Sovereign Credit Rating

Questionable Methodologies

Ahmed Naciri

• Publisher: Routledge
• Year: 2016
• Print ISBN: 9781138678545
• eBook ISBN: 9781317192992
• Edition: 1
• Topic: Business
• Subtopic: Accounting Standards
• Index: Business

The current degradation of sovereign balance sheets raises very real concerns about how sovereign creditworthiness is measured by credit rating agencies. Given the disastrous economic and social effects of any downgrade, the book offers an alternative and calls for more transparency about the quantitative measures used in calibrating the rating process and how sovereign ratings are validated. It argues that oversight is required and procedures improved, including subjecting methodologies of assessing default to more standardization and monitoring.

Sovereign Credit Rating explains the process of sovereign creditworthiness assessment and explores the consequences of possible inaccuracies in the process. Developing an innovative new methodology to assess ratings accuracy, it shows that the announcement of each rating action by the major credit rating agencies show alarming inconsistencies.

Written by an internationally recognized author and professor, this unique book will be of interest to researchers and advanced students in corporate governance, accounting, public finance and regulation.

1 Introduction to the book

Sovereign credit ratings, SCR, are evaluations of the creditworthiness of governments and are determined by specialised private institutions, called credit rating agencies, CRA. The main use of sovereign credit ratings is to orient investors in government bonds investment; to help them assess the likelihood that the sovereign issuer will be able to face its debt financial obligations. Sovereign credit ratings may also play another determining role, especially for emerging and developing countries. They may give investors confidence in investing in emerging and developing environments seeking foreign capital and therefore in need of demonstrating transparency and credit standing. Although sovereign credit ratings may play a major role in global capital allocation and efficiency, they were recently subject of controversies. Three major agencies, Fitch Ratings, Moody’s Investors Service and Standard & Poor’s (S&P), together called the Big 3, dominate the global credit allocation, but are also blamed for many of its ills. The Big 3 were especially accused of opacity and recently subjected to legal monitoring. Among the Big 3, Moody’s seems to have improved more significantly its disclosure procedures and appears to constitute the best bet. For this reason and for simplification purpose, Moody’s and the Big 3 will be interchangeably used in this book and Moody’s should even be praised for its improved disclosure efforts.

This chapter starts by introducing the reader to the activity of sovereign rating, its history, it role, its definition and principles, its approach and accuracy, and finally the methodology of the book and synopses. It concludes for a need of methodological upgrading and monitoring efficiency improvement, not necessarily an increasing surveillance.

The activity of sovereign rating

Sovereign credit rating seems to have a long history, the first general government bonds is thought to have been issued by the city of Amsterdam around 1517, but the first bond issued by a national government was sold by the Bank of England in 1694, for the purpose of raising money to fund a war against France.¹ Similarly, sovereign defaults have been a fact of life throughout history (Gianviti et al., 2010); in fact, countries like Austria, Greece, Germany, Italy, Portugal, and Spain have each experienced at least one case of sovereign default since 1824 (Zettelmeyer, 2006). Germany alone has defaulted on its sovereign debt three times in the past 100 years (Kratzmann, 1982). Actually, Germany’s constitutional court has explicitly recognised the state’s right to free itself from an excessive debt burden by means of declaring bankruptcy Looking back to 1929, Poor’s Publishing already rated Yankee bonds that were issued by more than twenty-one sovereign governments. A Yankee bond is a bond denominated in U.S. dollars and that was publicly issued in the U.S. by foreign banks and corporations (Bahtia, 2002). According to the Securities Act of 1933, Yankee bonds must first be registered with the Securities and Exchange Commission (SEC) before they can be sold. They are often issued in tranches and each offering can be as large as $1 billion (Investopedia). Table 1.1 gives the repartition of the Yankee bonds by issuer in the year 1929.

Sovereign defaults spiked during the 1930s depression and by 1939 all European sovereign were in the speculative grade, except the United Kingdom and later in the same year most sovereign ratings were suspended during the whole World War II period, with the exception of those on Canada, the United States, and few South American republics. Yankee bonds will be rated again by S&P and Moody’s, only after World War II, but the new momentum in the sovereign rating activity will be discouraged again by the introduction of the so called interest equalisation tax (IET), by the United States in 1963. Its withdrawal in 1974 will however give a new start to the sovereign activity and will allow the main agencies to dominate the market, securing themselves a combined market share of about 95 per cent of all ratings revenue (Beers and Chambers, 1999). Although more than 100 credit rating agencies globally issue credit, this book will focus on only the three biggest among them. These are Fitch Ratings, Moody’s Investors Service and Standard & Poor’s (S&P). The sovereign rating coverage of these three largest agencies dwarfs that of the rest of the agencies around the world, and put them in a position where they count for very little on the global credit market. The Big 3 have a lot in common; they for instance share comparable approaches of ratings and ratings definitions. Table 1.2 gives major rating agency statements on what their ratings are designed to measure.

The three statements are similar and have in common the disclaiming statement of any responsibility regarding the predictive value of ratings of any specific frequency of default or loss that can be used with high confidence in decision making. Such disclaiming appears so strong to the point where one may wonder what is the practical usefulness of ratings, if they cannot be used as predictors of risk of default. Theoretically, however, sovereign credit rating activity is suggested to allow the aggregation of the information about the credit quality of sovereign borrowers and their related debt offerings and further sovereigns seek ratings so that they and their private sector borrowers can access global capital markets and attract foreign investment, thereby adding liquidity to markets that would otherwise be illiquid (IMF, 2010). Previous academic literature has only focused on differences in sovereign rating quality between the major rating agencies; this book aims at a different objective, namely assessing the accuracy of the approach used by agencies in assessing sovereign default.

Table 1.1 The repartition of the Yankee bonds by issuer in the year 1929

Region	Country
Asia	Australia, China and Japan
Europe	Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hungary, Italy, Norway and the United Kingdom
North America	Canada and the United States
South America	Argentina, Chile, Colombia, Peru and Uruguay

Source: adapted from Bahtia (2002).

Table 1.2 Rating agency statements on what their ratings are designed to measure

Agency	Statements on what the rating is designed to measure
Fitch	According to Fitch, credit ratings assess risk in relative rank order (as ordinal measures). They are not predictive of a specific frequency of default or loss. Fitch warns that credit ratings do not directly address any risk other than credit risk and do not deal with the risk of a market value loss on a rated security “due to changes in interest rates, liquidity and other market considerations.”
Moody’s	Moody’s underlines the fact that ratings are intended to convey opinions of the relative creditworthiness of issuers and obligations.
Standard & Poor’s	According to Standard & Poor’s credit ratings are designed primarily to provide relative rankings among issuers and obligations of overall creditworthiness; the ratings are not measures of absolute default probability. Creditworthiness encompasses likelihood of default and also includes payment priority, recovery, and credit stability.

Source: Fitch, Moody’s and Standard & Poor’s

In theory and potentially CRAs are supposed to provide three kinds of services, basically: an information service, a monitoring service, and a certification service. Indeed, since investors have often less knowledge, compared with issuers, about the factors that determine sovereign credit quality, CRAs consequently are in a position where they can address an important problem of asymmetric information, between sovereign debt issuers and investors. Asymmetric information exists when a sovereign debt issuer has more or superior information compared with investors. CRAs might therefore provide an independent evaluation and assessment of the ability of sovereign issuers to meet their debt obligations. They might actually provide “information services” that aims three distinct objectives (IMF, 2010):

1. (i) The reduction of information costs
2. (ii) The increase of the pool of potential borrowers
3. (iii) The promotion of the liquidity of the markets.

Further, CRAs may also provide valuable “monitoring services” through which they can influence issuers to take corrective actions to avert downgrades via “watch” procedures. This is equivalent to a contractual provision between the issuer and the CRA where the former takes the engagement to undertake specific actions to mitigate the risk of a downgrade (Boot et al., 2006). Accurate sovereign ratings may help strengthen the fundamentals of sovereign balance sheets, especially in those countries facing immediate strains. They may encourage sovereigns to enhance the quality of their balance sheets, by following a credible path to ensure fiscal sustainability (see the October 2010 World Economic Outlook and the November 2010 Fiscal Monitor).

Finally, a sovereign credit rating can be seen as a certification service, where the CRA insures investors of the capacity and willingness of the issuer to meet its financial commitments regarding interest payments and repayment of principal, on a timely basis. This is supposed to be reached through the measurement of the relative risk that an entity or transaction will fail. “A sovereign is typically deemed to default when it fails to make timely payment of principal or interest on its publicly issued debt, or if it offers a distressed exchange for the original debt (IMF, 2010).

In order to assess sovereign credit ratings, CRAs map the relative risks into discrete rating grades that are usually expressed in terms of alphabetic rankings. For example Moody’s rates sovereign issuers from the most creditworthy to the least using Aaa, Aa, A and Baa, Ba, B, Caa, Ca and C. Similarly, Fitch and S&P use AAA, AA, A, BBB, BB, B, CCC, CC, C and D. Modifiers are also added to distinguish and rank ratings within each of the general classifications. In this regard, Moody’s uses numbers, e.g., Aa1, Aa2, Aa3; Fitch and S&P use pluses and minuses, e.g., AA+ and AA−. As a general rule, rating symbols above Baa3 for Moody’s or BBB− for Fitch and S& P are considered investment grades. These are bonds that are considered by CRAs as likely enough to meet payment obligations. Inversely rating symbols under Ba1 for Moody’s and BB+ for both Fitch and S&P included down to Caa/CCC are considered speculative. These are bonds that are judged by the rating agency as unlikely to meet debt payment obligations. CRAs usually signal in advance their intention to consider rating changes, Fitch, Moody’s, and S&P, for example, all use negative “review” or “watch” notifications to signal a short term downgrade potential, i.e., a downgrade is likely to happen within the next 90 days. They also use a negative “outlook” notification to signal a medium term downgrade potential, i.e., to point to a potential for a downgrade within the next two years for investment-grade credit and one year in the case of speculative-grade. Although agencies’ rankings can have different scales for different debt terms, the discussion in this book concentrates solely on long-term debt rating scales.

Fundamental sovereign credit risk analysis

The CRAs determine sovereign ratings using a range of quantitative and qualitative factors, with which they try to measure a country’s ability and willingness to face its yearly debt obligations (interest payments and capital reimbursement). Some factors differentiate the rating of sovereigns over and above other instrument ratings. One of them is the concept of “willingness to pay.” Such a concept reflects the potential risk that even if a sovereign had the capacity to pay, it may not be willing to do so, whenever it judges the social or political costs to be too high. To capture this willingness element, CRAs assess a range of qualitative factors such as institutional strength. Table 1.3 summarises key factors used by CRAs in sovereign credit rating assessments, and extended discussion of the methodology can be found in Chapter 6.

Major CRAs have recently gained remarkable notoriety, equivalent to a market authority and impacting almost as the state itself, by deriving their influence from three sources: (i) the perceived information content of the ratings; (ii) the incorporation of the ratings into financial regulations which used to given the force of law; and (iii) the incorporation of the ratings in private investment rules (Bruner and Abdelal, 2005). There is, however, another more fundamental reason why investors would want to rely on ratings, irrespective of the previously cited reasons; it is, after all, extremely costly for the average investor to undertake the necessary analysis to rate a sovereign debt. Social efficiency may, of course, suggest trusting a third party with this function, as it may prove beneficial for all the parties involved, conditional that the accuracy of the ratings is assured.

Following the recent crisis, along with the US and the European sovereign downgrades, questions are insistently being asked again about the usefulness of CRAs and the accuracy of their sovereign credit risk assessments. Indeed, such questionings can be encountered going back to the 1990s. CRAs have then been accused of mingling with market efficiency. They were also accused, during the 1997 Asian crisis, of being too slow initially to downgrade East Asian sovereigns, and subsequently of downgrading them more than the worsening fundamentals justified. Such concerns become relevant whenever one of the two following condition is met: when ratings actually influence markets and when ratings are inaccurate and/or ill timed. Empirical tests show that sovereign ratings do in fact influence markets, although more via credit warnings (“outlooks,” “reviews” and “watches”) than through actual rating changes and more significantly when the investment-grade threshold is crossed.

Table 1.3 Key factors used by CRAs in sovereign credit rating assessments

Agency	Key factors in sovereign credit rating assessments
Fitch	Macroeconomic policies, performance, and prospects; structural features of the economy; public finances; external finances
Moody’s	Economic strength; institutional strength; financial strength of the government; susceptibility to event risk
Standard & Poor’s	Political risk; economic structure; economic growth prospects; fiscal flexibility; general government debt burden; offshore and contingent liabilities; monetary flexibility; external liquidity; external debt burden

Source: Fitch (2010); Moody’s (2008); and Standard and Poor’s (2008).

Agencies define rating “accuracy” on an ordinal (rank ordered) basis. They often claim that their ratings are supposed to reflect ordinal risk rankings. In fact, they constantly make it clear concerning sovereign rankings that their ratings do not aim for a mapping of default risk measures into rating grades, and in a mood of half-empty/half-full glass, they constantly pretend that their rating processes only involve forming views about the likelihood of obvious scenarios and not forecasting them. Moody’s, however, with what might be considered as a contradictory statement, underlines that although ratings typically are not defined as precise default rate estimates, there is an expectation that they will, on average, relate to subsequent default frequency. In any case, empirical analysis shows that CRAs ran...

Table of contents

• Cover
• Title
• Copyright
• Dedication
• Contents
• List of figures
• List of tables
• List of appendices
• List of abbreviations
• Preface
• 1 Introduction to the book
• 2 General sample and general methodology
• 3 Sovereign credit universe
• 4 Macroeconomic environment of sovereign default
• 5 The history of sovereign ratings and the emergence of the three major sovereign credit agencies
• 6 Agencies’ methodology for sovereign default assessment
• 7 Testing the accuracy of agencies’ approach to assessing sovereign worthiness
• 8 Subjectivity and asymmetry, why accuracy in sovereign ratings should not be expected
• 9 Disclosure and transparency, the quest of accuracy in the sovereign ratings
• 10 Concluding remarks, sovereign creditworthiness accuracy
• Bibliography
• Data appendices A–C
• Index