Sovereign Credit Rating

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21 Aug, 2024

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A Sovereign Credit Rating is the grading of a nation’s creditworthiness based on its economic and political scenario. The world-renowned credit rating agencies are responsible for assessing individuals, corporations, and other entities and analyzing countries and sovereign bodies to offer them a credit rating.

It is done at the request of a country and conducted to reflect the risk involved in investing in the assessed nation’s bond market. A high credit rating is a reputed achievement, especially for developing countries, so that they can attract foreign investments in their financial markets.

What Is A Sovereign Credit Rating?

A sovereign credit rating assesses nations’ and particular sovereign entities’ creditworthiness based on economic and political conditions.
Similar to credit ratings of a company, firm, or individual, each rating agency gauges and offers a rating to nations upon request.
The various factors that affect these ratings are external debt, default history, inflation rate, per capita income, and GDP of a country.
Having good global credit ratings helps measure the creditworthiness of a country or entity and inform investors about its geopolitical scenarios.

Sovereign Credit Rating Explained

The sovereign credit rating refers to the scores assigned to countries and sovereign entities, defining their creditworthiness. The top three agencies—Fitch Ratings, Standard & Poor's (S&P), and Moody’s sovereign credit ratings- are responsible for evaluating the nations and assigning them credit ratings based on several factors. These ratings help countries gain international reputation and utilize funds in the bond markets.

Each credit agency has its rating system and assigns ratings through symbols and codes. Letting agencies access and assess a nation’s economic and political scenario reflects that a country is willing to share its critical information with the world and make its financial data public.

A higher credit rating indicates an excellent international reputation, a stable economy, increased economic growth, and political development. In contrast, a low credit rating means there is a high credit risk, the nation is low on reserves, and investors are withdrawing or are not interested in investing in it. From the induction of credit rating until today, many countries have defaulted on their debts, bonds, and financial obligations. A sovereign rating differs from a credit rating given to a corporate entity or individual, holds different significance, and has separate determinants.

Factors

The factors that affect this assessment are as follows -

External Debt: Many countries rely on other countries, world authorities, and international financial institutions for funds, resources, and other forms of monetary help to regulate their economy. The higher the debt, the more it influences its credit rating.
Default History: If the country has a brief history of default, it goes hand in hand with external debt and international loans. It indicates that the nation not only depends on others for funds but also defaults on repaying the loans.
Inflation Rate: In a simple comparison, many countries have a high inflation rate, making it difficult for their people to invest, buy, or spend their money in the market, leading to a lack of money supply and cash flow regulation.
Per Capita Income: A country’s per capita income is primarily considered, expressing the average income per person in a specific region. A high per capita means the country’s citizens have a good standard of living, pay taxes, and contribute to the economy. Similarly, a low per capita income means a poor standard of living, societal problems, and economic issues.
GDP: Gross Domestic Product (GDP) is a significant metric for analyzing a country’s creditworthiness. A strong GDP means a strong economy, whereas a stagnant GDP value refers to a poor economy and other internal problems a country has long faced.
Economic Development: When a country has low economic development, it simply means that there are no new projects and businesses are facing monetary issues, which eventually means that the government lacks funds and is either trying to take external debt or will default on its payment to its lender countries.

Examples

Below are two real-world examples of this rating-

Example #1

In April 2023, S&P Global Ratings increased Greece’s credit rating to positive and decided to keep Italy’s rating stable. The credit rating agency did so as Greece’s structural reforms, fiscal baselines, and foreign investments have observed a reasonable improvement. The country has faced many economic challenges yet is predicted to be one of Europe’s fastest-growing economies.

The 2022 Eurostat data shows that Greece improved its budget surplus by 0.1% after two consecutive years of running a deficit. It also led to Greece’s investment grade staying intact at BB+ or B (credit ratings just below investment grade). A significant change arrived after things went back to normal after the COVID-19 pandemic.

Example #2

In February 2023, Fitch Ratings reduced Pakistan sovereign credit rating by two notches, bringing it down from CCC+ to CCC-. This action was taken under the influence of significant refinancing risks, Pakistan’s significantly low reserves, and challenging conditions established by the International Monetary Fund (IMF). The second reduction from October was when the same credit rating agency decreased Pakistan's sovereign rating from B- to CCC+.

The IMF and Pakistan failed to sign a deal, though the negotiations continued as the country desperately needed funds for the economic crisis. Generally, Fitch does not reduce ratings in such short intervals. Still, after S&P Global, another credit rating agency, cut down Pakistan’s rating from B to CCC+, Fitch ratings initiated this decision.

Impact

The significant impact of these ratings is mentioned below -

It helps develop countries to prove their worth and presence in the international market.
Based on the credit rating, businesses, and foreign investors decide whether to invest in the underlying nation’s economy.
A country with good credit ratings can attract foreign investments in its domestic markets.
Credit rating is also a measure of the political climate of a country and so directly or indirectly impacts it.

Importance

Below are a few points depicting the importance of these ratings -

It measures the creditworthiness of a nation or sovereign entity.
Inform investors about the economic and political scenario of the countries.
It is an essential metric for any country to have an excellent global credit rating.
Briefly elaborates on the financial and banking system of the country, including market growth and development.

Frequently Asked Questions (FAQs)

1. How is sovereign credit rating helpful to invest in FDI?

These ratings are crucial for investors as Foreign Direct Investment (FDI) flows from low to higher credit-rating countries. Hence, countries with high credit ratings attract more foreign investors and vice versa.

2. Can a company rating be higher than a sovereign credit rating?

All three world sovereign credit rating agencies share a standard policy that states that credit ratings are the limit or should be treated as a ceiling for mostly all corporate borrowers in their home country. No corporate entity can be rated above the sovereign country's debt.

3. Which country has the highest sovereign credit rating?

Australia and Canada are listed on Moody’s sovereign credit rating as the highest, with top ratings from all three credit rating agencies, followed by most European countries like Denmark, Germany, Netherlands, Norway, and Sweden, including the European Union. Apart from these, Singapore lies above the US.