What is a Sovereign Credit Rating?

What is a Sovereign Credit Rating?

A sovereign credit rating is an independent assessment of the creditworthiness of a country or sovereign entity. Sovereign credit ratings can give investors insights into the level of risk associated with investing in the debt of a particular country, including any political risk.

At the request of the country, a credit rating agency will evaluate its economic and political environment to assign it a rating. Obtaining a good sovereign credit rating is usually essential for developing countries that want access to funding in international bond markets.

Obtaining a good credit rating is important for a country that wants to access funding for development projects in the international bond market. Also, countries with a good credit rating can attract foreign direct investments.

The three influential rating agencies include Moody’s Services, Fitch Ratings, and Standard & Poor’s. Although there are other smaller credit rating agencies, the three agencies exert the highest influence over market decision-makers.

Understanding Sovereign Credit Ratings

In addition to issuing bonds in external debt markets, another common motivation for countries to obtain a sovereign credit rating is to attract foreign direct investment (FDI). Many countries seek ratings from the largest and most prominent credit rating agencies to encourage investor confidence. Standard & Poor’s, Moody’s, and Fitch Ratings are the three most influential agencies.

Other well-known credit rating agencies include China Chengxin International Credit Rating Company, Dagong Global Credit Rating, DBRS, and Japan Credit Rating Agency (JCR). Subdivisions of countries sometimes issue their own sovereign bonds, which also require ratings. However, many agencies exclude smaller areas, such as a country’s regions, provinces, or municipalities.

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Sovereign credit risk, which is reflected in sovereign credit ratings, represents the likelihood that a government might be unable—or unwilling—to meet its debt obligations in the future. Several key factors come into play in deciding how risky it might be to invest in a particular country or region. They include its debt service ratio, growth in its domestic money supply, its import ratio, and the variance of its export revenue.

Many countries faced growing sovereign credit risk after the 2008 financial crisis, stirring global discussions about having to bail out entire nations. At the same time, some countries accused the credit rating agencies of being too quick to downgrade their debt.

s to rate them. These potential conflicts of interest would not occur if investors paid for the ratings.

Determinants of Sovereign Credit Ratings

Credit rating agencies use both qualitative and quantitative techniques to determine the sovereign credit rating of a country. A 1996 paper published by Richard Cantor and Frank Packer titled “Determinants and Impacts of Sovereign Credit Ratings” outlined various factors that explain the difference in credit ratings assigned by the various rating agencies. The factors include:

1. Per capita income

Per capita income estimates the income earned per person in a specific area. It is calculated by taking the total income earned by individuals in a given area divided by the number of people residing in that area.

A high per capita income increases the potential tax base of the government, which subsequently increases the government’s ability to repay its debts.

2. GDP growth

The GDP growth rate of a country refers to the percentage growth in the GDP of a country from one quarter to another as the economy navigates a business cycle. Strong GDP growth means that a country will be able to meet its debt obligations since the growth in GDP results in higher tax revenues for the government.

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However, if the growth rate is negative, it means that the economy is experiencing a contraction, and the country may fail to honor its debt obligation if the situation continues.

3. Rate of inflation

Sovereign debts are susceptible to changes in the rate of inflation, and an increase in inflation will affect a country’s ability to finance its debt. A high inflation rate points to structural problems in a country’s finances, and it is likely to cause political instability as the public becomes dissatisfied with the increasing inflation.

4. External debt

Some countries rely heavily on external debts to finance their development and infrastructure projects. Increasing debt levels translate to a higher risk of default, which may affect its ability to access funding from international lenders. This burden increases if the foreign currency debts exceed the foreign currency income earned by a country in the form of exports.

5. Economic development

Credit rating agencies consider the level of development when determining the sovereign credit rating of a country. Usually, once a country has reached a certain level of development or per capita income, it is considered less likely to default on its debt obligations. For example, economically developed nations are considered less likely to default compared to developing countries.

6. History of defaults

A country that defaulted on its debt obligations in the past is considered to have a high sovereign credit risk by rating agencies. It means that countries with a record of defaults receive low ratings, making them less attractive to investors looking for low-risk investments.

Sovereign Credit Ratings in the Eurozone

The European debt crisis reduced the credit ratings of many European nations and led to the Greek debt default. Many sovereign nations in Europe gave up their national currencies in favor of the single European currency, the euro. Their sovereign debts are no longer denominated in national currencies.

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The eurozone countries cannot have their national central banks “print money” to avoid defaults. While the euro produced increased trade between member states, it also raised the probability that members will default and reduced many sovereign credit ratings.