SINCE the 2008/09 global financial crisis (GFC), the contentious issue of sovereign ratings has generated columns of news coverage. Indeed, the US subprime mortgage crisis that precipitated the GFC, followed by the ongoing eurozone crisis, greatly intensified interest in this topic, especially after some advanced countries lost their much-coveted sovereign credit rating of AAA (for example the US and France), the highest rating on the scale.
This growing interest can also be attributed to the fact that sovereign ratings, which influence the direction of capital flows, have undeniably strong implications for the financial market and the economy in general.
In essence, a sovereign rating summarises a credit rating agency’s (CRA) opinion of the ability and willingness of the government of a sovereign nation to fully service its debt on a timely basis. It is arrived at after an assessment of sovereign risk — the risk that the government of a sovereign nation fails to honour its debt obligations.
Note that it is not just the sovereign’s ability that matters; the willingness of the government to service the debt is also given due consideration. Contrary to popular opinion, a credit rating is not a report card of a country or a seal of approval of government policies. A sovereign rating primarily examines factors that enable a country to meet its debt obligations, rather than how well it achieves its broad macroeconomic policy objectives.
Ratings are forward-looking in nature. Sovereigns are rated “through the cycle” instead of at a “point in time” to avoid procyclicality and therefore ensure rating stability. In other words, sovereign ratings are typically based on the ability of the sovereign debt issuer to survive a cyclical trough.
This means that ratings do not change simply because of transitory factors. A change in the fundamentals of the economy would, on the other hand, cause a rating change. So too would changes in secular trends or policies that are unanticipated.
There are two kinds of sovereign credit ratings — the local-currency and foreign-currency ratings. A sovereign’s local-currency rating is usually higher than its foreign-currency rating because of its presumed greater ability to service local-currency debt, given its ability to print its own currency. The risk is that excessive money creation could erode the value of its obligations through inflation.
A sovereign’s foreign-currency rating, meanwhile, is usually lower that its local-currency rating because there is a higher risk of default due to its inability to print foreign currency. The task of the CRA then includes assessing the sovereign’s ability to generate the foreign exchange necessary to meet its debt obligations.
So what determines a sovereign rating? According to research literature, there are several factors and most CRAs include them in their methodologies.
Gross domestic product per capita, one of the determinants, has a positive relationship with the sovereign rating. The rationale is that countries with high GDP per capita, being obviously more developed, have, among other things, strong economic institutions to ensure growth and development. The level of economic diversification is also a factor as it has implications for the strength and sustainability of economic growth.
From a CRA’s sovereign credit rating perspective, an economy that is not only strong but also growing at a sustainable pace is credit positive. This is because stronger growth and more diversification normally lead to higher and more stable revenue collection and hence a stronger government financial position.
Monetary conditions are also critical in assessing a sovereign’s creditworthiness. Inflation, for instance, is commonly used as an indication of symptomatic problems at the macroeconomic policymaking level. For example, hyperinflation, which can be due to excessive money creation (money-printing by the central bank), is a sure sign of other macroeconomic problems in the country that can affect a sovereign’s creditworthiness and therefore credit rating.
Similarly, persistent deflation is credit negative as it indicates economic stagnation. Exchange rate trends, which are affected by monetary policy, are also scrutinised because of their impact on the economy’s international trade competitiveness, among other things, which ultimately affects economic growth.
To determine a sovereign government’s fiscal position, CRAs will go over the government’s revenue and expenditure with a fine-toothed comb. A government’s higher ability to extract revenue, relative to its peers, to some extent, implies a more efficient tax system and therefore scores sovereign credit points for the country. Meanwhile, a dependency on only a few sectors of the economy to generate revenue is credit negative as there is a higher risk of government revenues taking a hit from unexpected economic events.
A CRA will usually look at the levels of revenue (as a percentage of GDP) of all countries in its rating universe and then, based on the results, determine the appropriate rating bands. Similarly, CRAs scrutinise the breakdown of government expenditure to determine spending patterns. Expenditure items that can increase the future growth capacity of a country are credit positive from a CRA’s perspective. Conversely, expenditures that lead to, for example, economic inefficiencies are credit negative. These include financial leakages and indiscriminate subsidies.
The overall fiscal balance of a sovereign is naturally a very important rating factor as it ultimately influences the sovereign’s debt level. Generally, high and persistent budget deficits are credit negative. However, a CRA normally discriminates the way deficits are financed. A budget deficit that is financed through domestic sources is more favourable from a rating perspective.
Similarly, for a given level of debt, a more positive score will be given to a country with a high domestic-to-external debt ratio. This is because external debt tends to strain the foreign exchange reserves of a country. The implicit debt (contingent liability) of a country is also another factor used to gauge the fiscal position of a sovereign.
As an economy’s external vulnerability increases in tandem with the level of its foreign debt obligations, the amount of foreign reserves its central bank holds is also taken into account. The more foreign reserves the central bank holds, the more credit positive it is for the economy because of the buffer the reserves provide in case of unexpected reversals of short-term speculative capital flows.
A high stock of foreign reserves also helps ease concerns about the sovereign’s ability to service foreign debt obligations. This means that factors that can affect a sovereign’s capacity to generate foreign exchange reserves will also impact its credit rating.
Political risk is a major sovereign rating factor. Governance factors such as political stability and absence of violence, government effectiveness, regulatory quality, rule of law, control of corruption, and voice and accountability are carefully studied. The criticality of these factors is indisputable as they impact, among other things, the international competitiveness of a sovereign and therefore the country’s economic strength.
Last but not least is a country’s default history. As one would expect, there is a negative correlation between defaults and sovereign credit ratings: A country that has defaulted before is deemed likely to default again and thus, would attract a lower rating than if it had not defaulted before. This is because such a country would now seem to be more accepting of defaulting as a way to deal with its debt burden.
Nor Zahidi Alias is chief economist at Malaysian Rating Corp Bhd. The views expressed here are his own.
This article first appeared in Forum, The Edge Malaysia Weekly, on July 13 - 19, 2015.