Perspectives 2019 2020 Public Sector

Citi Perspectives 19 Structural Penalties in Sovereign Credit Ratings Paull Randt Anna Corcuera Credit ratings from at least two of the three dominant rating agencies — Fitch, Moody’s and S&P — are a prerequisite for countries raising funds in international debt capital markets, which in turn give sovereign issuers access to a broader set of investors, improved global recognition and lower cost financing. 1 All else being equal, a better rating enhances all of these benefits, and Citi’s Sovereign Advisory team helps our sovereign clients understand, obtain and maintain appropriate credit ratings. In our experience, some aspects of ratings might not be intuitive to either issuers or investors. 1 Khorana, A., C. Hulac, et al. (2018) “Unlocking the Door to Debt Capital: A Guide to Inaugural Credit Ratings,” Citi Financial Strategy and Solutions Group, 4-8. 2 “Rating” or “ratings” in this article refers to the Fitch Foreign Currency Issuer Default Rating (FC IDR); the Moody’s Government Bond Rating (foreign currency); and the S&P Global Issuer Credit Rating (ICR), Foreign Currency and Long Term. Each is described in, respectively, Fitch’s “Sovereign Rating Criteria, Master Criteria” (May 2019), Moody’s “Rating Methodology: Sovereign Bond Ratings” (November 2018), and S&P’s “Criteria: Sovereign Rating Methodology” (December 2017) and “Guidance: Sovereign Rating Methodology” (January 2019), with reference also to Fitch’s “Cross-Sector Criteria Report: Country Ceilings Criteria” (July 2019) and Moody’s “Request for Comment: Proposed Update: Sovereign Bond Ratings” (June 2019). For the most part, sovereign credit ratings reflect political, economic and financial conditions within the control of government officials, such as foreign exchange reserves, debt stocks and fiscal balances. However, some ratings inputs are outside the command of normal policymaking, including certain long-term historical variables such as the international status of the issuer’s currency and the size of the issuer’s economy relative to world GDP. To some sovereigns, being rewarded or penalized for such “hard-to-change” structural factors might seem unfair, and this article aims to explain the impact of such variables in the agencies’ methodologies and to introduce ways that governments might compensate for ratings handicaps. 2 This article is a brief investigation of three hard-to- change variables in the rating methodologies that might result in ratings penalties to sovereigns: (A) a past episode of debt restructuring, (B) possessing a non-reserve currency and (C) being a small economy. Although highlighting these variables, we do not intend to criticize any of Fitch’s, Moody’s or S&P’s sovereign rating methodology, nor is this article a comprehensive review of the rating models and component factors. Still less do we purport to reveal how sovereign issuers can improve their ratings overnight. Firstly, the models are not mechanical calculations, and the agencies retain considerable discretion in rating assignments. More generally, upgrades require sustained commitment to responsible, transparent public financial management rather than quick fixes. The Citi Sovereign Advisory team welcomes opportunities to support governments develop and execute such plans. We consider each of the past default, currency status and size variables to be hard for sovereign debt management offices to influence for different reasons. The first, like other rating factors, reflects past events and possibly the decisions of previous governments. Yet the adverse impacts can linger in a credit rating