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The future of sovereign ratings

Ahead of the October 8-10 annual meetings of the World Bank and the International Monetary Fund, David Beers, Standard & Poor's global head of sovereign and international public finance ratings, answers questions about the future of sovereign credit ratings.

Standard & Poor's now has credit ratings on 126 sovereign governments. Why do governments seek ratings from Standard & Poor's these days, and in what ways have their reasons changed from the past?
Until relatively recently, the rationale for seeking a sovereign rating was simple: credit ratings helped unlock funding in the cross-border bond markets. Nevertheless, it took quite some time for governments to become comfortable about accepting ratings across the entire credit spectrum. But once they did, our ratings expanded rapidly to the point where today Standard & Poor's rates virtually all cross-border bonds in the sovereign sector.

Over the past decade, we've also observed that governments have begun to see broader benefits from requesting credit ratings. For example, rated bonds denominated in both local and foreign currencies are now commonplace in the sovereign sector. Our ratings have also become an important element in the debt exchanges that many governments employ to emerge from default. But governments often seek sovereign ratings in pursuit of broader objectives such as fostering deeper local capital markets, attracting foreign direct investment, and supporting private-sector access to the global capital markets. Ratings, and the published research that underpins them, also play an important role in supporting greater public-sector financial transparency. As a result, even sovereigns that rarely issue cross-border debt are seeking credit ratings from Standard & Poor's. Indeed, this group of governments is now driving much of the growth in ratings in the sovereign sector.

Can you give examples of sovereigns that have been rated for reasons other than issuing cross-border debt?
The government of Chile was an early case. When the authorities requested ratings from Standard & Poor's in 1992, they told us that they were not planning any cross-border bond issuance. Indeed, Chile did not issue its first rated global bond until 10 years later, in 2002. In the meantime, the government wanted to demonstrate that its own credit standing had recovered from the Latin American financial crisis in the 1980s, when most governments in the region had restructured their cross-border bank debt. Equally important, Chile saw the sovereign rating as a benchmark that could enhance the private sector's access to capital markets and help attract foreign direct investment. Similar considerations appear to have been behind the government of Libya's request for a credit rating in 2009. Increasingly, too, the desire of governments to demonstrate financial transparency is a motivating factor, as is the case with the sovereigns we are rating in sub-Saharan Africa.

You mentioned sovereign defaults and the debt exchanges used by many sovereigns to come out of default. Have any ratings been withdrawn after a government default?
Just one (the Seychelles) thus far, and that is quite significant because in addition to the Seychelles,14 sovereigns -- Argentina, Belize, Cameroon, the Dominican Republic, Ecuador, Grenada, Indonesia, Jamaica, Pakistan, Paraguay, Russia, Suriname, Uruguay and Venezuela -- have either restructured bonds or bank loans, or did not make debt service payments on them when due, since their ratings were initially assigned. We used to think that many issuers would drop the ratings in a default situation. But we have found that most governments in financial distress realise that their credit story does not end abruptly when a default occurs.

All sovereign defaults are resolved eventually, although the process can take far longer than in a corporate bankruptcy. When sovereigns emerge from default their ratings improve, and that is something in which rated governments, as well as investors, have an interest. So, starting with Pakistan in 1999, Standard & Poor's became involved in rating the distressed debt exchanges that often resolve sovereign defaults. And we expect to be rating more governments emerging from default, from now on. About a quarter of rated sovereigns are currently rated in the 'B' category or lower, which, based on historical trends, indicates that a significant number could default in the coming years.

Standard & Poor's, along with other rating agencies, has been criticised for its sovereign rating actions during the Asian financial crisis and other periods of financial stress, and most recently because of its rating actions affecting some sovereigns in the eurozone. Has the criticism had any impact on the growth in sovereign ratings?
No, and this may come as a surprise to some people. I think the main reason is that most users of ratings, including the governments we rate, have a more nuanced understanding of the role that ratings play than do many of our critics. Market participants understand that credit risk exists because the future is uncertain, and that analysts cannot have perfect foresight. If we all knew for certain what the future holds, there would be no credit risk. As a result, occasionally there are big events with a credit impact that takes almost everyone by surprise, and the Asian financial crisis was one such event. While the story in the eurozone is still playing out, it's worth noting that we first lowered the ratings on sovereigns such as Greece and Portugal well before the market confidence crisis in the eurozone began to intensify last year.

At Standard & Poor's, we certainly learn from these episodes, and we incorporate what we learn into our credit analysis. Still, the fact is that our ratings methodology, which continues to evolve with experience, works: sovereign ratings are robust predictors of default risk. The ratings behave similarly to our corporate ratings across all rating categories, which is impressive given that we are comparing just 126 sovereigns with many thousands of rated companies. The historical rating transition and default rates are also similar. Therefore, while we cannot have perfect foresight, it is clear that sovereign ratings perform in the same way that Standard & Poor's ratings do generally, and I expect they will go on doing so even if tensions in credit markets persist. This track record, combined with our impartiality and independence, is why we believe that Standard & Poor's sovereign credit ratings and research add value in the global financial marketplace.

To continue reading this Q&A, please go to page two.

Why are sovereigns being affected by the volatility in the global credit markets?
The credit crisis that triggered the global economic recession of 2008-2009 has affected governments in a variety of ways. Many sovereigns are facing greater fiscal pressures and the prospect of slower trend GDP growth, much more so than in previous economic cycles since World War II. The balance sheets of a number of highly rated sovereigns in North America and Europe, in particular, are being stretched both by rising fiscal deficits and, importantly, by the high (and potentially still rising) cost of official banking system rescue packages.

The number of governments at risk of seeing their ratings lowered inevitably increases in such an environment, and downgrades affecting both advanced and emerging market sovereigns have occurred. Indeed, our expectation of a reversal of rapid credit growth and the possibility that financial contingent liabilities would migrate to government balance sheets were key factors behind our rating actions on Iceland, the Baltic states and several other sovereigns in Central and Eastern Europe and the eurozone during the past four years.

What is your outlook for global sovereigns?
Globally, we believe that downward pressure on sovereign ratings is easing somewhat in 2010. Still, there are a number of evolving credit stories in which, more than anything else, our ongoing assessment turns on the extent of the cumulative damage to government balance sheets and how long-lasting that is likely to be. So, further downgrades are certainly possible. Moreover, in the coming decade, demographic pressures on pension and healthcare spending look set to further increase fiscal pressures for a number of sovereigns. At the same time, however, it is important to note that many governments, including a significant number of emerging market sovereigns in Asia and Latin America, confront these challenges from historically strong fiscal and external positions and, in our judgment, are demonstrating the capacity to weather them with little or no change to their existing ratings. In fact, some of them -- Indonesia, Morocco, Panama, Sri Lanka, and Turkey to name some recent examples -- have had their ratings raised.

The good news is mainly in emerging market sovereigns, which run the gamut from speculative grade to low investment grade categories. They've shown great resilience through this downturn. That's largely because of their efforts to improve public sector balance sheets and their foreign exchange liquidity, efforts that were in part driven by earlier confidence crises. That naturally left them very well placed to ride out the downturn in terms of economic activity and trade. Indeed, we've seen some of our ratings improve in the emerging market space. And I would expect that trend to continue.

Are Asia’s sovereigns immune to the challenges in the eurozone?

For Asian sovereigns, we don't expect anything like the funding challenges some eurozone sovereigns currently face, for four reasons.

First, let’s not forget that the eurozone is a monetary union, in which 16 member states share a single currency and a single central bank. In our view, the current confidence crisis affecting some eurozone sovereigns stems from the divergence in economic, financial, and fiscal performances that has developed among the member governments since the euro was launched a little more than a decade ago. So, the dynamics behind current market pressures in the monetary union don’t exist in Asia because governments in the region do not share a common currency.

Second, looking at Asian sovereigns with relatively high debt burdens, a number of them fund themselves mainly from domestic sources -- thanks to high savings rates, home market bias and, in some cases, restrictions on outward portfolio investments. Japan, India, and Taiwan are examples of sovereigns in the region that rely largely on domestic sources, both to fund government budget deficits and to roll over maturing debt. In our judgment, they are unlikely to face increased funding pressures because the confidence of domestic investors is unlikely to respond to higher volatility in global debt markets.

Third, should financial turmoil worsen in Europe, it is possible that Asian sovereigns that borrow internationally could pay more on their commercial external debt, at least for a time. Sri Lanka, Pakistan and Mongolia are examples of sovereigns with significant external financing needs. However, all three countries are currently under IMF programmes. If they continue to meet the program targets, we expect official funding sources to shield them from much of the volatility in market interest rates.

Finally, we expect medium-term economic growth prospects to continue to be stronger in Asia ex-Japan than in Europe. In our view, this gives many Asian governments more policy flexibility, particularly in managing their public finances, compared with a number of their European peers.

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