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7/31/2019 Determinants Of Sovereign Credit Ratings
Sovereign debt, defined as debt incurred by governments, can take the form of
commercial loans or of bond issues. Particularly, developed countries are the largest
issuers of bonds in world capital markets. Moreover, the structure of private capital flow
to developing countries in the 1990s has dramatically changed since bond issues
exceeded bank lending. As a consequence, the demand for sovereign credit ratings, i.e.,
the risk assessments assigned by credit rating agencies to government bonds, has
significantly increased; all the more so as recent years have witnessed a significant
number of debt crises in developing countries. These credit ratings significantly influence
the terms and the extent to which, in developing countries especially, private and public
borrowers have access in international capital markets.
With the recent downgrade of the Philippines’ credit rating by global rating
agencies, Fitch IBCA and Standard & Poor’s (S&P), it is very important for policy
makers to know and identify the relevant determinants or factors that affect or influence
such credit rating organizations. Specifically, the London-based Fitch, which had been
the most optimistic about the Philippines’ prospects among global rating agencies, has
placed the country’s rating on a “negative” outlook since December last year, but
changed this to “stable” in May 2005 because of significant strides in fiscal reform,
including the passage of the expanded VAT law (e-VAT). Fitch believes that in the
context of the recent political crisis that the Philippines is undergoing, it is questionable
whether the weakened political leadership in the country will commit the necessary
political capital in the resolution of the e-VAT issue soon. On the other hand, United
States- based S&P voiced concern over the country’s ability to maintain the fiscal
consolidation needed to reduce the country’s high level of public and external
indebtedness. The combination of delayed fiscal consolidation, protracted politicalstalemate, and a possible change in economic policy has shifted the balance of risk on the
downside, making a “stable” outlook for the Philippines no longer justified, according to
S&P.
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1) Identify the determinants of sovereign credit ratings; and
2) Identify which factors have the largest influence on the international rating
agencies’ decision on what rating to give to a particular country.
III. SCOPE AND LIMITATIONS
The paper focused mainly on the various economic/political indicators affecting
the sovereign credit rating of a given country. Although there are two types of sovereignratings – local and foreign currency sovereign ratings – only factors influencing the credit
ratings on foreign currency denominated debts was studied. Note that sovereign credit
ratings are an indication of a government’s capacity and willingness to repay principal
and interests on obligations as they fall due. A country may resort to extensive revenue-
generation measures in the form of strict tax collection or through money creation to
service its local currency denominated debt. However, it must exert its best efforts to
secure the foreign currency it needs in order to service its maturing foreign obligations.
Further, although there are other international credit rating agencies like Fitch and
Moody’s, only the ratings given by the Standard and Poor’s were included in the analysis.
Considering that foreign currency denominated debts constitute a large part of our
country’s total debt, it is deemed more important to examine the various factors which
have an effect on our sovereign foreign currency credit ratings which are usually the basis
of foreign creditors in deciding what terms and conditions to impose on our external
borrowings or whether or not they will still provide the financing we need given the risks
involved.
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A review of empirical and theoretical underpinnings of sovereign risk premium of
emerging markets and how they are affected by economic fluctuations suggest that the
most important country-specific predictors of sovereign spread and default probabilities
are liquidity and solvency variables, credit ratings, and indicators of the quality of
macroeconomic policy (Souza, 2004).
In the evaluation of Canuto, et.al. (2004), the researchers analyze the factors that
determine sovereign risk and the role of international credit rating agencies in the
appraisal of such risk. Parallel to other undertakings as contained in international
literature, the results further validate that high sovereign credit ratings are determined by
the following variables: per capita income, inflation as evidenced by CPI, economic
growth, total external debt/current account receipts ratio, central government grossdebt/total fiscal receipts ratio, absence of default events, level of trade openness as
indicated by the sum of total exports and imports as a percentage of GDP.
Using data from S&P’s and Moody’s for June 2001 covering 81 developed and
developing countries (29 developed countries and 52 developing countries as classified
by the IMF in 2001), this study shows that the variables that exert significant explanatory
power for the rating levels are GDP per capita, external debt as a percentage of exports,
the level of economic development, default history, real growth rate, and the inflation rate
(Alfonso, 2003).
The results of a study Cantor and Packer (1996) using Moody’s and S&P’s ratings
in September 1995 illustrate the factors that appear to largely influence sovereign ratings,
as follows: per capita income, GDP growth and inflation, external debt, extent of
economic development, and default. On the one hand, these ratings aim to guide financial
markets on macroeconomic fundamentals of participating sovereigns and thus, effectively
affecting bond yield movements. This further strengthens the findings of other empirical
studies on similar topic.
In sum, empirical findings point to a host of factors that significantly explain how
credit rating agencies assess sovereign risks: per capita income, inflation rate,
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The cross-section data that were used in this study include: 1) sovereign foreign
currency credit ratings of a sample of 61 countries as of December 31, 2004; and
2) economic and political indicators of such countries as of December 31, 2003. There is
a one-year lag in indicators used to allow us to determine the credit rating that will be
given in the current year based on what has transpired (actual observations) in the
previous year.1
Since credit ratings assigned by the Standard and Poor’s are discrete and in
alphabetical form ranging from as high as AAA to as low as D, the ratings were
subdivided into 4 groups and transformed into numbers using the following format: 0 was
assigned to the lowest ratings ranging from D to CCC+; 1 for ratings from B- to BB+; 2
for ratings from BB- to AA+; and lastly, 4 was assigned to the highest rating of AAA.2
Considering that sovereign foreign currency credit ratings are in ranks or ordinal
in nature, the ordered logistic model was used to determine the factors affecting a
country’s credit rating – our variable of interest.
Possible independent variables that were used for the analysis include:
1) gross domestic savings [% of gross domestic product (GDP)]; 2) gross national income
per capita (in USD); 3) consumer price index (% change); 4) trade openness;
5) corruption perceptions index; and 6) default history of countries.
As mentioned earlier, data on sovereign credit ratings came from S&P; default
history of countries from the World Bank’s Global Development Finance 2004; and
corruption perceptions index from Transparency International. The 2003 data on the rest
of the inde pendent variables came from the International Monetary Fund’s InternationalFinancial Statistics and World Bank’s World Development Indicators.
1Complete list of data is presented in Annex A.
2Description of the alphabetical sovereign credit ratings as well as their numerical equivalent are shown in
Annexes B and C, respectively.
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general measure of the average annual changes in the retail prices of commoditiescommonly purchased by households reckoned from a base year and weighted by
the consumption pattern or basket of the households.
Corruption Perceptions Index
relates to perceptions of the degree of corruption as seen by business people andcountry analysts and ranges between 10 (highly clean) and 0 (highly corrupt).
Exports and imports of goods and services comprise all transactions between residents of an economy and the rest of the
world involving a change in ownership of general merchandise, goods sent for
processing and repairs, nonmonetary gold, and services.
Gross Domestic Savings represent the difference between GDP and total consumption. Domestic savings
also satisfy the fundamental identity: exports minus imports equal domestic
savings minus capital formation
Gross National Income (GNI)
takes into account all production in the domestic economy (i.e., Gross DomesticProduct or GDP) plus the net flows of factor income (such as rents, profits, and
labor income) form abroad. The Atlas method smoothes exchange rate
fluctuations by using a three-year moving average, price-adjusted conversionfactor.
GNI per capita
GNI divided by the actual population in a given country.
Inflation Rate
annual rate of percentage change or the year-on-year change in the CPI. Itindicates how fast or slow the CPI increases or decreases.
Sovereign Credit Rating
an assessment of the capacity and willingness of a government to timely serviceits debt, and in accordance with pre-agreed conditions when the loans were made
Trade Openness
measured by the sum of exports and imports as percentage of GDP
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Logistic models are used when dealing with discrete dependent variables. Logistic
regressions relate the probability of occurrence of an event, dichotomous outcomes(binary models) or multinomial outcomes (multinomial models), to a host of explanatory
variables. Within the multinomial models, ordered logistic models are used when thedependent variable is an ordinal variable which measures ranks such as ratings.
It assumes that the ordered logistic model is well adapted for modeling sovereign
ratings, which are clearly ordinal variables. The goal of this model is to express the
probability of a rating score assigned to a country as a function of the economic andpolitical determinants of the said country.
The probability obtained by applying a logistic function to a score obtained by a
linear combination of independent variables. Only the most statistically significantvariables are observed.
Therefore, the model helps identify which independent variables have the largest
influence over the rating agency’s choices.
In ordered dependent variable models, the observed dependent variable Y denotesoutcomes representing ordered or ranked categories. We can model the observed
response by considering a latent variable Y* that depends linearly on the explanatory
variables Xs:
Y* =x’ +
where ’s are independent and identically distributed random variables. The observed Yis determined from Y* using the rule:
Y = 0 , if Y* 1
= 1 , if 1 < Y* 2
= 2 , if 2 < Y* 3 …
= M , if Y* > M
It is worth noting that the actual values chosen to represent the categories in are
completely arbitrary. All the ordered specification requires is for ordering to be preservedso that Yi<Yj implies that Yi*<Yj*.
It follows that the probabilities of observing each value of Y are given by
Pr(Y=0) = F (1 – x’)
Pr(Y=1) = F (2 – x’) - F (1 – x’)
Pr(Y=2) = F (3 – x’) - F (2 – x’) …
Pr(Y=M) = 1 - F (M – x’)
where F is the cumulative distribution function of .
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Out of the 61 countries, 48 (78.7%) had inflation rates that are greater than and
equal to 0% but less than 10%; three countries (which constitute 4.9% of the sample) had
2003 consumer price indices that are lower than the 2002 level. The remaining ten
countries had inflation rates of at least 10% in year 2003.
Tabulation of CPI
Number of categories: 5
Cumulative Cumulative
Value Count Percent Count Percent
[-10, 0) 3 4.92 3 4.92
[0, 10) 48 78.69 51 83.61
[10, 20) 6 9.84 57 93.44[20, 30) 3 4.92 60 98.36
[30, 40) 1 1.64 61 100.00
Total 61 100.00 61 100.00
Trade Openness
The average value for trade openness indicator was 79.88%. The percentage of
the sum of exports and imports with respect to GDP ranged from as low as 22.81% to
207.64%. Countries with percentages above 150% included Malaysia (which posted thehighest trade openness indicator value of 207.64%), Estonia, Slovakia and Ireland.
0
2
4
6
8
10
12
14
20 40 60 80 100 120 140 160 180 200
Series: TRADE
Sample 1 61
Observations 61
Mean 79.88148
Median 68.59000
Maximum 207.6400
Minimum 22.81000Std. Dev. 37.88177
Skewness 0.946551
Kurtosis 3.779534
Jarque-Bera 10.65342
Probability 0.004860
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As evidenced by the p-value of the LR statistic, the joint null hypothesis of
significant slope coefficients is rejected at 5% level of significance. This means that at
least one of the slope coefficients is not equal to zero.
However, note that only the variables GNI, CPI and Corruption are significant at
95% confidence level while the dummy variable Default is only significant at 10% levelof significance based on the p-values of the Z-statistic. This means that S&P’s credit
assessment of a country depends only on the gross national income per capita of each of
the individual countries, on the rate of increase in consumer prices, the corruption
perceptions index of businessmen on the country and the default risk of a country.
Based on the estimated equation, for every one-percentage point increase in the
variable Savings (as % of GDP), the estimated logit will increase by 0.05289, ceteris
paribus. For every USD1 increase in the GNI per capita, the estimated logit will increase
by 0.000193, holding all other variables constant. For every one-percentage point
increase in inflation rate and trade openness, the estimated logit will decrease by
0.128559 and increase by 0.013382, respectively. For every one-unit increase in the
corruption perceptions index, the estimated logit will increase by 1.157246, ceteris
paribus. The estimated logit will decrease by 1.145463 if a country has defaulted or
rescheduled its loans, ceteris paribus.
However, these changes don’t make any sense because these are just the effects
on the estimated logits for every one-unit change in the independent variables. A more
meaningful interpretation is in terms of the odds ratios.
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Based on the results of the analysis, only the GNI per capita, percentage change in
CPI and corruption perceptions index are significant at 95% confidence level while
default history of countries is only significant at 10% level of significance. However,
savings and trade openness are insignificant in determining the credit rating of a country.
Countries with higher GNI per capita and are considered to be uncorrupt tend to
receive higher ratings while those with higher inflation rates and have defaulted or
rescheduled their foreign loans get lower sovereign debt credit ratings.
In contrast, savings and the trade openness level of countries do not have much
bearing on the S&P’s assessment of a given country.
Factors that have the highest influence on a country’s sovereign credit rating is
the corruption perceptions index; followed by default history; and the percentage change
in the consumer price index or the inflation rate.
Therefore, a country that seeks to receive a high credit rating, particularly theemerging and low-income economies that rely on foreign borrowings to finance their
own development, should implement measures to mitigate corruption in government. It
also implies that good governance is the bottom line key that S&P essentially looks for in
assessing a country’s particular credit rating.
Likewise, countries should avoid defaulting or even rescheduling debts and loans
as it contributes to the perceived default risk of a country. Finally, a government should
also exert best efforts to maintain price stability in general.
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Description of Sovereign Long-Term Foreign Currency Denominated Debt
Credit Ratings of Standard and Poor’s
AAA. An obligor rated ‘AAA’ has EXTREMELY STRONG capacity to meet its
financial commitments. ‘AAA’ is the highest Issuer Credit Rating assigned by Standard
& Poor’s.
AA. An obligor rated ‘AA’ has VERY STRONG capacity to meet its financial commitments. It differs from the highest rated obligors only in small degree.
A. An obligor rated ‘A’ has STRONG capacity to meet its financial commitments but is
somewhat more susceptible to the adverse effects of changes in circumstances andeconomic conditions than obligors in higher-rated categories.
BBB. An obligor rated ‘BBB’ has ADEQUATE capacity to meet its financialcommitments. However, adverse economic conditions or changing circumstances aremore likely to lead to a weakened capacity of the obligor to meet its financial
commitments.
BB. An obligor rated ‘BB’ is LESS VULNERABLE in the near term than other lower -rated obligors. However, it faces major ongoing uncertainties and exposure to adverse
business, financial, or economic conditions, which could lead to the obligor’s inadequate
capacity to meet its financial commitments. B An obligor rated ‘B’ is MORE
VULNERABLE than the obligors rated ‘BB’, but the obligor currently has the capacityto meet its financial commitments. Adverse business, financial, or economic conditions
will likely impair the obligor’s capacity or willingness to meet its financial commitments.
B. An obligation rated ‘B’ is more vulnerable to nonpayment than obligations rated‘BB’, but the obligor currently has the capacity to meet its financial commitment on the
obligation. Adverse business, financial, or economic conditions will likely impair the
obligor’s capacity or willingness to meet its financial commitment on the obligation.
CCC. An obligor rated ‘CCC’ is CURRENTLY VULNERABLE, and is dependent uponfavorable business, financial, and economic conditions to meet its financial
commitments.
CC. An obligor rated ‘CC’ is CURRENTLY HIGHLY-VULNERABLE.
SD and D. An obligor rated ‘SD’ (Selective Default) or ‘D’ has fail ed to pay one or more
of its financial obligations (rated or unrated) when it came due. A ‘D’ rating is assigned
when Standard & Poor’s believes that the default will be a general default and that theobligor will fail to pay all or substantially all of its obligations as they come due. An ‘SD’
rating is assigned when Standard & Poor’s believes that the obligor has selectivelydefaulted on a specific issue or class of obligations but it will continue to meet its
payment obligations on other issues or classes of obligations in a timely manner. Please
see Standard & Poor’s issue credit ratings for a more detailed description of the effects of a default on specific issues or classes of obligations.
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