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Relative risk ratings and shadow sovereign ratings for 120+ countries

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Sovereign credit ratings assigned by the major rating agencies (such as Fitch, Moody’s and Standard and Poor’s) play a major role in determining the government’s access to international capital markets. Although sovereign ratings relate to debt and creditworthiness of the central government, in effect they serve as a barometer of confidence and a ceiling for creditworthiness for the private sector as well. They influence the borrowing costs of private entities and in a wider sense overall investment flows. The sovereign rating is often a benchmark and sub-sovereign entities, such as companies and banks, rarely get a rating higher than the sovereign’s.

Since the global financial crisis that began in the second half of 2008, there has been a major realignment of sovereign ratings that has especially affected advanced economies. At the same time, some large developing economies (for example, India) have had minor erosions in their ratings or outlooks. However, capital flows to these economies have remained robust, suggesting that these flows may be guided not so much by the absolute credit ratings, but by relative ratings. Given the massive downgrades of certain highly rated economies, other economies that have not suffered these downgrades would become relatively more attractive, even if their absolute ratings remain the same or are slightly eroded.

In a recent paper,Kaushik, Hans, Supriyo and I carry out a comprehensive analysis of sovereign rating developments from the pre-crisis (July 2008) to post-crisis (December 2012) period. It develops a new rating measure - the “relative risk rating” – and goes on to compute the relative risk ratings and shadow sovereign ratings for 120+ countries as of December 2012. Post-crisis, the relative rating improved in developing economies (Azerbaijan, Ethiopia, Kazakhstan, Indonesia, and the Philippines) and deteriorated in high-income countries (Cyprus, Greece, Spain, Portugal, Ireland). Interestingly, India, Jordan, Poland, and the UK had their rating outlook downgraded by the rating agencies, but their relative rating actually improved as other countries suffered even worse downgrades.

Politically troubled Tunisia and Egypt also faced deteriorated ratings. The contributions of various economic and political factors to changes in ratings are then deconstructed in the paper.

A useful by-product of the shadow rating exercise is a confirmation that despite the disturbance caused by the global financial crisis, a handful of macroeconomic, structural and governance variables are sufficient to predict nearly 90 percent of the variations in ratings. The model also reveals that many currently unrated countries are not necessarily at the tail end of the rating spectrum -- some countries appear to be even investment grade and many are in the B or BB category, the rating range for emerging markets, and could potentially access international capital markets. During this period, the average rating of high-income countries deteriorated, while that of developing countries registered a slight improvement.

The relative and shadow ratings have obvious implications for the World Bank Group engagements in developing countries, especially for IDA portfolio risk assessment and design of risk guarantees. This paper is a key component of our work on market-based innovative financing including work on diaspora bonds and future-flow securitization.

We are extending this line of research in two different directions – to understand the relationship between sovereign and sub-sovereign ratings, and separately, the relationship between sovereign and supra-national ratings.

The above post first appeared in Let's Talk Development. 


Dilip Ratha

Lead Economist and Economic Adviser to the Vice President of Operations, Multilateral Investment Guarantee Agency, World Bank

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