Sovereign Credit Rating

What is a Sovereign Credit Rating?

A sovereign credit rating is an assessment of a country’s creditworthiness. It shows the level of risk associated with lending to a particular country since it is applied to all bonds issued by the government.

When evaluating the creditworthiness of a country, credit rating agencies consider various factors such as the political environment, economic status, and its creditworthiness to assign an appropriate credit rating.

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.

Sovereign Credit Ratings Explained

Sovereign credit ratings are important for countries that want to access funds in the international bond market. Usually, a credit rating agency will evaluate a country’s economic and political environment at the request of the government and assign a rating stretching from AAA grade to grade D.

By allowing external credit rating agencies to review its economy, a country shows that it is willing to make its financial information public to investors. A country with high credit ratings can access funds easily from the international bond market and also secure foreign direct investment.

A low sovereign credit rating means that a country faces a high risk of default and may have experienced difficulties in paying back debts. The level of sovereign credit risk depends on various factors, including a country’s debt service ratio, import ratio, growth of domestic money supply, etc.

Since sovereign credit ratings were introduced in the early 1900s, several countries have defaulted on their international bonds. For example, during the great depression, 21 nations defaulted on their debt obligations in the international bond market. Over the years, more than 70 nations have defaulted on either their domestic or foreign debts.

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.

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.

More Resources

CFI is the official provider of the global Capital Markets & Securities Analyst (CMSA)® certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

• Creditworthiness
• Gross Domestic Product (GDP)
• External Debt
• Sovereign Bond Yield
• See all fixed income resources