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Research Brief: Credit Ratings Close the Gap for Emerging-Market Firms

To overcome the "liability of foreignness" in global capital markets, emerging-market firms can strategically use a credit rating to make them appear more credible

Research Brief: Credit Ratings Close the Gap for Emerging-Market Firms

WHAT DID THE STUDY LOOK AT?

Emerging-market firms have a tough road when trying to raise capital internationally. This so-called liability of foreignness in capital markets (LOFCM) stems from unfamiliarity and differences in culture and institutional contexts. Securing a credit rating from agencies such as Standard and Poor’s (S&P) may be one way for firms to overcome the perception of weak institutional processes and to look more familiar. “Conservative accounting” — being quicker to report potential losses than possible gains — is highly valued by lenders and viewed favourably by the rating agencies. Therefore a shift to more conservative financial reporting at the time of getting rated suggests that firms are using a rating as part of a strategy to get a better deal on capital. This study examined whether or not emerging-market firms use an S&P rating to signal to international investors that they are committed to credible and transparent accounting.
 

HOW WAS THE STUDY DESIGNED?

Because of the unique importance of accounting conservatism for participating in capital markets, the researchers used measures of conservatism to assess the quality of each firm’s financial reports. They believed rated firms would adopt more conservative accounting practices as part of a strategy to overcome their LOFCM. The researchers’ sample was made up of 550 credit rating initiations from 18 emerging-market countries. The financial reporting of firms was tracked for the three years before and after being rated to detect the effect it had on firms’ activities.

WHAT DID THE STUDY FIND?

  • Since the mid-1990s, the number of emerging-market firms to secure a credit rating has taken off. The ratings obtained are generally proportional to their “country risk,” measured by institutional effectiveness, quality of bureaucracy, transparency and fairness of the legal system, and corruption among officials. 
  • Rated firms show all the signs of seeking and obtaining new sources of debt and investment. They have higher leverage (total debt to total assets), are more likely to cross-list shares in the U.S., and have higher valuations and growth opportunities.
  • Emerging-market firms reported their financial results more conservatively after being rated by S&P. This conservative style of financial reporting is beneficial to lenders because it quickly alerts them to deterioration in financial conditions. 
  • Firms that received a rating issued debt three times more often, and their share of debt from international sources grew from 20 percent to 50 percent. The extra capital was then used to expand internationally: mergers, acquisitions, and joint ventures increased 2.5 times over. Foreign sales also rose.

WHAT DO I NEED TO KNOW?


The capital markets rely on informational intermediaries — organizations that supply investors with assurances of a firm's finances. This can be a hurdle for firms based in countries plagued by unfamiliar and poorly-perceived institutions, making it difficult to acquire capital. Firms set on participating in international capital markets can opt to secure a credit rating to mitigate their LOFCM. Such a “springboarding” strategy would be less costly and onerous than cross-listing equity shares, which brings with it ongoing regulatory compliance commitments. With credit rating in hand, the firms can more readily acquire debt, boost production capacity, and enter into joint ventures or mergers, making international expansion a reality. 

Securing a credit rating and boosting “accounting conservatism” may also help emerging-market firms in their dealings with institutional investors, suppliers, and customers. This remains to be tested.

 

Title: Credit rating initiation and accounting quality for emerging-market firms
Authors: Kee-Hong Bae (York University), Lynnette Purda (Smith School of Business), Michael Welker (Smith School of Business), Ligang Zhong (Southwestern University of Finance and Economics).
Published: Journal of International Business Studies (2013: 44, 216–234)
 

— Ben Williamson

 

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