Market concern regarding sovereign credits increased to new levels in April 2010, when Standard & Poor’s (S&P) lowered its credit rating for Greece to non-investment grade at BB+. Today Greece’s rating is CC. Similarly, on August 5, 2011, S&P lowered the United States government’s rating to AA+ (one notch down from AAA) with a negative credit outlook due to concerns over the rising medium-term debt burden and challenges in attaining political consensus on the fiscal consolidation plan. The U.S. government downgrade was followed by S&P lowering the rating on state and local governments, government agencies, and corporates with significant support or revenue from government contracts.

We have seen how far-reaching the impact of sovereign credit downgrades can be, ranging from short-term impacts on consumer and corporate borrowing cost to long-term changes in public fiscal policy. To get a better understanding of the rating process from a user’s perspective, we are very fortunate to be able to discuss these issues with Marie Cavanaugh at Standard & Poor’s in New York.

Background to sovereign debt ratings

Sovereign credits are determined based on the combined score of five broad categories:

1. monetary
2. economic
3. external factors, including the level of external financing, actively traded currency, reserve currency
4. fiscal strength
5. political measures, including an assessment of the effectiveness and predictability of public economic and financial policies

Tables 1 and 2 (right) provide an overview of comparative economic statistics. (Note that the U.K., Germany, France, and Canada are AAA-rated sovereigns.) Additional IMF statistics on Greece’s borrowing and country fiscal balance are shown to the right in table 3 and chart 1.

What are some of the key differences in assessing a sovereign versus a corporate credit?

Marie: The credit analysis approach is quite similar for both credit types. Factors that affect creditworthiness include an assessment of the likelihood of default, as well as factors such as recovery, priority of payment, and stability.

A sovereign rating is a globally comparable and independent credit opinion, established via both quantitative and qualitative analysis in accordance with published criteria. The rating is not an investment recommendation.

Standard & Poor’s sovereign analysis includes projections of generally three to four years. The analysis also aims to look through political and economic or business cycles. A rating outlook indicates the likely rating trajectory, with a positive suggesting a 33% or better chance of an upside scenario consistent with an upgrade, and a negative outlook suggesting a 33% of better chance of a negative scenario consistent with a downgrade.

Unlike corporate credits, sovereigns generally do not issue debt that is either secured or subordinated. Naturally, the rating criteria are different for sovereign versus corporate credits. Criteria for sovereign credit ratings focus on political and economic factors, while corporate criteria focus more operating and financial characteristics.

How does the banking sector affect the sovereign rating process?

M: The strength of the banking sector is an important consideration in the assessment of sovereign creditworthiness. Most developed countries have well-developed banking systems, able to intermediate savings into productive investments in an efficient manner. Banks provide a core economic function and are a key conduit for the implementation of monetary policy. However, because sovereigns tend to provide support when systemic risk threatens the banking system, banks are also a sovereign contingent liability when those circumstances arise. There were different levels of government support for the banking sector during the 1997 Asian crisis and in the 2008 global financial crisis. The sovereign rating criteria took into account this contingent liability, though in some cases it turned out to be larger than estimated.

There is foreign currency debt rating versus local currency debt rating in sovereign rating. What is the difference between these in the Euro area?

M: Generally, a sovereign has significantly greater flexibility in meeting its local currency obligations than foreign currency debt because of its control of the local currency money supply, its fiscal flexibility, and its role in regulating the resident financial sector. Sovereign local currency defaults have been less frequent than foreign currency defaults. As a result, local currency sovereign debt ratings may be zero to two notches higher than foreign currency ratings.

Members of the European Monetary Union ceded control of monetary and exchange rate policy to the European Central Bank and operate under a unified currency for the benefit of price stability. As a result, there is no difference between local currency ratings versus foreign currency ratings for all sovereigns and any other entities in the Euro area member states.

What circumstances will be considered a satisfactory resolution of a sovereign credit event and result in an upgrade?

M: Upgrades are a function of improvement in one or more of the five broad factors that make up the sovereign rating criteria. Thus, an upgrade is usually driven by improvements in political institutions or processes, the economic structure or growth prospects, external performance, or fiscal or monetary flexibility. The focus is on improvements in fundamentals, rather than on improvements driven by cyclical factors.

Marie Cavanaugh
Managing Director, Sovereign Ratings Group Standard & Poor’s Ratings Services

Marie Cavanaugh is a managing director in Standard & Poor’s Sovereign Ratings Group and a participant in most sovereign rating committees globally. The group determines Standard & Poor’s credit ratings on central governments, multilateral lending institutions, national development and export-import banks, and other sovereign-supported public-policy-oriented entities. Marie also contributes to the assessment of sovereign and country risk in non-sovereign credit ratings.

Special thanks are extended to John Piecuch and Dmitri Sedov at Standard & Poor’s, New York.

Other references:
1. “Fiscal monitor: addressing fiscal challenges to reduce economic risks,” International Monetary Fund, September 2011.
2. “The future of sovereign credit ratings,” Standard & Poor’s, September 24, 2010.
3. Other publications on sovereign and corporate rating criteria are available at the Standard & Poor’s website at www.standardandpoors.com