The Importance of Ratings

Sovereign ratings are a crucial assessment tool for investors and businesses seeking information about the financial risks in developed and emerging markets worldwide. Given the importance of this subject for the financial sector and for those with financial responsibilities, we have asked Standard & Poor’s as a “top player” in this field to write an article explaining “the world behind the ratings”.
This is part 1 of a small series; in the next newsletter you will find an article that gives more specific information about the rating of the “transition economies” in post-communist countries.
Behind the Ratings
Sovereign defaults have always reflected a variety of factors, including wars, revolutions, lax fiscal and monetary policies, and external economic shocks. Today, fiscal discipline, debt management, structural inefficiencies constraining productivity, and contingent liabilities arising from weak banking systems are among the significant economic policy challenges facing many sovereigns. The associated credit risk, which may seem manageable for a time, can quickly mushroom - as events in a number of emerging market countries in the late 1990’s have shown. Standard & Poor’s believes an understanding of sovereign ratings - what they mean and the criteria behind them - is as relevant now as ever.
Forward-Looking
Standard & Poor’s sovereign credit ratings reflect its opinions on the ability and willingness of sovereign governments to service their commercial financial obligations in full and on time. Ratings coverage continues to expand, with the 100th sovereign rating in 2004 assigned to Burkina Faso. A rating is a forward-looking estimate of default probability. Sovereign ratings are not “country ratings”, an important and often misunderstood distinction. Sovereign ratings address the credit risks of national governments, but not the specific default risks of other issuers. A rating assigned to a non-sovereign entity is, most frequently, the same or lower than that assigned to the sovereign in the main country of domicile, but may be higher. Defaults by rated sovereign issuers of bank and bond debt include those of the Republic of Argentina; the Russian Federation and the Islamic Republic of Pakistan, although other rated sovereigns have defaulted in the years before they were rated. Default and transition studies indicate that, compared with corporate ratings, sovereign ratings show more stability at most rating levels. In most instances, the sovereign default record is lower than the corporate default record. However, such comparisons are affected by the small sample size of sovereign defaults. Standard & Poor’s expects sovereign default probabilities to converge with corporate ratios over time as the number of sovereign observations increases, some-thing one would expect given the same rating definitions.
No Exact Formula
Standard & Poor’s appraisal of each sovereign’s overall credit worthiness is both quantitative and qualitative. The quantitative aspects of the analysis incorporate a number of measures of economic and financial performance and contingent liabilities, although judging the integrity of the data is a more qualitative matter. The analysis is also qualitative due to the importance of political and policy developments and because Standard & Poor’s ratings indicate future debt service capacity. Standard & Poor’s divides the analytical framework for sovereigns into 10 categories. As part of the committee process that Standard & Poor’s uses to assign credit ratings, each sovereign is ranked on a scale of 1 (the best) to 6 for each of the 10 analytical categories. There is no exact formula for combining the scores to determine ratings. The analytical vari-ables are interrelated and the weights are not fixed, either across sovereigns or over time. Most categories incorporate both economic risk and political risk, the key determinants of credit risk. Economic risk addresses the government’s ability to repay its obligations on time and is a function of both quantitative and qualitative factors. Political risk addresses the sovereign’s willingness to repay debt.

The 10 categories are:
• Political Risk (including stability and legitimacy of political institutions);
• Income and Economic Structure (including prosperity and the degree to which an economy is market- oriented);
• Economic Growth Prospects (including size and composition of savings and investment);
• Fiscal Flexibility (including government revenue, expenditure and surplus/ deficit trends);
• General Government Debt Burden (including share of revenue devoted to interest);
• Offshore and Contingent Liabilities (including robustness of financial sector);
• Monetary Flexibility (including price behavior in economic cycles);
• External Liquidity (including reserve adequacy);
• Public-Sector External Debt Burden (including sensitivity to interest rate changes);
• Private-Sector External Debt Burden (including sensitivity to interest rate changes).

Rated sovereigns formed an exclusive club of the world’s most credit worthy governments until the 1990s. Standard & Poor’s rated just a dozen sovereign issuers in 1980 -all at the ‘AAA’ level. Rating downgrades were relatively rare over the remainder of that decade and, when they occurred, were usually of modest dimensions. Nowadays, the sovereign sector is far more heterogeneous. The 106 sovereigns Standard & Poor’s now monitors carry ratings between ‘AAA’ and ‘SD’ (Selective Default’). Given the range of credit quality, rating changes occur more frequently. Standard & Poor’s has introduced an internal early-warning system to assist in rating surveillance.
Strong Response
Rating changes occur whenever new information significantly alters our view of likely future developments. This usually results from the policy response or the degree of latitude in a given area being different from what was expected.One of the lessons of recent years for sovereigns is that a strong policy response that identifies and addresses sources of stability is key. Whether the problem is a weak banking sector, excessively leveraged corporates, inflexible exchange-rate regimes, or high fiscal imbalances, a strong policy response is crucial for strengthening both the economic environment and sovereign credit worthiness.

[ For more information: Kevin Daly, Director Marketing Sovereign Ratings Standard & Poor’s, London Tel.: +44 20 7176 7112 ]

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