Introduction

Rating the Credit Rating Agencies on Sovereign Debt Ratings

Introduction

Over the last two decades, there has been a massive increase in the mobility of international capital in the world economy. This trend has clearly proved a liberating force for many of the world’s emerging economies, with the rapid growth of economic activity in North East Asia in the 1970s and 1980s, and then in South East Asia over the last decade or so illustrating these positive effects. But the process of mobilising international credit is heavily geared to establishing the security of obligations taken on by borrowing governments and corporations. For corporations, there are long established procedures emoployed in the ebvaluation of individual borrowers, with the use of credit rating systems operated by internaitonal private sector agencies obviously a core element of these procedures. For national governments seeking to raise funds, the appropriate procedures have, in the past, not been so clear cut. Today, though, there is a rapidly growing accepance of credit ratings on sovereign (national government) borrowing cpacity. And it is the same private sector agencies that have initiated these assessment systems. International capital markets view very closely yhe pronouncements of these agencieas in relation to particualar countries.

For this reason, the views expressed by the credit rating agencies can have a significant impact on the borrowing cpacity of governments and, in turn, can heavily influence the economic and social policy formation process in such countries. The agnecies are becoming very popwerful in this respect. The purpose of this Topic is to investigate the nature and extent of this power and whether there is any call for it to be monitored or even moderated in a formal sense by the international community.

Objectives

In studying this Topic, students will gain

· a broad picture of the way in ahich sovereign credit ratings are determined and use in international credit markets;

· an indication of how sovereign credit ratings may drive changes in government management of economi, business and social policy in many countries;

· a deeper understanding of the nature of risk for capital providers in foreign markets; and

· an awareness off how this issue of sovereign credit ratings may influence the future development of institutional relations in the world economy.

The new wave of international capital mobility

Examination of Figure 1 reveals that there have, in the last 100 years, been two major periods of intense international capital mobility. The first of these occurred between 1880 and 1914, a period of extensive investment in railroads, utilities and public works in the countries of the new world. Initially, theses borrowings were channeled on a one by one basis through large international merchant and investment banks, and the information requirements needed to establish the security of the borrwing arrangements were largely established on a one to one basis pertaining to each investment project of each borrowing government.

In 1914, the onset of World War 1 brought about a rapid decline in borrowing of this nature, a decline which persisted in the 1920s with the onset of international financial instability in the wake of the collapse of the gold standard.

It was notable that, by the end of this period, the American economy, having escaped war time damage and with the large scale investment in its economic base over the previous fifty years, actually became a net exporter of capital. Earlier in 1909, out of its very deregulated financial markets, a new phenomenon, the credit rating agency had emerged with the publication of the first Moody’s ratings. In the new era of US lending abroad, Moody’s began to issue ratings on a one by one basis of foreign government debt issues. This single issue rating system was to prevail through to the 1970s.

In the period 1930 to 1945, first the Great Depression, then the Second World War inhibited international capital flows, and then the Marshall Plan involving US government investment in the restoration of war-ravaged Eurpope and Japan dominated arrangemnts in the immediate post war period.

During the 1950s and 1960s through to the mid 1970s, the western world was characterised by strong economic growth, international exchange rate stability and relatively high levels of trade protection. As a consequence, international investment and lending took more of a back seat in financae markets. What capital movements did occur largely involved direct investment by first US then later European multinational corporations. The information required to establish security of the investments involved was gathered on a one to one basis, project by project.

The first major “oil crisis” in 1973 marked the beginning of a new era for world financial markets. The Arab other oil producing states, in forcing up the international price of oil, very rapidly acquired massive surpoluses of foreign currency holdings. These immense funds needed a home, and in the context of world political strategies at the time, much of the money found its way through to the then less developed nations and regions of the world. Significantly, the se funds were passed into the developing world by two major routes, either directly in bilateral negotiations between the oil producing countries and friedly or allied countries, or through the on-lending of funds placed as US$ deposits with merchant baks based mainly in Europe. These latter funds became known as Euro Dollars and they became the first large scale sources of borrowings to be freely available in the open market for tapping by nation governments. Thus was initiated the second large wave of international capital mobility. Interstingly, the stnadard procedure with many of these loans did not involve credit rating as such, but more an assessment of each indivdual laon on an ad hoc basis.

The Euro Dollar market grew at a phenomenal rate, gradually drawing all of the world’s major financial operators into its realm. In turn, equivalent markets sprng up in non-European financial centres. When the American capital markets took to handling the issue of foreign target debt securities, they applied the same rigorous information requirements as were demanded of domestic debt issues. For the most part, the rating agencies applied ratings on a loan by loan basis. This apporach continyued into the 1980s. In the latter part of that decade though, it appears the number of issues for some countries became so numerous, that a system of continuous rating of individual foreign government borrowers (rather than each single debt issue) began to emerge. By 1998 though, still only 15 countries were rated in this way. These were basically major plyers in the world economy and the ratings applied were of the highest levels, raising little controversy and certainly not of any consequence for government policy formation in the countries concerned.

Over the last decade, though, the participation of less credit worthy govrnment borrowers in the open international capital market has grown very rapidly. Along with this has come an explosion in the number of countries entering the sovereign credit rating process. And the ratings applied exxtend from the highest levels down to some very shaky classisfications indeed. Hence the issues have arisen as to the approriateness of indivdual agency ratings of partivcular countries and the impact such ratings have on national policies for the govenrments concerned. In the next section we look at the way in which a country’s rating is struck and then move on to address these issues in subsequent sections.

The sovereign credit rating process

The aim of the sovereign credit rating is to guage the relative security of a national government’s debt obligations over a continuing period of time. There are two perspectives involved in this assessment:

· The fiscal capacity of the government to fulfill its obligations; and

· The willingness of a governement to do so.

In addressing these perrspectives, agencies have to investigate:

Political risk This involves an analysis of the country’s internal political and social situation, and its relationships with surrounding and other relevant political states.

Economic risk This involves an analysis of the country’s overall economic position including the fiscal and monetary conditions (particulalry inflation), the balance of payments, GDP growth, productivity trends and general infrastrucutre conditions.

In the course of risk analysis, the rating agencies gather data from Central Bank publications, official statistics, IMF reports, World Bank reports, OECD and other international agency reports, and any other seriously researched material avaliable.

Table 1: Sovereign Credit Rating Criteria

Politics

· Stability of the existing government structure

· Central & local government relations and their repective responsibilities

· Leadership turnover

· Sources of political unrest

· Homogeneity of population

· Demographic structure

· Educational levels

· Foreign economic/political relations

· Domestic/regional security.

Domestic economy

· Principal industries

· Agriculture sector

· Natural resources

· GDP

· Inflation rate

· Unemployment rate

· Government budget

· Composition of domestic debt

External economy

· Principal exports

· Energy imports

· Balance of payments policy

· Foreign capital

· Stability of currency

· Foreign debt delinquency

Statistics

(At least 5 years)

· GDP

· Inflation rate

· Money supply growth

· Export growth rate

· External debt

· Leading exports

· Petroleum imports

· Official external reserves

· Balance of trade

· Balance of payments data

Attachment 1 provides a more detailed listing of these indicators. In the ratings process, it is not possible to allocate precise values to a substantial number of these measures. Instead, some form of indexing based on informed but subjective judgement of the situation is employed. The agencies then combine their indexes and other data into a weighted averaging process to come up with a single variable that can determine the actual rating awarded to the country. The two US agencies (Moodys and Stnadard and Poor) do not publish the exact index values or the weights attached to various indicators. However, various estimates have been made using multiple regression analysis of ratings against known “hard value”data such as GDP growth or inflation. These tend to align approximately with the published weights emoployed by the Euromoney and EIU agencies shown in Table 2.

On this basis, it can be seen that subjective judgement enters the rating process at two points, the indexing of mainly political indicators and the allocation of weights to various indicators. Not surprisingly, the different agencies come up with many variations in their assessments of individual countries.

Table 2 Rating Agencies: Weighting of Criteria for Assessing Country Risk

Rating agency

Criteria for ratings

Institutional Investor

Information provided by 75100 leading banks that grade each country on a scale of 0100, with 100 representing least chance of default.

Individual responses are weighted using a formula that gives more importance to responses from banks with greater worldwide exposure.

Criteria used by the individual banks are not specified.

Euromoney

Assessment based on three main indicators:

Analytical indicators (40 percent):
Political risk (15 percent)
Economic risk (10 percent)
Economic indicators (15 percent)
(debt service/exports, external debt/GNP, balance of payments/GNP)

Credit indicators (20 percent)
Payment record (15 percent)
Rescheduling (5 percent)

Market indicators (40 percent)
Access to bond markets (15 percent)
Selldown on short-term paper (10 percent)
Access to discount available on forfeiting (15 percent)

/Economist Intelligence Unit (EIU)

Medium-term lending risk (45 percent)

Total external debt/GDP, total debt-service ratio, interest-payment ratio, current account/GDP, savings/investment ratio, arrears on international bank loans, recourse to IMF credit, and the degree of reliance on a single export.

Political and policy risk (40 percent)

Short-term trade risk (15 percent)

Source: Nadeem Ul Haque,Donald Mathieson, and Nelson Mark, Rating the Raters of Creditworthiness, Finance and Development, The World Bank, March 1997.

Table 3 Comparison of Rating Symbols

S&P'S, IBCA, and NIS Ratings Investor	Moody's Rating	Institutional	Comments
AAA	Aaa	86-100	Highest quality
AA+, AA, AA-	Aa1, Aa2, Aa3	71-85	High quality
A+, A, A-	A1, A2, A3	41-55	Adequate payment capacity
BBB+, BBB, BBB-	Baa1, Baa2, Baa3	56-70	Strong payment capacity
BB+, BB, BB-	Ba1, Ba2, Ba3	29-40	Likely to fulfill obligations, ongoing uncertainty
B+, B, B-	B1, B2, B3	20-28	High risk obligations
CCC+, CCC, CCC-	Caa	17-19	Current vulnerability to default, or in default
C, D	Ca,D	10-13	In bankruptcy or default

Source: The Credit Rating Industry, Federal Reserve Bank of New York, Summer-Fall 1994.

The Impact of Sovereign Credit Rating on Individual Countries

Three major studies have been completed on how rating variations affect individual countries. These studies have been carried out by the Banque National du Paris (BNP), the International Monetary Fund (IMF) and the Federal Reserve Bank New York (FRBNY).

The BNP study In this study published as Spreads on Sovereign Issues, Ratings, Liquidity and Economi Fundamentals: An Empirical Study in the Bank’s Global Market Reesearch, 4 December 1997, the researchers assessed the variability of the interest rates attached by the market to debt issues of five European countries, Belgium, Denmark, Finland, Spain and Sweden. The rate variation over time was tested for correlation with four objectively measurable variables, inflation, trend, liquidity and chamnges in the sovereign credit ratings of the five countries. The research found overwhelmingly that the greatest impact on interest rate variations came from changes in credit ratings for the five countries. This suggests that the importance of ratings as a force impacting of policy deliberations of nation states should not be underestimated.

The IMF study The results of this research are published in the IMF’s World Economic Outlook, March 1998, Chapter IV, Developments and Prospects in Emerging Markets, Pp 35-37. The diagram presenting the results is reproduced here as Figure 1. This highly innovative diagram requires a bit of concentration. However, it is well worth your while to make the effort.

The research sought to measure changes in the economic fundamentals of three groups of countries over the period 1989 to 1995. The countries are distinguished according to the date at which they came to be awarded sovereign credit ratings by Moody’s.

Table 4 Countries Considered in the IMF Assessment of Rating Impacts

Group A Countries	Rated prior to 1990	Argentina, Brazil, China, India, Korea, Malaysia, Singapore, Thailand, Venezuela
Group B Countries	Rated between 1990 - 96	Bahrain, Chile, Columbia, Egypt, Indonesia, Israel, Jordan, Mauritius, Mexico, Oman, Pakistan, Peru, Philippines, Saudi Arabia, South Africa, Taiwan, Trinidad, Tunisia, Turkey, UAE, Uruguay
Group C Countries	Nor rated by end-1996	Bangladesh, Bolivia, Botswana, Burkino Faso, Cameroon, Congo, Costa Rica, Cote d’Ivoire, Cyprus, Dominican Rep., Ecuador, Gabon, Ghana, Guinea, Jamaica, Kenya, Madagascar, Morocco, Nepal, Nigeria, PNG, Paraguay, Senegal, Tanzania, Uganda, Zambia, ZImbabwe

The “web” in the top right hand corner records the economic fundamentals of Group A countries on an index basis at the end of 1995. The other webs in the top line record how different were the economic fundamentals for Group A in 1993 and 1989 respectively. It can be seen that inflation in group A countries was far worse in 1989 and 1993 than in 1995.

The second two rows of webs compare economic fundamentals in Group B and Group C countries at the equivalent points in time. The close any value is to zero on the radial index, the closer is that fundamental to the position of Group A countries in 1995. For instance, looking at inflation, all three groups had achieved a simalr outcome in 1995.

What is clear from an overall view of the webs diagram is that the Group A countries have done better than Group B or C countries at pulling their economies into shape over the period studied. And the Group B countries have outperfomed the Group C countries over that period. This evidence strogly supports the view that the awarding of sovereign credit ratings acts as a strong disciplinary force on government policy makers.

The FRBNY study In this study, Richard Cantor and Frank Packer of the FRBNY, published as Determinants and Impact of Sovereign Credit Ratings, FRBNY Economic Policy Review, October 1996 have attempted to determine on a comparative basis the weighting values employed by Moody’s and Standard and Poor, and the impact of changes in their sovereign credit ratings on changes in the cost of borrowing for national governments. Their stufdy confirms the results of the other two research efforts.

From the BNP, IMF and FRBNY studies, it is clear that sovereign credit ratings do impose pressure on the policy formation process in the individual countries concerned. It remains to examine the significance of this observation in the context of world economic and political relationships.

The Reliability of Sovereign Credit Ratings

In a different study conducted by Nadeem Ul Haque,Donald Mathieson and Nelson Mark of the IMF, and published as Rating the Raters of Country Creditworthiness, Finance and Development, March 1997, the research sets out to assess how useful sovereign credit ratings are in determining a country’s credtiworthiness.

The study group used data from the period 1981 for the Institutional Investor, 1982 for Euromoney and 1989 for the Economist Intelligence Unit through to 1993. Econometric analysis was conducted of changes in ratings and relative rating levels in comparison with a range of economic and political indicators. Form the results, it is apparent there exists a high level of varianbiltiy between different agencies and for a given agency, variations in treatement of countries varies over time ans accoding to prformance levels in certain key indicators. For instance, a small change in inflation is important in low inflation countries wheas it tends to be ignored for countries where inflation is above a certain threshold level.

In a subsequent study published as The Relative Importance of Political and Economic Vatriables in Creditwothiness Ratings, IMF Working Paper WP/98/46, April 1998, this same IMF team found that there appears to be virtual ommission in practice of political events as an influence on sovereign credit ratings. The study examined the impact of a broad range of serious political events on ratings levels and found little statistical relationship betweeen these sets of variables.

Table 4 Serious Political Events Considred int eh IMF Analysis of Rating Methodology

Coups The number of ext4ra-consitutional or forced changes in the top government elte and/or its effective control onf the nation’s power structure in a given year.

Assassination Any politically motivated murder or attempted murder of a high government official or politician.

General Strikes Any strike of 1,000 or more industrial or service workers that involves more thwen one employer and that is aimed at national government policies or authority.

Guerilla Warfare Any armed activity, sabotage, or bombings carried on by independent bands of citizens or irregular forces and aimed at the overhtrow of the present regime.

Major Government Crises Any rapidly developing situation that threatens to bring the downfall of the present regime - excluding situations of revolt aimed at such overthrow.

Purges Any systematic elimination by jailing or execution of political opposition within the ranks of the regime or the opposition.

Riots Any violent demonstration or clash of more than 100 citizens involving use of physical force.

Revolutions Any illegal or forced change in the top government elite, any attempt at such change, or any successful or unsuccessful armed rebellion whose aim is independence from the central government.

Anti-Government Demonstrations Any peaceful public gathering of 100 people for the primary pyurpose of displaying or voicing their opposition to government policies or authority.

If serious political developments are not relevant to the rating agency methodology, it is questionable what role they are playing in world financial markets. Indeed, the interested international investor might simply construct a weighted index of hard economic information and carry out their own rating assessments. This would be relatively cheap and, in many cases, provide the investor with much motre up to date information.

Conclusion

From a review of all of these studies, it is apparent that the credit rating process is characterised in many ways by an arbitrary drawing together of many different indicators, some numerical and others purely subjective. The lack of consistency across the different agencies in their approach to rating formulae and weighting systems indicated the outcome on any one rating event can be quite arbitrary. In this sense, the creditworthiness of any individual country as indicated by the rating it is awarded is a matter of more or less subjective conjecture. This is complicated by the apparent failure of the rating agencies to account for serious political disturbances in their assessment process. In turn, the adjustments enforced in policy formation by governments in response to credit ratings can be seen as the partial product of this diverse and arbitrary rating system used amongst the different agencies. Perhaps it is time for international institutions, both inter-government and private sector, to engage in a process of dialogue aimed at establishing a uniform system of soverien credit rating that produces a more consistent behaviour of agencies amongst themselves and over time.

ATTACHMENT 1