SOVEREIGN DEBT RATING

What does sovereign debt rating mean?

For investors who plan to invest abroad, sovereign debt rating is taken as an indicator of the risk involved in investing in bonds issued by the national government of a country. Unlike corporate, the central government has powers like the ability to raise taxes and control money supply.

That’s why they have to be rated separately and typically, the ratings of a government of a particular country are higher than other sectors in the same regime.

The rating scale that is currently being quoted in the media is devised by credit rating agency Standard & Poor and according to it AAA is the best rating for any country. On this scale, the ratings go down to AA+, AA, AA-, A+ and so on till the worst rating which is D, which means the government is in default. Downgrading on the scale means that the risk in investment in that country’s debt is assessed to have increased and because of this, existing investors might withdraw their money while future ones might prefer to invest in safer venues.

How often have national governments defaulted on their debt?

As a national government controls most of its affairs, in the case of default, it can’t in practice be forced to pay back its debts. Some part of its overseas assets might get seized and political pressure may be applied on it, but all of that gives little relief to the investors. The government also faces pressure from domestic investors. Governments rarely default. Typically, a government on the verge of a default enters into negotiations with the investors to try and reschedule the debt or roll them over.

The market is driven by sentiments and in many cases, suspicious investors demand higher returns. There have been many incidents of sovereign debt crisis in the past. Recently, Greece, Ireland and Portugal were swallowed up by a crisis when the governments were unable to pay back investors. Similarly, in the early 1980s, Latin American countries were caught in a debt crisis as the foreign investments grew higher than their incomes and the governments were unable to pay back. Similar situations have also occurred in Mexico, Russia and Argentina.

How is rating scale devised?

The most important element in devising the scale is an analysis of the history of sovereign defaults. According to S&P, most of the defaults since the 19th century have occurred because of past policies which keep a government ill-prepared for sudden events like war, regime change or changes in trade patterns. There are essentially five key factors in determining the government’s rating.

These factors are Institutional effectiveness and political risk; economic structure and growth prospects; external liquidity and international investment position; fiscal flexibility and performance combined with debt burden; and monetary flexibility.

While some of these can be measured quantitatively, others are more qualitative in nature and hence the agency has devised scales to quantify them. For instance, political stability is rated on the basis of effectiveness, stability, and predictability of the sovereign’s policy-making, transparency of political institutions and so on.