in ADR markets are also significant in the windows of (−5, +5) and(−10, +10). Thus, contrary to the findings in local markets, upgrades in ADR marketschange firm values. The finding that upgrades have a significant effect on ADR prices foremerging market firms differs from previous studies in developed markets. In addition,these findings suggest that rating changes by the Big Two have more significant effect onequity values in ADR markets than those in local markets without regard to financial ornon-financial firms.

According to Hooper et al. (2005), sovereign credit rating changes affect equity marketindices in emerging markets. As a result, we hypothesize that sovereign credit ratingsconcurrent with corporate rating changes affect stock returns of emerging market firms.Therefore, we separate corporate rating changes concurrent with sovereign rating changesfrom corporate rating changes that are not contemporaneous with sovereign rating changes.

Table 5 Mean cumulative abnormal returns (CARs) and Z-statistics for rating changes in local markets. Therating changes of Moody’s and S&P are from Bloomberg database. Daily local stock prices are fromDatastream database, and we calculate market-adjusted returns with the MSCI Emerging Market Index andthe Datastream Local Market Indices. Z-statistics are provided in all parentheses. N is the number ofobservations, and contaminated observations are excluded in the sample

Window Change Local markets: all firms Local markets: non-financial firms

Local market index MSCI index Local market index MSCI index

(−1, +1) Down −1.16% (−3.5649)*** −0.95% (−3.5711)*** −0.55% (−0.3534) 0.20% (0.1178)

N=501 N=502 N=195 N=204

Up 0.02% (0.1438) 0.18% (1.1755) 0.09% (0.3975) −0.38% (−0.7689)N=673 N=676 N=333 N=344

(−5, +5) Down −1.48% (−2.0463)** 0.1% (0.1062) −0.62% (−0.3081) 2.04% (0.8537)

N=501 N=502 N=195 N=204

Up −0.99% (−1.2893) −1.31%* (−1.7261) −0.07% (−0.1339) −0.10% (−0.1827)N=673 N=676 N=333 N=344

(−10, +10) Down −2.66% (−2.8162)*** −0.49% (−0.4101) −2.51% (−1.0945) 1.33% (0.5275)

N=501 N=502 N=195 N=204

Up −2.33% (−1.6376) −2.27%* (−1.6550) −0.56% (−0.8546) −0.27% (−0.3799)N=673 N=676 N=333 N=344

*p=0.10; **p=0.05; ***p=0.01

Table 6 Mean cumulative abnormal returns (CARs) and Z-statistics for rating changes in ADR markets. Therating changes of Moody’s and S&P are from Bloomberg database. Daily ADR prices are from CRSP, andwe calculate market-adjusted returns with CRSP equally weighted market index. Z-statistics are provided inall parentheses. N is the number of observations, and contaminated observations are excluded in the sample

Event

window

All firms Non-financial firms

(−1, +1) (−5, +5) (−10, +10) (−1, +1) (−5, +5) (−10, +10)

Down −2.40%(−4.009)***

−4.92%(−3.680)***

−11.07%(−5.676)***

−2.40%(−4.274)***

−4.82%(−3.462)***

−11.25%(−5.464)***

N=154 N=154 N=154 N=142 N=142 N=142

Up 0.29%

(1.539)*

0.80%

(2.313)**

1.14%

(1.905)**

0.23%

(1.049)

0.85%

(2.117)**

1.25%

(1.757)**

N=217 N=217 N=217 N=188 N=188 N=188

*p=0.10; **p=0.05, ***p=0.01

J Financ Serv Res (2009) 35:141–166 153

The former includes corporate rating change announcements concurrent with the sovereignrating change announcements and is equivalent to the definition of CON in Eq. 1.

Table 7 describes mean CARs of corporate rating change announcements concurrent withsovereign rating change announcements in ADR (Panel A) and local markets (Panel B andC). The CON column examines corporate rating changes concurrent with sovereign ratingchanges in the event windows of (−1, +1), (−5, +5), and (−10, +10). The PURE columncontains observations not included in CON. For rating downgrades in ADR markets (PanelA), regardless of all firms or non-financial firms, both CON and PURE samples are generallysignificant at the 1% level, which implies that sovereign rating changes do not affectcorporate rating changes. For example, with regard to non-financial firms, while CON samplehas mean CARs ranging from −2.08% (z=−2.328) for event window (−1, +1) to −11.95%(z=−2.940) for event window (−10, +10), the mean CARs of PURE sample spans from−2.63% (z=−3.833) to −10.72% (z=−5.608) for the corresponding event windows.

Moreover, for rating upgrades in ADR markets, none of CON upgrades is significant inany event window. Only PURE observations for all firms are significant at the 1% or 5%level in every event window. For instance, the 160 upgrades of PURE observations for the3-day window have mean CARs of 0.50% (z=1.796), and the value is significant at the 5%level. For non-financial firms, PURE events in the windows of (−5, +5) and (−10, +10) aresignificant at the 5% and 10% levels, respectively. We conclude that the market’s reactionto upgrades from PURE events is stronger than that from CON events in ADR markets. Thefindings indicate that, regardless of the announcements of sovereign rating changes, theannouncements of corporate rating changes affect stock returns in ADR markets.

The findings in local markets (Panel B and C) differ from those in ADR markets. Forupgrades in local markets, regardless of market indices, none of the PURE events or CONevents for all firms or non-financial firms is significant for every event window. Thenegative and significant results for the upgrades of all firms in the event windows of (−5,+5) and (−10, +10) are puzzle and not consistent with our intuition. On the other hand,although the downgrades of PURE observations do not affect stock returns in general, thedowngrades of CON observations for MSCI index have mean CARs of −1.65% (z=−2.784)for event window (−1, +1) for all firms, which is significant at the 1%. When we employlocal stock market indices for downgrades (Panel C), CON effects are also significant for allfirms. No downgrades are significant for non-financial firms. With regard to all firms fromthe 3-day event window to 21-day window, the mean CARs ranges from −1.12% (z=−1.7435) to −3.62% (z=−2.5710), and they are significant at the 10% and 5% levels,respectively. The results imply that the severe stock market reactions in local markets to theannouncements of corporate rating downgrades are attributed to concurrent announcements ofsovereign rating downgrades. After adjustment for sovereign rating downgrades, corporatedowngrades do not affect stock returns in local markets. We summarize our evidence asconsistent with capital market segmentation in corporate rating changes in ADR markets.

Cross-sectional estimation results are reported for both upgrades and downgrades inTable 8 for the rating downgrades and upgrades of all firms. We test the full version of Eq.1 in the ADR markets (Panel A) as well as local markets (Panel B and C) along with MSCIindex and local market indices. In the ADR markets, for upgrades, only SPEC variable issignificant at the 10% level. For example, rating upgrades within speculative grades orspeculative to investment grades have more severe price reactions than those withininvestment grades (t=1.91). On the other hand, for rating downgrades in the ADR markets,there are no significant relationships between stock returns and the independent variables.

In Panel B and C, the results in local markets are not much different from those in ADRmarkets. In general, we do not find any significant relationship between the independent

154 J Financ Serv Res (2009) 35:141–166

Tab

le7

MeanCARsof

ratin

gchange

announcementsconcurrent

with

sovereignratin

gchange

announcements.CON

isdefinedas

corporateratin

gchangesconcurrent

with

sovereignratin

gchangesin

theeventwindo

w(−1,

+1).PUREisobservations

notincluded

inCON.The

ratin

gchangesof

Moody’sandS&Parefrom

Bloom

berg

database.

Daily

localstock

prices

arefrom

Datastream

database,and

wecalculatemarket-adjusted

returnswith

theMSCIem

erging

marketindex

andtheDatastreamlocalm

arketindices.

Daily

ADR

prices

arefrom

CRSP,

andwecalculatemarket-adjusted

returnswith

CRSPequally

weightedmarketindex.

Z-statisticsareprovided

inallparentheses.N

isthe

numberof

observations,andcontam

inated

observations

areexcluded

inthesample

Event

window

Allfirm

sNon-financial

firm

s

Upgrades

Dow

ngrades

Upgrades

Dow

ngrades

PURE

CON

PURE

CON

PURE

CON

PURE

CON

ADR

markets

(−1,

+1)

0.50%

(1.796)**

−0.30%

(−0.099)

−2.46%

(−3.833)***

−2.33%

(−2.235)**

0.38%

(1.236)

−0.19%

(−0.097)

−2.63%

(−3.833)***

−2.08%

(−2.328)***

N=160

N=57

N=87

N=67

N=138

N=50

N=81

N=61

(−5,

+5)

1.08%

(2.328)***

0.01%

(0.542)

−4.72%

(−3.523)***

−5.19%

(−2.054)**

0.95%

(1.851)**

0.57%

(1.019)

−4.64%

(−3.381)***

−5.07%

(−1.867)**

N=160

N=57

N=87

N=67

N=138

N=50

N=81

N=61

(−10,+10)

1.15%

(1.651)**

1.11%

(0.957)

−10.72%

(−5.721)***

−11.53%

(−3.090)***

1.19%

(1.392)*

1.41%

(1.064)

−10.72%

(−5.608)***

−11.95%

(−2.940)***

N=160

N=57

N=87

N=67

N=138

N=50

N=81

N=61

Local

market:MSCIindex

(−1,

+1)

0.01%

(0.0527)

0.06%

(0.2018)

−0.8%

(−0.280)

−1.65%

(−2.784)***

−0.44%

(−0.7340)

−0.26%

(−0.4002)

0.19%

(0.1144)

0.23%

(0.4366)

N=511

N=165

N=317

N=185

N=271

N=73

N=121

N=83

(−5,

+5)

1.26%

(0.7797)

−3.4%

(−1.9781)**

1.12%

(0.9214)

−1.61%

(−1.2227)

−0.34%

(−0.5671)

0.96%

(0.9419)

2.03%

(0.8367)

−0.31%

.(−0.1150)

N=511

N=165

N=317

N=185

N=271

N=73

N=121

N=83

(−10,+10)

−3.02%

*(−1.6878)

−0.04%

(0.0367)

−1.72%

(−1.7494)*

−0.04%

(−0.0675)

−1.1949(−1.3088)

1.70606(1.2488)

1.76421(0.6600)

−2.39(−0.5756)

N=511

N=165

N=317

N=185

N=271

N=73

N=121

N=83

Local

market:localmarketindex

(−1,

+1)

−0.2%

(−0.4976)

0.2%

(0.6746)

−1.04%

(−1.4711)

−1.12%

(−1.7435)*

0.04%

(0.1794)

−0.01%

(−0.0142)

−0.46%

(−0.2964)

−3.65%

(−1.4704)

N=508

N=165

N=317

N=184

N=263

N=70

N=116

N=79

(−5,

+5)

−1.26%

(−1.2603)

−0.16%

(−0.2753)

−1.12%

(−1.1570)

−2.12%

(−1.9604)*

−0.22%

(−0.3865)

0.52%

(0.6363)

−0.57%

(−0.2788)

−2.33%

(−0.7860)

N=508

N=165

N=317

N=184

N=263

N=70

N=116

N=79

(−10,+10)

−2.7%

(−1.4509)

−1.17%

(−1.4457)

−2.1%

(−1.6764)*

−3.62%

(−2.5710)**

−0.75%

(−0.9522)

0.21%

(0.2274)

−2.41%

(−1.0317)

−5.83267

(−1.0616)

N=508

N=165

N=317

N=184

N=263

N=70

N=116

N=79

*p=0.10

;**p=0.05

;**

*p=0.01

J Financ Serv Res (2009) 35:141–166 155

variables and stock returns not only for upgrades but also for downgrades. In the case ofupgrades for MSCI index, MD dummy has negative relations with stock returns (t=−1.68).We interpret the results in Table 8 to mean that there is no marginal information effect forcorporate rating changes in the local markets as well as ADR markets.

We also examine regional effects of Moody’s and S&P in rating changes for the 3-dayevent window in Table 9. We report on only Asia and Latin America and do not post non-financial firms separately because of the small number of observations. The market’s reactionto Moody’s and S&P’s downgrades with local market indices is significant (z=−2.4071 forMoody’s and z=−2.6281 for S&P, respectively) at the 1% level. The difference in meanCARs between Moody’s and S&P for local market indices is not significant at any level. Theuse of MSCI index has the similar results. In particular, S&P’s downgrades have greater priceeffects in Asia regardless of market indices. For instance, while the mean CARs of S&P’s inAsia are −1.53 (z=−2.3413) for local market indices and −1.26% (z=−2.2944) for MSCIindex, which are significant at the 5% levels respectively, none of Moody’s downgrades issignificant in Asia. Additionally neither Moody’s nor S&P is influential in Latin America. Onthe other hand, rating upgrades are not significant in each region. We conclude that the datasuggest the influence of S&P is similar to that of Moody’s in local markets.

5 Additional tests

5.1 Evidence from the tests of capital market segmentation

The Economist (2007) reports that emerging market firms that issue debt in internationalcapital markets are ten times larger than domestic firms that do not issue foreign currencydebt. The Wall Street Journal (2007b) reports that, out of 1,500 emerging market firms, the

Table 8 Estimates of model of 3-day CARs for rating changes in ADR markets and local markets for non-financial firms. In Eq. 1, CAR=cumulative abnormal return for the 3-day window of (−1, +1) for localmarkets and ADR markets respectively; MC=natural log of total market capitalization; DEBT=total debt/total assets; MD=1 if a rating is assigned by Moody’s and 0 otherwise; SOV=sovereign credit ratings on thedate of corporate rating changes1; CON=1 if corporate rating changes occur concurrently with sovereigncredit rating changes during the event window (−1, +1) and 0 otherwise; SPEC=1 if rating downgrade(upgrade) is from speculative grade to speculative or investment (speculative) grade to speculative(investment) grade and 0 otherwise. The rating changes of Moody’s and S&P are from Bloomberg database.T-statistics are provided in all parentheses. N is the number of observations, and contaminated observationsare excluded in the sample

Variable ADR markets MSCI index Local market index

Upgrade Downgrade Upgrade Downgrade Upgrade Downgrade

MC −0.6401% (−1.16) 0.5138% (−0.44) −1.51% (−1.30) −1.82% (−0.59) 0.15% (0.33) −1.26% (−0.43)DEBT −0.5198% (−0.20) −1.2274% (−0.29) 0.01% (0.49) 0.01% (0.15) 1.49% (1.80)* 0.00% (−0.00)MD 0.4125% (−0.58) 0.9681% (−0.76) −2.66% (−1.68)* 2.75% (0.10) −0.40% (−0.65) 7.68% (0.28)

SOV 0.1654% (−1.27) 0.0988% (−0.43) 0.01% (0.03) −0.39% (−0.69) 0.00% (0.03) −0.03% (−0.05)CON −0.9862% (−1.24) 1.2993% (−0.94) 0.61% (0.34) −1.15% (−0.06) 0.01% (0.02) −3.52% (−0.18)SPEC 1.8245% (1.91)* 1.9688% (−0.9) −2.37% (−1.11) −1.96% (−0.26) 0.02% (0.03) −1.72% (−0.24)N 139 127 209 89 209 89

R2 0.0547 0.0222 0.0331 0.0118 0.0177 0.0033

Adj R2 0.0117 −0.0267 0.0044 −0.0606 −0.0114 −0.0696

*p=0.10; **p=0.05; ***p=0.01

156 J Financ Serv Res (2009) 35:141–166

Tab

le9

Mean3-day(−1,

+1)

CARsandZ-statisticsforratin

gchangesforallfirm

sin

AsiaandLatin

America.

The

ratin

gchangesof

Moody’sandS&Parefrom

Bloom

berg

database.Daily

ADRprices

arefrom

CRSP,

andwecalculatemarket-adjusted

returnswith

CRSPequally

weightedmarketindex.

Daily

localstockprices

arefrom

Datastream

database,and

wecalculatemarket-adjusted

returnswith

theMSCIEmerging

MarketIndexandtheDatastreamLocalMarketIndices.Z-statisticsareprovided

inallp

arentheses.

Nisthenumberof

observations,andcontam

inated

observations

areexcluded

inthesample

Change

Local

marketindex

MSCIindex

Agency

Meandifference

Agency

Meandifference

All

Moody

’sS&P

M−S&P

All

Moody

’sS&P

M−S&P

All

Dow

n−1

.16%

(−3.5649)***

−1.16%

(−2.4071)**

−1.17%

(−2.6281)***

0.003%

(0.0044)

−0.95%

(−3.5711)***

−0.88%

(−2.4393)**

−1.01%

(−2.6333)***

0.12%

(0.2258)

N=501

N=214

N=287

N=501

N=502

N=214

N=288

N=502

Up

0.023%

(0.1438)

−0.25%

(−1.0067)

0.24%

(1.1001)

−.049%

(−1.4844)

0.18%

(1.1755)

0.23%

(1.0436)

0.13%

(0.6473)

0.10%

(0.3303)

N=673

N=299

N=374

N=673

N=676

N=299

N=377

N=676

Asia

Dow

n−1

.28%

(−2.8020)***

−1.01%

(−1.5805)

−1.53%

(−2.3413)**

0.53%

(0.5804)

−0.89%

(−2.5663)**

−0.51%

(−1.2024)

−1.26%

(−2.2944)**

0.75%

(1.0761)

N=301

N=145

N=156

N=301

N=301

N=145

N=156

N=301

Up

0.06%

(0.2869)

−0.31%

(−0.9399)

0.37%

(1.3140)

−0.68%

(−1.5775)

0.18%

(0.8927)

0.15%

(0.5132)

0.21%

(0.7371)

−.01%

(−0.1313)

N=423

N=192

N=231

N=423

N=426

N=192

N=234

N=426

Latin

Dow

n−0

.75%

(−1.8880)*

−1.01%

(−1.3816)

−0.59%

(−1.2861)

−0.41%

(−0.5001)

−0.92(−2.4658)**

−0.95(−1.4618)

−0.90%

(−1.9837)

−0.05(−0.0659)

N=166

N=59

N=107

N=166

N=167

N=59

N=108

N=167

Up

0.42%

(1.1051)

0.36%

(0.6447)

0.48%

(0.8950)

−0.11%

(−0.1497)

0.61%

(1.7898)

0.88%

(1.8746)

0.38%

(0.8145)

0.49%

(0.7248)

N=135

N=59

N=76

N=135

N=135

N=59

N=76

N=135

*p=0.10;**p=0.05;**

*p=0.01

J Financ Serv Res (2009) 35:141–166 157

portion of firms with more than 10% of their stock held by foreign investors increased from8% in 2001 to 38% in 2006. It is reasonable to assume that firms listed in ADR markets areowned by more foreign investors and issue more debt in the international capital markets inforeign currencies. As a result, we hypothesize that emerging market firms with ADRsare more likely to purchase ratings from the Big Two and react more strongly to theannouncements of corporate rating changes by Moody’s or S&P than those in localmarkets. We also hypothesize that, when the credit ratings of emerging market firms arechanged, mean stock market reactions for firms cross-listed in the U.S. will be moresevere for those firms listed on only local markets because expected bankruptcy costsand foreign exchange risks of the cross-listed firms should be higher than those of localfirms.

In Table 10, we compare the Market Capitalization and Debt Ratios of sample firms inADR markets with those in local markets for the tests of capital market segmentation. Themajority of sample firms in ADR markets duplicate the sample firms in local markets. InPanel A, the market capitalization of sample firms in ADR markets ($1,878.884 million) isalmost two times larger than that in local markets ($996.96 million), and the mean andmedian differences between ADR markets and local markets are significant at the 1% level(t=3.320 and z=5.104). The differences in mean Debt Ratios between the two markets alsoconfirm our findings on Market Capitalization. Even though the mean Debt Ratio in ADRmarkets is 60.17%, the mean in local markets is more than three times higher (194.10%).The median difference of Debt Ratios between the two markets is significant (z=−10.266)at the 1% level. We conclude that the quality of firms in ADR markets is significantly betterthat in local markets. In addition, in Panel B, we show that 71.43% of sample firms in ADRmarkets issue foreign currency debt while only 40.37% of sample firms in local markets do.As a result, we argue that well-known, larger or cross-listed firms in ADR markets causecapital market segmentation.

Additionally we check the robustness of our results in Table 10 with only non-financialfirms. We examine the capital market segmentation hypothesis by employing probitregression model. The more international activities emerging market firms with ADRshave, the greater they face expected agency costs and bankruptcy costs relative to localfirms. It is difficult for U.S. shareholders of ADRs to monitor the managers of emergingmarket firms, and bankruptcy costs will be high if those firms experience financial distress.Therefore, ADR investors demand higher standards for emerging market firms whoseshares are trading in the U.S. As a result, we expect emerging market firms with ADRsshould carry lower debt ratio and higher market capitalization ratio. Additionally it is moreprobable that firms with ADRs issue more foreign currency-denominated debt because theyare more likely to sell bonds in the international capital markets.

Our probit model is stated in the following Eq. 2.

PROBIT ¼ b1þ b2 FRþ b3 MCþ b4 DEBTþ" ð2Þ

In Eq. 2, PROBIT=1 if an emerging market firm has an ADR and 0 otherwise; FR=1 ifa firm has a foreign currency-denominated bond and 0 otherwise. The definition of MC andDEBT is the same as that in Eq. 1. We expect positive and significant coefficients for FRand MC, but negative and significant coefficient for DEBT. In Eq. 2 we examine twomodels: model 1 with all variables in Eq. 2 and model 2 without FR variable. Table 11describes that, regardless of a model used, the results are consistent with our expectation,and all coefficients are significant at 1% or 5% level. For example, in Model 1, firms withADRs are more likely to issue foreign currency-denominated debt (t=2.36), have large

158 J Financ Serv Res (2009) 35:141–166

Tab

le10

Descriptiv

estatisticsof

thewhole

sampleforthetestsof

capitalmarketsegm

entatio

n.T-statisticscomefrom

two-samplet-testswith

equalvariancesandz-statistics

from

two-sampleWilcoxon

rank-sum

(Mann–Whitney)tests.For

marketcapitalization,

units

arequoted

inmillions

ofUSdollars

and,

fordebt

ratio

,indecimalterm

s.a N

isthe

totalnumberof

ratin

gchange

observations.Marketcapitalizationanddebt

ratio

arecalculated

basedon

MC

andDEBT

variablesin

Table8,

andcomefrom

Worldscope

database.T-statisticsareprovided

inallparentheses

Descriptiv

estatisticsof

samplea

Percentageof

firm

swith

foreigncurrency

ratin

gsin

thesample

NMean

SD

Min

Max

Median

t-statistics

z-statistics

Totalnumberof

firm

sin

thesample

Firmswith

foreigncurrency

ratin

gsPercentage

Marketcapitalization

ADR

markets

287

5,308.185

7,519.328

3.063

46,676.68

1,878.884

(3.320)***

(5.104)***

5640

71.43

Local

markets

824

3,668.464

7,085.35

0.393

84,873.67

996.96

218

8840.37

Debtratio

ADR

markets

288

0.602

0.176

0.221

1.024

0.570

(−0.898)

(−10.266)***

Local

markets

931

1.941

25.298

0.019

546.75

0.812

*p=0.10;**p=0.05

;**

*p=0.01

J Financ Serv Res (2009) 35:141–166 159

market capitalization (t=3.61), and have less debt ratio (t=−12.77). We conclude that U.S.investors require higher expected returns for cross-listed emerging market firms evidentlybecause of greater expected bankruptcy costs and foreign exchange risks.

5.2 Expected vs. unexpected rating changes

When we examined the market segmentation hypothesis, we dropped the observations withother information releases such as earnings surprises or credit rating changes by other ratingagencies, which appear in the Lexis-Nexis database within five trading days (t=−2, +2)around the announcement date. However, there is a possibility that the some of the relevantinformation available in local markets might not be filtered by the Lexis-Nexis database. Byexamining the long-run stock returns following the bond rating changes of Moody’s,Dichev and Piotroski (2001) find negative abnormal returns to the announcements of ratingdowngrades. In particular, they report that the negative abnormal returns after downgradesare more striking for small, poor-credit-quality firms and when negative earnings surprisespreceded rating downgrades. Following the method of Dichev and Piotroski (2001), wedistinguish expected rating changes from unexpected ones because the Lexis-Nexis may notcapture all pertinent information around the announcement date.

When S&P and Moody’s anticipate important corporate events such as mergers,regulation changes, recapitalizations, and operating changes, they first announce “Credit-Watch (S&P)” or “Watchlist (Moody’s) before they change ratings. For example, if S&Pexpects to raise (cut) ratings of an issuer, it announces “positive (negative) CreditWatch.”However, rating agencies oftentimes change ratings without first announcing “CreitWatch”or “Warchlist.” When rating agencies change ratings after they first announce positive(negative) “CreditWatch” or “Watchlist,” we classify those events as “expected” ratingchanges; otherwise, we call them “unexpected” rating changes.

Table 12 reports expected and unexpected rating changes for non-financial firms for eachevent window. For local markets, we separately examine the effects of expected andunexpected rating changes with MSCI index from those with local market indices. In thecase of ADR markets, the 104 downgrades of the unexpected rating changes have meanCARs of −2.63% (z=−3.791) for (−1, +1) window, −4.97% (z=−2.573) for (−5, +5)window, and −13.23% (z=−4.947) for (−10, +10) window, and for all windows the valuesare significant at the 1% level. When we investigate downgrades in local markets,regardless of expected or unexpected rating changes, no event window is significant at any

Table 11 Probit regression for the tests of market segmentation for non-financial firms. N is the total numberof rating change observations. In Eq. 2, PROBIT=1 if an emerging market firm has an ADR and 0 otherwise;FR=1 if a firm has a foreign currency-denominated bond and 0 otherwise. MC=natural log of total marketcapitalization; DEBT=total debt/total assets; MC and DEBT come from Worldscope database. T-statistics areprovided in all parentheses

Variable Model 1 Model 2

FR 0.4363 (2.36)**

MC 0.4197 (3.61)*** 0.4539 (3.94)***

DEBT −5.4891 (−12.77)*** −5.5675 (−13.01)***N 554 554

Log likelihood −211.9972 −214.7633Pseudo R2 0.3684 0.3602

*p=0.10; **=0.05; ***=0.01

160 J Financ Serv Res (2009) 35:141–166

Tab

le12

Expectedvs.unexpected

ratin

gchangesfornon-financialfirm

s.WhenS&PandMoody’schange

ratin

gssubsequently

afterthey

firstannoun

cepo

sitiv

eor

negativ

e“C

reditW

atch

(S&P)”

or“W

atchlist(Moo

dy’s),”weclassify

thoseeventsas

“exp

ected”

ratin

gchanges;otherw

ise,wecallthem

“unexp

ected”

ratin

gchanges.The

ratin

gchanges

ofMoo

dy’s

andS&Parefrom

Bloom

berg

database.Daily

ADR

prices

arefrom

CRSP,

andwecalculatemarket-adjusted

returnswith

CRSPequally

weightedmarketindex.

Daily

localstockprices

arefrom

Datastream

database,andwecalculatemarket-adjusted

returnswith

theMSCIEmerging

MarketIndexandtheDatastream

Local

Market

Indices.Z-statisticsareprovided

inallparentheses.Nisthenu

mberof

observations,andcontam

inated

observations

areexclud

edin

thesample

Change

ADR

MSCIindex

Local

marketindex

Unexpected

Expected

Unexpected

Expected

Unexpected

Expected

(−1,

+1)

Dow

n−2

.63%

(−3.791)***

−1.76%

(−1.988)**

0.15%

(0.0732)

0.04%

(0.0121)

−0.21%

(−0.1129)

−0.58%

(−0.1778)

N=104

N=38

N=81

N=43

N=80

N=39

Up

0.18%

(0.866)

0.46%

(0.66)

−0.62%

(−0.9343)

0.01%

(0.0188)

−0.02%

(−0.0630)

0.01%

(0.0132)

N=157

N=31

N=286

N=58

N=283

N=50

(−5,

+5)

Dow

n−4

.97%

(−2.573)***

−4.43%

−3.203***

2.90%

(1.0610)

0.56%

(0.1198)

0.86%

(0.3577)

−2.72%

(−0.6600)

N=104

N=38

N=81

N=43

N=80

N=39

Up

0.44%

(1.388)

2.90%

(2.030)**

−0.23%

(−0.4170)

0.69%

(0.4870)

−0.32%

(−0.5554)

1.61%

(1.1690)

N=157

N=31

N=286

N=58

N=283

N=50

(−10,+10)

Dow

n−1

3.23%

−(4.947)***

−5.84%

(−2.438)***

−0.38%

(−0.1120)

5.85%

(1.3376)

−3.66%

(−1.2311)

0.13%

(0.0287)

N=104

N=38

N=81

N=43

N=80

N=39

Up

0.94%

(1.159)

2.80%

(1.710)**

−0.33%

(−0.3910)

−1.51%

(−0.8227)

−0.94%

(−1.1576)

−0.39%

(−0.1943)

N=157

N=31

N=286

N=58

N=283

N=50

*p=0.10

;**p=0.05;**

*p=0.01

J Financ Serv Res (2009) 35:141–166 161

Tab

le13

Mean3-day(−1,

+1)

CARscomparisonbetweenlocalandglobal

ratin

gagencies

fornon-financialfirm

s.Local

ratin

gagencies

areTaiwan

Ratings

Corp(TRC)in

Taiwan,RAM

Ratings

Services(RAM)in

Malaysia,

CreditRatingInform

ationServicesof

India(CRISIL)in

India,

PEFIN

inIndonesia,

Korea

InvestorsService

(KIS)in

Korea,T

haiR

atingandInform

ationServices(TRIS)in

Thailand,P

hilip

pine

RatingServices(PHIL)in

Philip

pines,andXIN

HUAin

China.G

lobalratingagencies

areS&Pand

Moody

’s.T

heratin

gchangesarefrom

Bloom

berg

database.T-statisticscomefrom

two-samplet-testswith

equalv

ariances

Daily

localstock

prices

arefrom

Datastream

database,

andwecalculatemarket-adjusted

returnswith

theMSCIEmerging

MarketIndexandtheDatastream

LocalMarketIndices.Z-statisticsareprovided

inallparentheses.Nisthe

numberof

observations,andcontam

inated

observations

areexclud

edin

thesample

Change

Local

agencies

Globalagencies

Com

parison(T-tests)

Local

marketindex

MSCIIndex

Local

marketindex

Local

agency

−global

agency

(MSCIindex)

Local

agency

−global

agency

(Local

marketindex)

Dow

nTotal

−2.32%

(−4.7796)***

−1.13%

(−1.9849)**

−1.07%

(−2.1163)**

−1.19%

(−1.5558)

−1.25%

(−1.7673)*

N=425

N=124

N=119

N=549

N=544

Korea

−3.35%

(−5.3671)***

−3.37%

(−1.3769)

−1.24%

(−0.6169)

0.02%

(0.0116)

−2.10%

(−1.0386)

N=293

N=31

N=31

N=324

N=324

Non-K

orea

−0.06%

(−0.0856)

−0.99%

(−1.6803)*

−1.06%

(−2.0247)**

0.93%

(0.7927)

1.00%

(0.9481)

N=132

N=93

N=88

N=171

N=220

Up

Total

−0.40%

(−1.4431)

−0.49%

(−1.4429)

−0.10%

(−0.3262)

−0.10%

(−0.1899)

−0.29%

(−0.6204)

N=343

N=333

N=344

N=676

N=687

Korea

−0.37%

(−0.9834)

−1.02%

(−0.6107)

0.64%

(1.2018)

0.65%

(0.5337)

−1.01%

(−1.4835)

N=223

N=91

N=91

N=314

N=314

Non-K

orea

−0.44%

(−1.2449)

−0.41%

(−1.3776)

−0.22(−0.6226)

−0.03%

(−0.0438)

−0.23%

(−0.2890)

N=120

N=242

N=253

N=362

N=373

*p=0.10;**p=0.05;**

*p=0.01

162 J Financ Serv Res (2009) 35:141–166

level. With regard to the downgrades of expected samples for ADR markets, all eventwindows are significant at the 1% and 5% levels. For instance, the downgrades of the BigTwo have mean CARs ranging from −1.76% (z=−1.988) for event window (−1, +1) to−5.84% (z=−2.438) for event window (−10, +10). In ADR markets, unexpecteddowngrades have stronger effects than expected counterparts. We also conclude thatmarket reactions to expected and unexpected changes in ADR markets for downgrades aremuch stronger than those in local markets.

For expected and unexpected upgrades in local markets, all event windows are notsignificant whether we use local market indices or MSCI index. In the case of upgrades inADR markets, the 157 unexpected events do not deliver any information to stock markets.However, expected upgrades for longer event windows (−5, +5) and (−10, +10) aresignificant at the 5% level. The 31 upgrades have mean CARs of 2.90% (z=2.030) for thewindow of (−5, +5) and of 2.80% (z=1.710) for the window of (−10, +10). The findingsconfirm the market segmentation effect that rating changes result in different stock marketreactions between ADR and local markets regardless of expected or unexpected ratingchanges.14

5.3 Local vs. global rating agencies

Li et al. (2006) find that Moody’s and S&P are more influential than the two majorJapanese rating agencies, Rating and Investment Information (R&I) and Japan CreditRating Agency (JCR), for rating changes even in the Japanese capital markets. They findthat stock prices react more strongly to downgrades in credit ratings of Moody’s and S&Pthan those of Japanese raters in the Japanese market. We also access whether there is anydifferential impact of the rating changes of Moody’s and S&P (global agencies) versusthose of local rating agencies. We find that eight local rating agencies in Asia provideratings information to Bloomberg database. They are Taiwan Ratings Corp (TRC) inTaiwan, RAM Ratings Services (RAM) in Malaysia, Credit Rating Information Services ofIndia (CRISIL) in India, PEFIN in Indonesia, Korea Investors Service (KIS) in Korea, ThaiRating and Information Services (TRIS) in Thailand, Philippine Rating Services (PHIL) inPhilippines, and XINHUA in China. TRC, RAM, and CRISIL are affiliated with S&P, andKIS, Moody’s. During the sample periods TRC announced 11 downgrades and 28upgrades; RAM 165 and 98; CRISIL 98 and 66; PEFIN 44 and 43; TRIS 2 and 19; PHIL15 and 9; XINHUA 43 and 12; KIS 399 and 661. Out of total 777 downgrades and 936upgrades, we examine only 425 downgrades and 343 upgrades after we drop contaminatedobservations and events without stock prices. We consider only non-financial firms in theanalysis.

Table 13 provides the comparison of 3-day (−1, +1) mean CARs to rating changesbetween local and global rating agencies. We analyze only non-financial samples. For therating changes of global agencies, we investigate only eight Asian countries which havecorresponding local raters. Even though upgrade announcements by local or globalagencies are not significant at any level, the mean CARs of downgrades by local and globalagencies are −2.32% (z=−4.7796) and −1.07% (z=−2.1163 for local market indices), whichare significant at the 1% and 5% levels, respectively. In addition, t-test results between local

14 We examined cross-listed (listed in both ADR markets and local markets) firms. Even though the stockmarket reactions of cross-listed firms in ADR markets are significant (results appear in Table 5), those inlocal markets are not (results are available upon request). As a result, our conclusion does not change.

J Financ Serv Res (2009) 35:141–166 163

agencies and global agencies (local market indices) show that local agencies are moreinfluential than global ones in local markets (z=−1.7673).

On the other hand, we divide the rating changes by local agencies into two parts, Koreaand non-Korea samples, because Korea has 293 (68.94%) observations for downgrades and223 (65.01%) for upgrades. We report that the Korean rating agency (KIS) has strongerinfluence in Korea than the Big Two. While the mean CARs of KIS is −3.35%, which issignificant at the 1% level, those of the Big Two is insignificant in Korea. Even if thesample size of global agencies is small (31 observations), the findings are very interesting.Meanwhile, while local agencies have no influence outside Korea for downgrades,downgrades by global agencies are significant at the 5% level (z=−2.0247 for local marketindices).15 We conclude that global raters have stronger influence than local counterparts inlocal markets except Korea.

6 Conclusion

We examine stock market reactions to corporate credit rating changes in 26 emergingmarket countries included in the MSCI Emerging Market Index. We hypothesize thatemerging market firms in ADR markets are more likely to purchase ratings from the BigTwo (Moody’s and S&P) and react more strongly to the announcements of corporate ratingchanges by Moody’s or S&P than those in local markets. We compare the effect of creditrating changes of the Big Two in two different emerging stock markets, local markets (localcurrencies) and ADR markets (U.S. dollars) and find that, after control for sovereign creditrating changes, the mean CARs and z-statistics in ADR markets for downgrades andupgrades are significant, while those in local markets are not, and conclude that there iscapital market segmentation in ADR markets as well as local markets for the credit ratingchanges of emerging market firms.

The finding of market segmentation holds whether we use a single emerging marketindex (the MSCI Emerging Market Index) or Datastream local stock market indices,whether we separate expected rating changes from unexpected ones, and whether weemploy short or long event windows. Furthermore, the market segmentation effects areprofound for non-financial firms. We find evidence that investors react strongly to ratingchanges in the ADR markets because they require higher costs of capital for firms cross-listed both in the ADR markets and local markets due to greater expected bankruptcy costsand foreign exchange risks of those firms compared with firms listed only in the localmarkets. In particular, firms in ADR markets issue more foreign currency-denominated debtin better quality (lower debt ratio), and are larger in size (higher market capitalization) thanthose in local markets. We also report that stock markets react significantly not only torating downgrades, but also to upgrades in the ADR markets. On the other hand, we findthat the influence of Moody’s is stronger than that of S&P’s in Asia.

15 We examine event windows (−5, +5) and (−10, +10) and find the similar results.

164 J Financ Serv Res (2009) 35:141–166

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