Understanding Sovereign Ratings and Credit Rating Agencies

The term “credit rating” is something that every individual or business is quite familiar with. It is an important factor that is considered by financial lending institutions to determine the repayment capacity of an individual or business. In short, credit rating is a measure of a business entity or individual’s ability to repay any financial obligation undertaken, based on their repayment histories and income. Some of the top credit rating agencies in India include CARE, CRISIL, ICRA, etc. 

Similarly, the creditworthiness of countries is also assessed and this is known as a sovereign rating. So, what exactly is a sovereign rating and how is this rating bestowed on a country? Who are the credit rating agencies involved? And how does a rating impact a country and its growth and development? 

What is a Sovereign Rating?

A sovereign rating measures and evaluates the creditworthiness of a country. This rating depicts the risk related to the lending to any specific country, inclusive of political risk. When requested by any specific country, the authorized credit rating agency evaluates the economic as well as the political environment of the country in order to assign the rating.  A good sovereign rating is quite important for any developing country as it enables them to attract FDI. 

Who are the Credit rating Agencies?

Amongst the pool of credit rating agencies, the top three rating agencies are Moody’s, Standard & Poor’s, and Fitch Ratings, who are highly influential and account for about 90 percent of the market. A rating of BBB- or higher is given by Standard & Poor to countries that it rates as investment grade, and a rating of BB+ or lower is considered speculative. According to Moody’s, a rating of Baa3 or higher is considered as investment grade, and that of Ba1 or below is considered speculative.

The focus in this article is on the credit rating agency – Standard & Poor, and the criteria considered by them in evaluating the sovereign rating of a country.

About Standard & Poor:

Standard Statistics was created in the year 1906 and it published ratings related to corporate bonds, municipal bonds, and sovereign debt. In the year 1941, it merged with Poor’s Publishing and formed what is known as Standard and Poor’s Corporation. In 1966, this was acquired by  McGraw-Hill Companies. The S&P 500 Index which is a stock market index is a great tool that helps in the analysis as well as decision-making, in addition to being an economic indicator of the U.S.

Standard and Poor have 17 ratings that can be allotted to corporate as well as sovereign debt. A rating between AAA to BBB- is termed as investment grade, which indicates that the country can repay the debts without any concern. A rating between BB+ to D is regarded as speculative, having an uncertain future. A country with a lower rating has a high potential of being a defaulter.

Factors that determine a Sovereign Rating

A lot of factors are considered during the credit rating process. The credit rating agencies make use of qualitative as well as quantitative methods to measure and decide a country’s sovereign rating.  Let us look at the criteria that are considered by Standard & Poor in their credit rating process.

Standard & Poor has five key determinants – political risks, economic, monetary, external, and fiscal which form the basis of the sovereign ratings assigned to countries. Every single determinant is graded on a scale of six points. The key determinants consist of numerous variables that could be either quantitative or qualitative.

  1. Political: This score depicts the political risks as well as institutional effectiveness. Under this determinant, the stability, and effectiveness of the political institutions are being assessed in addition to their level of transparency and answerability. The data and processes of these political institutions and policy-making institutions are also assessed. 
  2. Economic Structure and Growth: These factors indicate a country’s growth aspects and its economic structure. The levels of Growth and income form the basis for economic factors. A lot of financial ratios are used to understand and determine the overall health of the nation, for instance, the Debt to GDP ratio. 
  3. External Liquidity Score: This depicts the country’s external liquidity in addition to its investment position internationally. Factors such as gross external financing requirements, net external debt, foreign exchange reserves that can be used, the total reserves, the current account receipts, the net FDI, net external liabilities, terms of trade, etc., are considered while evaluating the external score. The point of focus would be whether India is being considered as a good investment destination by FII’s, whether there is an inflow of FDI and how good the domestic investment condition is.
  4. Fiscal Score: This is the last factor and it is a measure of the debt burden, fiscal performance, and flexibility. The focus here is on whether the fiscal deficit is under control, whether the aid offered by the Government is backed by any basis, and whether there is professional budgetary management. These factors give an overview of the condition of government finances.
  5. Monetary: This looks into the monetary flexibility of a nation. Under this, the performance of the RBI is assessed – whether it is robust enough, whether it regulates the supply of money as per the requirements, whether it is keeping a tab on the inflation levels and ensuring it is under check, etc. 

Conclusion

When a country permits an external credit rating agency or agencies to assess and appraise its economy, it indicates that the country is prepared to disclose its financial information to the investors. Any nation having a high credit rating gets access to international funds easily via the international bond market. It can also attract foreign direct investment easily. On the other hand, a country with a low sovereign rating portrays a picture of being a defaulter and might face difficulties in repayment of debts. Credit Rating Agencies are expected to provide investors with objective information that has been derived using accurate and sound methods of analysis. The analyses provided by different credit rating agencies give investors the required information which enables them to understand the various risks as well as opportunities with different investment environments. This insight helps investors make informed decisions related to industries, countries, or securities, where they intend to invest.

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Ved
Ved holds a Master's Degree in Management Studies in Finance from the ICFAI Business School Mumbai. He is extremely passionate about Equity markets and swears by the age-old maxim of “Time in the market is more important than timing the market”. He has in-depth knowledge & knack of the mutual fund industry and loves working on client portfolios and analyzing Mutual fund schemes on myriad subjective and objective parameters.