Wednesday, February 17, 2010

Sovereign debt rating criteria

There are some doctrinal problems associated with the stance of the large rating agencies. For example, below are S&P's guidelines, with my comments in italics.

For sovereign governments, the key determinants of credit quality are political and economic risk. Economic risk addresses a government's ability to repay obligations on time. Political risk addresses the sovereign's willingness to repay, a qualitative factor that distinguishes sovereigns from most other issuers. Political risk encompasses the stability and legitimacy of political institutions. At the regional and local government level, the analysis includes the supportiveness and predictability of the public sector system and the matching of revenue to service responsibilities.

Economic risk is thus misguided for currency issuing countries. This includes Japan, the U.S., and the U.K. Matching revenue to service responsibilities is somewhat of a misnomer as well, considering these countries do not need to "raise" revenue in order to spend their own currency.

The foundation of government creditworthiness is the economic base. The economic structure, demographics, wealth, and economic growth prospects play a key role in credit analysis.

Again, growth prospects delineated within a sovereign country's own currency is a different thing when commodity convertability is an issue. And, of course, all of these issues are notoriously difficult to predict with reasonable accuracy.

Budgetary performance is a central component of financial analysis. Special attention is paid to revenue forecasting, expenditure control, long-term capital planning, debt management, and contingency plans. The debt burden relative to the economic and population base, as well as the government's debt structure and funding sources are considered.

With sovereign currency issuing countries, debt structure and funding sources have little bearing on credit worthiness, instead, Taxation and Government Spending function as aggregate demand dampeners and enhancers, respectively.

Off-balance sheet obligations are recognized. Quantitative elements are captured in a number of ratios that can be compared to those of peers.

Very well. But care must be given when analyzing sovereign currency issuers; their "debt" functions as something other than a drag on economic activity and future creditworthiness. I need not remind the reader here that "off balance sheet" poses its own problems with detection, valuation, and predicting future inflows and outflows of currency.

For sovereigns, financial analysis includes fiscal and monetary flexibility. The financial sector may be viewed as a significant contingent liability for a sovereign government. External liquidity is also analyzed.

Interesting. This appears to be aimed at Europe, U.K., and the U.S. External liquidity is not a factor for sovereign currency issuing countries.

Similar to the rating process in the private sector, analytical judgment, rather than a formulaic approach, is employed to weigh the individual RAMP categories and reach a rating decision.

OK, just as long as private sector corollaries do not bleed into analysis concerning non-convertible sovereign currency issuers.

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