Perspectives 2019 2020 Public Sector

22 Structural Penalties in Sovereign Credit Ratings Size Penalty The options are even narrower for leaders in small countries with small economies. Geographic and relative GDP size are factors in all three agency methodologies, with bigger being better in regards to quantitative rating outcomes. This methodological design is based in macroeconomic theory and observation but reflects highly immutable country characteristics. Although all national economies are growing and shrinking each year, relative positions are broadly stable. For the years 2015-2017, the average growth rate for all countries in Moody’s universe of 138 rated sovereigns was 2.9%, and only nine economies during that period grew consistently at a rate more than one standard deviation faster or slower. 13 Meanwhile, a significant expansion or diminution of a country’s geographic area is an unwelcome sign. The international community will often withhold recognition of the change, and in instances resulting in new states, ratings are rarely a near-term concern. 14 Therefore, we see that the rating agencies impose a “size penalty” on smaller sovereigns. Per the methodologies, the agencies are interested in the size of the sovereign’s economy as a proxy for economic concentration. Fitch measures the share of an economy as a percent of world GDP, and Moody’s divides countries into 15 size categories based on nominal GDPs (20 in the proposed new model). “Scale is an important driver of creditworthiness,” asserts Moody’s, “A larger, more diversified economy has a higher capacity to generate sufficient and stable revenues for a sovereign to services outstanding debt.” 15 The S&P methodology agrees that “economic concentration and volatility are important because a narrowly based economy tends to correlate with greater variation in growth,” but it does not attempt to measure size directly. Rather, it instructs analysts to negatively adjust its Economic Assessment score for countries with “significant exposure to a single cyclical industry (typically accounting for more than 20% of GDP).” 16 This perspective on GDP size and composition finds support in macro- and development economics literature. Larger economies will more likely have a greater variety of economic activity than small ones, and there is substantial evidence that diversification is linked to the resilience of growth, productivity and competitiveness through business cycles — which are all credit-positive attributes. 17 In contrast, concentrated economies are more exposed to changes in industries and supply chains, whether of price, technology, customer preference, operations or other variables. A serious, unanticipated shock to an undiversified economy could have knock-on effects to government accounts through tax receipts, employment and other channels. Chart 1 illustrates the size-rating relationship for the 117 rated sovereigns in the Fitch universe. 18 Although there are highly-rated economies smaller than 1% of world GDP, the numeric bulk of this set is clustered in the BBB- to B- range; in contrast, there is only one economy greater than 1.0% of world GDP with a high yield (below BBB-) rating. Of course, one would expect to see some positive correlation in this data, because as a model input, GDP size is endogenous to the Fitch outcome. One would also expect the correlation to be weak (r = 0.28), given that this is only one of 18 variables. 13 These are Bangladesh, Cambodia, China, Cote d’Ivoire, Ethiopia, India, Macao (rated separately from China), Tanzania and Venezuela. This does not suggest that ordinal ranks do not change — Romania and Mauritius, which have very similar-sized economies, regularly traded ranks between 2012 and 2017 — but that with rare exceptions countries do not surge up (or down) the ranks. 14 Serbia is an interesting exception, given that it is both a rated sovereign and lost 12% of its territory when Kosovo declared independence in 2008. As will be explained, the impact of this change on Serbia’s rating cannot be estimated. 15 Moody’s (2018), “Rating Methodology: Sovereign Bond Ratings,” 10. 16 S&P (2017) “Criteria: Sovereign Rating Methodology,” 12. 17 Fruman, C. (2017), “Economic diversification: A priority for action, now more than ever,” World Bank Blogs, blogs.worldbank.org ; McIntyre, A. et al (2018), “Economic Benefits of Export Diversification in Small States,” IMF Working Paper; Papageorgiou, C. and N. Spatafora (2012), “Economic Diversification in LICs: Stylized Facts and Macroeconomic Implications,” IMF Staff Discussion Note. 18 For legibility, this chart terminates the x-axis at 5.0% of world GDP. Only three countries — the USA (25.2%), China (16.4%), and Japan (5.9%) have economies above this threshold.