Thursday 21st April 2005

 
Assessing the credit quality of sovereigns
 
 
 
 
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By Arjoon Harripaul

Senior Rating Analyst

In the earlier articles, we looked at the capital markets and bond markets, the evolution of credit ratings, the rating symbols used by the global agencies and the role of a rating agency in the development of local bond markets.

In this article and the ones to follow, we will be discussing the rating methodologies adopted by CariCRIS in assigning ratings. The publication of these methodologies is an important part of CariCRIS’ effort to be transparent and to bring about investor confidence in the analytical robustness and the objectivity of its credit ratings. We begin with CariCRIS’ approach in assigning ratings to national governments, also known as sovereign ratings.

The CariCRIS sovereign rating gives investors an insight into the relative risks associated with lending to various Caribbean governments. In other words, it is an objective assessment of a particular sovereign’s creditworthiness relative to other debt issuing governments in the region, for instance between the Government of Jamaica and the Government of Barbados. It is important to note that sovereign ratings assess the credit risk of national governments and are not to be seen as a “country rating”.

The CariCRIS framework for assigning a sovereign credit rating is based on internationally established best practices, involving a fair amount of qualitative judgment as well as quantitative parameters such as debt/GDP, fiscal deficit/GDP, etc. Sovereign risk is usually assessed by analysing five key risk categories viz income and economic structure, fiscal policy/indebtedness, monetary and exchange rate policy, balance of payments and external liquidity and finally, the political environment.

The analysis focuses on the question of how these risk parameters affect the sovereign’s ability to repay its debt. Sovereign ratings also have another dimension viz the currency of debt. The ratings explicitly indicate this by adding a suffix “foreign currency” or “local currency.”

Typically, local currency ratings are one or two notches higher than the foreign currency ratings, reflecting the ability of the government to print local currency or raise taxes to meet its debt obligations. Exception to this includes countries that have an official currency peg (such as Panama) or which are part of a larger monetary union and have a common currency (such as the OECS countries), where “printing money” is not an easy option available to the sovereign.

A natural question arises here. If a government has the ability to print money or raise taxes, why is it not rated “AAA”, at least for its local currency? The answer lies in the fact that no government has unlimited ability to print money or raise taxes as this may have other serious repercussions, such as high inflation, sharp depreciation against hard currency, etc.

Weighing these costs, the government might choose to default on its local currency, rather than print money to meet debt obligations. Thus, unless the fundamental credit quality of the sovereign is strong, the ability to print money cannot take the local currency ratings significantly higher and hence the strong linkage with its foreign currency rating.

We now take a closer look at some of the risk parameters under each risk category.

Income and economic structure

This parameter assesses the state of the economy, its performance, composition, size and diversity, quality of income distribution and quality of private sector participation in the economy. A partial list of factors assessed under this risk category include:

Size of the economy;

Past growth rates;

CariCRIS’ assessment of future growth rates;

Key drivers of growth;

Degree of private sector participation and their global competitiveness;

Human development index, and its trend-line.

Fiscal policy/indebtedness

Under this parameter, CariCRIS assesses the fiscal policy and performance of the sovereign and compares the same with other sovereigns in the region. The extent of indebtedness of the sovereign, the nature of such debts and extent of the sovereign’s fiscal flexibility in meeting its debt repayments are assessed in this parameter. A partial list of factors assessed include:

Government revenues, growth in revenues and quality/diversity of these revenues;

Government expenditure levels, past growth and composition (discretionary vs committed);

Coherence and consistency of government policy, methods of deficit financing;

Effectiveness and equitable nature of tax regimes and government flexibility to increase tax revenues;

Debt/GDP and Interest/Govt revenues, their trend in the past and CariCRIS’ expectation of future indebtedness;

Off-budget and contingent liabilities, size and health of the non-financial public sector enterprises.

Monetary stability

and exchange rate policy

In this risk category, CariCRIS assesses the government’s monetary policy and track record in maintaining stable monetary conditions including past inflation rates, interest rates and exchange rates. The independence of central bank to pursue sustainable exchange rate and monetary policies and extent of development of domestic equity, bond and foreign exchange markets to facilitate the achievement of monetary policy objectives are also assessed in this risk category.

Balance of payments and external liquidity

The government’s policy on external liquidity and ability to meets its balance of payments are assessed in this risk category. A partial list of factors assessed in this risk category include:

Current and capital account position;

Extent of net international reserves and its trend in the past;

Comparison of immediate foreign exchange needs (imports, debt repayments) and external indebtedness vis-à-vis reserves;

Extent of government control on private sector foreign exchange needs;

Foreign investment inflows in the past, quality and stability of this source of foreign exchange.

Political risk

The political environment has a profound impact on every aspect of a sovereign’s operations and consequently its credit quality. The factors assessed in this risk category are predominantly qualitative and the assessments are made in relation to other countries in the Caribbean region. A partial list of factors assessed include:

Stability, predictability and transparency of a country’s political institutions;

Continuity of economic policies;

Consensus (or lack of it) on the direction of economic policies across major political parties;

Degree of social cohesiveness and acceptability of key economic decisions by the populace;

Any national/cross-border security concerns and their impact on potential investment inflows.

Based on these five broad parameters, CariCRIS assigns sovereign ratings in local currency and foreign currency to about 19 countries in the Caribbean region. No sovereign analysis can be considered comprehensive in this region, without an analysis of the impact of natural disasters.

While assigning sovereign ratings, CariCRIS will perform a comprehensive catastrophe risk analysis on each sovereign, including the probability of occurrence based on past history, preparedness of the government to handle natural disasters, extent of damage witnessed in the past, impact analysis at various levels of damage, extent of insurance penetration, financial strength of the insurance companies, etc. and factor in this assessment in its sovereign risk analysis.

Comments/suggestions on this methodology can be forwarded to [email protected]

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