The relationship between interest rates and sovereign ratings: An analysis using a Markov-switching model

In this paper, the correlation between the evolution of creditsʹ interest rate and sovereign rating was analysed. In order to capture this view, a Markov-switching approach was engaged to model the transition probabilities of low and high volatility regimes for interest rate. Also, the official rate of inflation and the amount of domestic credit denominated in lei were used as explanatory variables. The results of vector autoregressive approach revealed interesting interactions between the three macro variables, with interest rate being explained by both inflation rate and domestic credit. For the fact that the sovereign rating denotes a qualitative measure provided without a regular frequency, but which incorporates some subjective aspects, it was proposed as an indicator function to account for the sovereign ratings downgrades. Thus, to observe the relation between interest rate and sovereign rating, the transition probabilities of switching regimes for interest rate with the values of the indicator function mentioned before was correlated.