Sovereign Ratings

CI's Analytical Approach

CI's sovereign credit ratings indicate the ability and willingness of sovereign governments to repay existing and future commercial debt obligations on time and in full. Government creditworthiness is also a key consideration in assessing the repayment capacity of private sector entities for two reasons. Firstly, because the sovereign usually has the ability to impose exchange controls or a moratorium on private external debt service. For this reason, the credit rating of an international borrower will, in most cases, be no higher than the rating of the sovereign of the country of domicile. Secondly, because government financial distress is often associated with an unstable operating environment, characterised by macroeconomic, interest rate and exchange rate volatility.

CI views sovereign credit analysis as more of an art than a science and explores creditworthiness in the context of medium-term scenarios and stress tests. The core of the analytical process is similar to a debt sustainability exercise. The outstanding stocks of public debt and external debt are estimated and the debt structures analysed in terms of maturity, currency, and interest rate composition. A number of key ratios are calculated to help identify trends, spot potential risks, and facilitate cross-country comparison. Debt ratios are projected forwards (usually for three to five years) based on CI's expectation of the time path of explanatory variables such as the budget balance or the external current account balance and economic growth and interest rates. Estimates are made of the likely funding needs along those debt paths.

After deriving baseline projections, CI judges whether a government or country could be expected to continue servicing its debt without having to make substantial adjustment efforts. If so, CI explores the resilience of repayment capacity to normal macroeconomic and commodity price fluctuations, and to a range of shocks, both generic and country specific. If not, CI gauges the likelihood of adjustment being delivered in a timely fashion, focussing on the structural and political constraints to reform. Where funding needs appear to be onerous, CI digs deeper to identify the factors that could hasten the onset of a payments crisis and those, other than a timely policy correction, that may forestall a crisis (e.g. financial support from official creditors).

The Principal Categories of Sovereign Analysis

To discipline the rating process and aid peer group analysis, CI divides sovereign analysis into four broad-based analytical categories with the aim of establishing the level of political risk, economic growth prospects, and the sustainability of both the public finances and the country's external position.

CI assesses the durability of a country's social and political fabric and the stability of government and policymaking institutions. We examine how government policies are formulated and executed and review the track record of policymakers in identifying and rectifying policy mistakes. We evaluate the government's ability to devise and enact necessary reforms, taking account of the degree of consensus among ruling parties or groups, the size of the government's power base, and its ability to mobilise public support.

CI examines a country's economic structure, paying particular attention to the level and distribution of per capita income, the diversification of the production and export bases, the susceptibility of the economy to exogenous shocks, and the pace and depth of structural change. We consider the outlook for the real economy, and assess the appropriateness of the macroeconomic policy mix and the stability of the exchange rate regime. We review the government's structural reform programme and any efforts to strengthen the labour, product and financial markets. CI also takes into account developments in the money, capital and real estate markets and explores national and sectoral balance sheets for imbalances that may increase financial vulnerability, such as unhedged foreign currency borrowing in the non-bank private sector.

On the fiscal side, significant emphasis is placed on the consistency between the evolution of the budgetary position and the government's capacity to service its debts on a forward-looking basis. Because the future is uncertain and government finances are exposed to many risks, including macroeconomic shocks and contingent liabilities, we look closely at the government's ability to manoeuvre in an appropriate and timely way in the event of adverse developments.

Budgetary trends are analysed and the diversity and depth of the government's revenue base and flexibility of the spending structure examined. The government's gross financing requirement is calculated and the government's ability to meet its financing needs, and the form and cost that any new borrowing is likely to take, are assessed.

Budgetary analysis is complemented by an analysis of the government's balance sheet in order to assess solvency and gauge financing risks stemming from any weaknesses in the debt structure. Besides the direct debt of the government and its projected value, CI assesses government exposure to contingent liabilities and the likelihood and cost of such liabilities crystallising on the government balance sheet.

CI's approach to external sustainability is analogous to that for fiscal sustainability and involves a combination of flow and stock analysis to establish whether a country has the ability to generate the foreign exchange needed to meet its current and future external debt service obligations in full.

Balance of payments trends are analysed and prospects assessed. CI judges the consistency of the external current account balance with underlying fundamentals and whether it can be financed comfortably, and explores the implications of its size and the composition of financing flows for the evolution of the country's net foreign liability position in general and net debt position in particular.

CI examines trends in the ratios of both gross and net external debt to GDP and to current account receipts. High and rising ratios are generally, but not necessarily, a cause for concern and the reasons for the growth in external borrowing are always assessed. For example, borrowing for productive investment may result in ratios that are high in the short run but are likely to decline steadily in the medium term as new capacity comes on stream.

CI pays particular attention to the external debt of the public sector. Public external debt and financial assets are analysed by maturity, currency, and interest rate structure in order to evaluate balance sheet risks. Public external debt service (interest plus principal) is calculated and projected forwards and compared with official reserves and current account receipts.

We place significant weight on international liquidity and official reserves in particular because they can help to shield the economy from external shocks. The degree to which expected uses of foreign exchange are covered by foreign resources is captured in the ratio of the country's gross external financing requirement to official foreign exchange reserves. A complementary indicator is the ratio of short-term external debt by residual maturity to official reserves. Besides these standard measures, CI constructs ad hoc indicators designed to capture the peculiarities or vulnerabilities of the economy concerned.