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Metodológia pre hodnotenie štátov
Pondelok, 19 November 2018

1. Scope of application

This Methodology applies to national governments that, in the ERA’s opinion, possess stable and measurable economic attributes and respective fiscal authorities that allows for an assessment of their creditworthiness to international creditors.

This Methodology uses the ERA’s International Rating Scale and allows for relative comparison of rated entities according to the degree of credit risk faced by the creditors of rated entities.

ERA identifies two types of default ratings within the scope of this methodology:

  • SD indicates that the Rated Entity is in default on one or more of its financial obligations. The Agency has reasons to believe that the debtor will continue to service its other financial obligations in a timely fashion and in full amount.
  • D indicates that the Rated Entity is in default on most if not all of its financial obligations.

Default for the scope of this methodology is defined as the Rated Entity’s current and/or future inability (according to ERA) to service its financial obligations that are based on one of the following credit events or their combination:

  • unexecuted or delayed principal or interest payments in accordance with the Rated Entity’s contractual obligations (with the exception of missed payments that fall within the contract-stipulated grace period);
  • coming into effect of an acceleration of an obligation as a consequence of a required acceleration on any other similar obligation (cross-acceleration);
  • coming into effect of an acceleration of an obligation due to a declared default on any other similar obligation(s) (cross-default);
  • waiver or moratorium, which prompts the counterparty to refuse payment or dispute its legal obligations;
  • debt restructuring that entails a unilateral withdrawal, deferment, changes in the debt repayment schedule and/or interest rate that are viewed as less favorable by the creditors in comparison with the initial debt agreements;
  • asset substitution under a stress scenario, in which the following two conditions are met simultaneously:

    - the Rated Entity offer its creditors new or restructured debt (in combination with other assets), discounted cash receipts, which are smaller than the discounted cash receipts of the original debt;
    - this operation allows the Rated Entity to avoid bankruptcy or default on future payments.

Credit risk in the context of sovereign-rated entities relates to both the ability and willingness to pay. This Methodology assesses the the relative probability of default by a national government on its debt (interest and/or principal payments) to private creditors. Failure to pay on bilateral debt between the rated entity and other governments (or supranational institutions) may not constitute a default according to this Methodology, unless such default poses a default risk as a byproduct of a potential pari passu treatment of official and private creditor debt.

2. Information sources

In the course of rating analyses, the ERA relies upon information obtained from both the rated entity and other sources. Below is the list of core sources of information used by the ERA in its rating analyses under this Methodology:

1.  Information from the public sources:

  • Government statistics, and data from official government agencies including central banks);
  • Supranational publications;
  • Mass media;
  • Other sources that provide, in ERA’s opinion, information relevant to its rating analysis.

2.  Information provided by government officials (for solicited ratings):

  • ERA’s questionnaires and forms filled out by the rated entity;
  • Information obtained during the rating meeting between the Agency and the rated entity, as well as subsequent oral and written communications;
  • Information regarding budgetary performance;
  • Comprehensive information on debt, including its debt service schedule; Reports prepared by relevant government departments.

3.  ERA’s own data:

  • Rating analyses conducted previously by ERA;
  • Aggregated financial and operating indicators of other rated entities, with relevant analytical adjustments;
  • ERA’s macroeconomic and sectoral forecasts.

The above list is not exhaustive.

Information adequacy is determined in accordance with ERA’s general principles regarding the overall rating process. In case, in ERA’s opinion, the information available is insufficient and/or unreliable, the Agency will refrain from assigning a rating and/or stop its participation in the rating process via a rating withdrawal announcement.

3. Analysis Structure

The assessment of the credit risk related to issued debt and financial obligations of a national (sovereign) government is based on the analysis of two sets of factors:

  • Macroeconomic factors;
  • Forward looking factors.

Macroeconomic factors allow for the assessment of the government’s current debt burden and its ability to service that debt given the resources available to the national government. The analysis includes evaluation of current wealth levels, debt accumulation and its distribution among economic agents (international financial institutions, businesses, individuals), the economy’s capacity to generate foreign exchange, its reliance on foreign funding sources, plus sources of liquidity available to the government.

Macroeconomic factors are subdivided into the following categories:

  • Economic factors describe the level of national income, its growth, as well as price dynamics;
  • Debt factors describe the level of public debt relative to various income measures;
  • Public finance factors describe the level of government involvement in the economy, including its level of indebtedness, as well as the government’s debt servicing burden vis-à-vis the rest of the economy;
  • Private finance factors describe the level of private sector indebtedness, both domestic and foreign;
  • Foreign dependence factors describe cross-border trade and funds flows that both serve as an FX-income and FX-liability;
  • Liquidity factors describe the volume of liquid FX assets at the government’s disposal.

Forward-looking factors assess the country’s economic development and social stability with regards to its capacity to generate future income available for debt servicing. These indicators also serve as a proxy for the country’s willingness to pay its debts. The level of development of a country’s institutional framework provides an important insight into how that society views creditors’ interests. Such an assessment is undertaken in addition to a government’s ability to pay as described by the macroeconomic indicators. The analysis of this set of factors is partly based upon expert opinion and partly quantified as discussed in detail is Section 6, “Forward-looking indicators”.

The forward-looking indicators are subdivided into the following categories:

  • Rule of law and transparency indicators analyze a country’s institutional framework including how stable that framework is.
  • Social cohesion indicators refer to social stability and the distribution of both wealth and income.
  • Education indicators describe to what extent education policy delivers high-quality, efficient, and equitable education, which will result in a high-quality work-force.
  • Research indicators describe to what extent research supports technological innovation, which in turn may foster the creation and introduction of new products and services.
  • Government and Resource Efficiency indicators describe the government’s ability to achieve its policy goals by utilizing its resources in the most efficient manner.
  • Adaptability indicators describe the government’s ability to adapt its policy framework given a changing environment.

The weights assigned to the two categories of factors vary depending on the level of wealth per capita. When analyzing low income countries, more weight is assigned to the macroeconomic factors while the analysis of the high-income countries is conducted with a bigger weight assigned to the forward looking factors. Middle income countries are analyzed with both sets of indicators weighted equally. The following table sets the guidelines for the weights distribution relative to per capita income levels:

Table 1. Factors’ weights distribution relative to the GDP per capita category

GDP per capita

Macroeconomic factors weight

Forward looking indicators weight

High

10%

90%

Middle

20%-80%

80%-20%

Low

90%

10%

The categories are defined on the basis of deciles from GDP per capita country rankings:

  • First decile (highest GDP per capita countries) receiving 10% weight for macroeconomic factors and 90% for forward-looking factors;
  • Last decile (lowest GDP per capita countries) receiving 90% weight for macroeconomic factors and 10% for forward-looking factors;
  • Weighting of factors for deciles from second to nine (mid-level GDP per capita countries) changes gradually with 10% step per every decile.

The rationale for using variable weights for different levels of GDP per capita income is based upon the observation that medium- and low per capita income countries are more susceptible to changes in the macroeconomic environment. As a result, more emphasis is placed on the macroeconomic factors, which address the current state of the economy and the volume of resources available to the government for debt servicing.

Countries with a high per capita income tend to be more resilient to macroeconomic shocks, hence more attention is paid to the forward-looking factors in order to assess the probability of creditors’ claims being honored (willingness to pay), given the high level of resource availability (ability to pay).

Forward-looking indicators for countries with a low GDP per capita income provide less predictive power regarding government creditworthiness because the institutional framework and long-term resource-generating capacity are usually limited, thereby, not providing enough creditor protection. Thus, more weight is placed on macroeconomic factors.

The weighting of the indicator categories within the two groups of factors is assigned as follows:

Table 2. Indicator categories weights within factors

Macroeconomic factors

Weight

Economic factors

10%

Debt factors

30%

Public finance factors

20%

Private finance factors

10%

Foreign dependence factors

10%

Liquidity factors

20%

Forward-looking factors

Weight

Political and economic stability

50%

Reform capacity and efficiency

50%


Each set of factors provides an intermediate score that is derived from the decile in which a particular factor fits. Once the intermediate scores are derived, they are added in accordance to respective weights from Table 1 based on the appropriate GDP per capita category.

Following the assessment of the above factors and prior to arriving at the final credit rating, modifiers accounting for a government’s crisis management track record are applied to reflect the institutional resilience of the government to financial crisis (-es) and its ability to direct policies in a precautionary and counter-cyclical direction.

The modifiers include factors from the following categories:

  • Analysis of its past crisis track record;
  • Timing of the authorities’ response to the crisis and the existence of early signaling mechanisms;
  • Effectiveness of crisis remediation and precautionary policies;
  • Existence and effectiveness of automatic stabilizing mechanisms.

The modifiers application is based on expert opinion and results in extra notches being added or subtracted from the preliminary rating. The notching mechanism and analytical rationale are discussed in section 7.

Scheme 1. The analytical model

Shema1
4. Macroeconomic factors

The following section outlines the economic rationale behind the indicators within the macroeconomic factors:

  • Economic factors; Debt factors;
  • Public finance factors; Private finance factors;
  • Foreign dependence factors; Liquidity factors.

4.1. Economic factor

The indicators included under the economic factor aim to evaluate the size of the national economy relative to the rest of the world; its growth dynamics; inflationary pressures; and, long-term demographic tendencies.

4.1.1.    Nominal GDP ($)

The volume of nominal Gross Domestic Product in USD is used for the purposes of international comparison of all value added of goods and services produced within a country’s borders. Although the indicator itself is widely criticized for not accounting for a significant volume of wealth generated outside the jurisdiction or in the informal sector of the economy, it is a good proxy for a base assessment of the country’s economic and financial stability and relative creditworthiness. In general, the higher the volume of nominal GDP measured in USD, the wider the economic base that is available for the national government to acquire resources for debt servicing.

4.1.2.    Nominal GDP growth (local currency, %)

The dynamics of nominal GDP in local currency are used to assess the government’s fiscal position, over time, relative to the state of the economy. Tax revenues are closely linked to nominal GDP growth. Spending, which is mostly domestic, is clearly based directly on government policies. Comparing the fluctuations in revenues and expenditures, over time, provides an insight into how flexible revenue and expenditures are. This particular indicator allows us to assess the government’s propensity to vary expenditure and/or possibly increase debt given fluctuations in available resources (i.e. GDP in local currency). The higher nominal GDP growth is, the higher is the government’s capacity to service its local currency debt.

4.1.3.    Real GDP growth (%)

Real GDP growth measures economic growth, adjusted for inflation. In developing countries, higher GDP growth is not always beneficial. Much depends on how the growth in investment is being financed. Many countries find that they are balance-of-payments constrained, discussed below.

4.1.4.    GDP per capita ($)

The level of GDP per capita in USD is somewhat limited in its informational content because it may vary significantly because of sudden shifts in the exchange rate. The better measure for comparing income levels on an international basis is the next indicator.

4.1.5.    GDP per capita ($, PPP basis)

The level of GDP per capita, measured in terms of purchasing-power-parity (PPP), allows cross-country comparisons adjusted for differences in their respective costs-of-living. Given that calculating such measures are challenging and subject to criticism, most practitioners only use the World Bank’s statistics for per capita income on a PPP basis for international comparisons.

4.1.6.    Inflation (CPI, %)

The CPI measure is used for multiple purposes. It is based on the prices of a basket of goods and services. Interpreting the CPI must be country specific because, in some cases, low inflation is beneficial, while in other countries, such a low level of inflation may represent a challenge to the government. However, if inflation suddenly surges, and approaches hyper-inflation, it is unambiguously negative. As with low inflation rates, moderate rates of inflation may or may not be beneficial depending on the particular structure of the economy being analyzed. Deflation is also almost always unambiguously negative relative to a government’s debt burden.

4.1.7.   Population growth (%)

Population growth rates impact sovereign creditworthiness over a long time horizon. A growing population may signal the need for higher government social spending (medical services and education) which may pose a major burden for low-income countries. Higher population growth may also put strains on employment, because higher GDP growth rates will be needed to provide adequate employment for an increasing workforce. Such higher growth rates may pose a risk depending on how balance-of-payments constrained the country is. Low or negative population growth rates pose a quite different risk. This is especially true if the population is aging at a significant pace. Low or negative population growth implies a growing burden on the existing workforce to finance social spending of all sorts. This adds considerable risks, over time, even for many of the world’s most advanced countries. Emigration and immigration may prove positive for both high population growth and low or negative population growth countries. The issue that immigration plays on creditworthiness will depend on the country’s ability to successfully integrate new immigrants. For cultural and social reasons such integration may remain elusive and actually add to a government’s risk.

4.2.  Debt factor

The indicators included in the debt factor aim to evaluate to what extent the national economy is leveraged. Excessive reliance upon debt financing (especially in foreign-currency) may leave the country prone to higher credit risk, especially related to foreign-currency rollover risk. Monetary unions present different risks as regards 5.2.1 and 5.2.2 because countries within a monetary union such as the Eurozone usually issue debt almost exclusively in their domestic urrency. However, unlike non-monetary union governments, governments in the Eurozone are not able to create domestic currency. The current account and external debt ratios play a more indicative role as measures of domestic efficiency and competitiveness for Eurozone governments, rather than the central role such indicators might place on emerging market economies. In addition, for very high-income countries not in a monetary union, the current account and external debt ratios are also not particularly relevant in determining that government’s rating since their ability to source foreign exchange usually has little to do with its current account and external debt ratios.

4.2.1.   Current Account Balance (US$) and Current Account/GDP (%)

Current account balances will vary greatly depending on the size of the country. Therefore, the current account balance/GDP ratio is used for international comparisons. Since the current account balance includes the balances on good and services and unilateral transfers (emigrant remittances and foreign aid), it is a good proxy for a country’s ability to finance (if negative) or to save (if positive) the difference between domestic savings and investment. Once again, the size of current account balance and the current account/GDP ratio must be analyzed depending on a particular country’s circumstances. Even high current account deficits may not pose a risk if the investment being financed by those inflows is being used efficiently. The problem arises when large current account deficits are maintained over time, but do not produce enough income to justify the increased use of foreign savings. For countries, outside of a monetary union, current account balance analysis is vital to examining a government’s creditworthiness. However, for countries in monetary union, although a current account balance still measures the same flows, it is best viewed as a proxy for a country’s overall competitiveness within the monetary union, since it no longer measures a country’s access to foreign exchange. Since current account balances are always, by definition, financed, the key for risk assessment is how that balance is financed. For instance, foreign direct investment flows pose a much lower risk than medium-term foreign loans, which in turn pose a lower risk to the country than short-term capital inflows.

4.2.2.   External Debt (US$) and External Debt/GDP (%)

External debt measurement is a complicated because it may be calculated in numerous ways: foreign currency debt held by residents and non-residents; foreign currency debt held by non-residents; foreign and local-currency debt held by non-residents; public sector debt denominated in foreign currency; and, public sector debt denominated in foreign and local currency held by non-residents. External debt is not usually viewed as a risk for advanced economies with deep capital markets, a flexible exchange rate and a strong domestic banking system. For all others, the higher the external debt level or its ratio to GDP, the higher the credit risk.

4.2.3.   Public debt/GDP, %

The public sector debt/GDP ratio needs to be closely analyzed in relation to the government’s involvement in the national economy and the size of the public sector itself. A large public sector or a government substantially involved in the economy tends to generate large volumes of debt, including external debt. However, a larger public sector provides a government with more options to mobilize resources for debt servicing. Hence, the analysis of the public debt/GDP ratio needs to be closely linked to the analysis of the overall public sector.

4.3.  Public finance factor

The indicators included in the public finance factor aim to evaluate risks stemming from government actions and its role in the national economy. The analysis focuses on budgetary balances and debt sustainability.

4.3.1.    General Government Revenue/GDP and General Government Expenditure/GDP(%)

The category, general government is a broad measure of a government’s role in the economy. However, general government may not include government involvement in the economy via the overall public sector, which will include government-owned enterprises. These two general government ratios characterize direct government involvement in the national economy in terms of the share of income being collected and redistributed via the state. Once again, both these ratios need to be examined on a case-by-case basis. Countries with a high government expenditure/GDP ratio may find it politically difficult to reduce expenditures because of the impact such a reduction will have on GDP growth. Increasing revenues in countries with a high revenue/GDP ratio may also prove politically difficult since residents are already being heavily taxed. The opposite is true for countries with low revenue/GDP and expenditure/GDP ratios

4.3.2.    General Government Primary Balance/GDP (%)

The primary balance is the gap between government revenue and expenditure minus interest payments on consolidated government liabilities. Taken as a proportion of GDP, this indicator allows us to assess the government’s capacity to service its debt. A primary surplus is needed for a government to either stabilize its debt/GDP ratio or to reduce that ratio over time. A negative primary balance is a good indicator that the government will experience a significant rise in its debt burden over time.

4.3.3.    General Government Financial Balance/GDP (%)

Financial balance is in all respects identical to the primary balance except that it accounts for interest payments on the existing debt, thus representing a government’s net borrowing requirements.

4.3.4.    General Government Debt/GDP (%)

The ratio of general government debt to GDP shows to what extent government debt is counterbalanced by a country’s overall resource base, which is potentially available to the government. The critical level for this indicator would vary for countries with different levels of GDP per capita. High-income countries usually have more sophisticated financial systems that provide refinancing opportunities and, which are able to tap international markets for the same reasons. Hence, the sustainable level of government debt to GDP may be substantially higher for those governments.

The size of the public sector debt in proportion to GDP needs to be closely analyzed in relation with the government involvement into national economy and the size of the public sector itself.

Large public sector or a sovereign government substantially involved into economy tend to generate large volumes of debt, including external. However, the larger public sector provides sovereign government with more options to summon resources for the debt repayment and servicing. Hence the debt indicators analysis need to be closely linked to the analysis of the public sector.

4.3.5.   General Government Debt/General Government Revenue (%)

This is one of the most important measures of a government’s creditworthiness because it measures government debt against government income. Once again, advanced economies can often sustain much higher debt/revenue ratios than middle- or low-income economies. This ratio has proved to be an important indicator of the risk that a government may eventually default on its debt.

4.3.6.   General Government Interest/General Government Revenue (%)

The ratio of government interest payments on existing debt to general government revenue measures annual revenue flows the government must allocate towards debt servicing. This indicator is highly dependent upon other measures in a given factor category since its level would rise as the government accumulates more debt, which would be perceived as raising risk. Rising risk would drive down prices of existing debt held by the public. As with the ratio of general government debt to GDP, critical levels for this indicator would also depend upon the depth and complexity of national financial markets.

4.4.  Private finance factor

Private finance indicators help evaluate risks stemming from the domestic financial system. The analysis focuses on the intensity of domestic financial activity as well as its adequacy to serve the real economy.

4.4.1.   Domestic Credit (% Change)

Changes in domestic credit growth provide potential insights into the health of the overall domestic financial system. High rates of domestic credit growth may signal deteriorating financial portfolio credit quality. As the risk appetite of banks rises, lending criteria may become looser, another indicator of potential financial stress. Bank balance sheets are often viewed as contingent liabilities of the government, because there is a high probability of government support for systemically important banks and other financial institutions. As a result, rapid credit growth may imply somewhat higher government risk because of its indirect impact on a government’s contingent liabilities.

4.4.2.   Domestic Credit/GDP (%)

The ratio of domestic credit to GDP serves as a measure of the national financial market’s depth. Higher ratios are usually associated with more developed economies. On the other hand, high levels of domestic credit to GDP in medium and low-income countries could be regarded as a warning sign of future credit risks for the financial system.

4.4.3.   Investment/GDP, % (Gross Domestic Investment/GDP)

The ratio of gross domestic investment to GDP measures the volume and rate of fixed capital formation. However, it does not measure investment quality. High rates of investment do not automatically imply high rates of return. Therefore, the indicator may only be interpreted in light of the overall circumstances of the economy.

4.4.4.   Gross Domestic Savings/GDP (%)

The ratio of gross domestic savings to GDP illustrates to what extent the national economy is able to fund domestic investment. If domestic investment exceeds domestic savings the gap must be closed by foreign capital inflows. Medium- and low-income countries, where the savings rate is low due to low levels of per capita income, are more reliant upon foreign savings inflows. There are generally three ways a government can foster growth in domestic savings or its equivalent, a decline in domestic dissaving: 1) The government may reduce its deficit; 2) Institute policies which raise retained corporate profits; and, 3) Implement policies to raise personal savings. In the near-term, the only option is to change a government’s fiscal position. Increasing corporate profits and raising the personal savings rate would both take time before significant results are seen. Therefore, this indicator will need to analyzed in conjunction with the government’s fiscal position and the country’s current account balance.

4.5. Foreign dependence factor

As noted in 5.1.1 and 5.1.2, foreign dependence or 5.5 is far less important for rating governments in monetary union and/or for governments in very high-income countries. However, foreign dependence is very important for governments in middle- and low-income countries (emerging market countries). The indicators included in the private finance factor aim to evaluate a country’s exposure and vulnerability to global financial market turmoil and/or trade flow fluctuations. The analysis in this section focuses on the balance between FX sources and uses.

4.5.1.   Real Effective Exchange Rate (REER)

The REER attempts to account for differences between domestic and international inflation rates adjusted for nominal exchange rate changes. Although exceedingly complex to measure, and is only available for a small group of countries, when available, it provides a powerful insight into nominal foreign exchange rate risks.

4.5.2.   Real Exports & Imports (% Change)

Nominal trade flows indicators are adjusted for price changes. These indicators attempt to measure export and import volumes.

4.5.3.   External Debt/Exports, (%)

This ratio describes the extent to which the external debt of the country is covered by total current account receipts (exports in the broadest sense).

4.5.4.   Short-Term External Debt/Total External Debt (%)

This indicator provides a simple measure of maturity risk faced by a middle or low-income country. It is not particularly relevant for advanced economies. The higher this ratio, or the more rapidly it is growing is an indication that the country may be more susceptible to changes in market sentiment.

4.5.5.   Reserves to Imports (months)

The ratio of reserves to monthly imports indicates how long a particular country could theoretically go without changing its existing level of imports and no access to international finance. This indicator is only useful for middle- and low-income countries with fixed exchange rate regimes. Middle- and low-income countries with flexible exchange rates are better analyzed using other indicators.

4.5.6.   Debt Service Ratio (%)

The debt services ratio is defined as interest payments on FX-debt and FX-debt maturing within one year as a percent of total current account receipts. This measures to what extent total FX-inflows cover debt-related outflows for medium- and long-term FX debt.

4.5.7.   External Short-Term Debt + Current Maturities Due on Medium-to-Long External Debt/FX Reserves (%)

This indicator is a different, but is a significant measure of a country’s short-term debt service burden compared to its ability to repay debt if international capital markets are suddenly closed to a country’s residents. As is the case with some other indicators, this ratio is useful only for the analysis of medium- and low-income countries. The higher the ratio, the higher is potential rollover risk, either due to temporary factors or to more structural issues.

4.5.8.   External Debt/International Reserves (%)

Similar to the above, this is an overall measure of debt reserve coverage.

4.5.9.    Contractual Obligations on Outstanding Long-Term Debt

The analysis of future debt service on outstanding long-term external debt allows us to assess potential risks arising from the maturity structure of the debt. Although current coverage ratios may not signal any immediate risks, clustering of debt repayments in any particular future period could pose a threat to a country’s creditworthiness since such debt will either have to be repaid or rolled-over into new debt securities. If there is a significant bulge in debt service, the ability of a country, in particular, national governments, may prove too onerous.

4.6.  Liquidity factor

The indicators included in the liquidity factor aim to evaluate liquidity risks arising from a possible mismatch between the level of short-term foreign claims on the government and available liquid and foreign assets. This is another factor that is relevant to medium- and low-income countries, but is not particularly relevant to countries in monetary union or countries with very-high incomes.

4.6.1.    Liabilities Owed to BIS Banks Due Within One Year/Total Assets Held in BIS Banks (%)

This measures the extent to which short-term debt and current maturities on medium and long-term debt owed by the government to BIS banks are covered by total assets held by residents in BIS banks. Although not all assets held by domestic residents in BIS banks may be liquid, even less liquid assets may provide comfort to lending institutions. Therefore, this indicator provides insight into the willingness of foreign banks to fund resident short-term debt plus current maturities.

4.6.2.    Total Liabilities Owed to BIS Banks/Total Assets Held in BIS Bank (%)

This is a broader measure of the liquidity position of residents in the long-run as opposed to the short-term risks addressed by the previous indicator.
5.  Forward-looking factors   

The following section outlines the economic rationale behind indicators within forward looking factors:

  • Rule of Law & Transparency;
  • Social cohesion;
  • Education; Research;
  • Government efficiency;
  • Adaptability.

The above criteria are assessed in accordance with the Country Policy and Institutional Assessment indicators and World Governance Indicators provided by the World Bank. The scores of these indicators would be mapped to 1 to 10 scale in the following manner:

ERA and CPIA scores conversion

ERA score

CPIA

10

6

9-8

5

7-6

4

5-4

3

3-2

2

1

1

ERA and WGI scores conversion

ERA score

WGI

10

91%-100%

9

81%-90%

8

71%-80%

7

61%-70%

6

51%-60%

5

41%-50%

4

31%-40

3

21%-30%

2

11%-20%

1

0%-10%

The rated sovereign would be awarded points on 1-to-10 scale, with 10 being the highest possible score, in accordance to the respective score of the relevant World bank indicators. The Agency reserves the right to correct the scores derived out of CPIA and WGI indicators in accordance with its own expert judgement based on the assessment of the relative quantitative indicators.

5.1.   Rule of Law & Transparency

The rule of law and transparency indicators deal with the question of the predictability and transparency of a country’s judicial system and/or the predictability of its own societal norms.

Protection of property rights and predictability in the application of the law helps insure that government creditor claims will more likely be respected. At the same time, it must be noted that governments have enormous flexibility in dealing with local or foreign-currency debt subject to local law. There is much less flexibility for governments when dealing with debt subject to foreign law.

The extent of rule of law and degree of transparency could be estimated based on expert opinion with regards to the key legal institutions being effective in ensuring contracts enforcement and preventing abuse of power by either authorities or business. The assessment of the following criteria provides sufficient grounds for evaluating to what extent institutional and legal framework of the sovereign facilitates stable and predictable environment or on the contrary fosters credit risks:

  • Government policy predictability;
  • Lawmaking process consistency;
  • Court’s independence and its ability to enforce its decisions;
  • Powers separation and mutual control efficiency;
  • Property rights protection mechanisms;
  • Corruption and power abuse possibility;
  • Society’s involvement.

The initial assessment is carried out on the basis of the following indicators:

  • CPIA business regulatory environment rating and;
  • CPIA property rights and rule-based governance rating; 18
  • PIA transparency,  accountability, and corruption in the public sector rating;
  • WGI Rule of Law estimate;
  • Control of Corruption: WGI Estimate.

Business regulatory environment rating by CPIA assesses the extent to which the legal, regulatory, and policy environments help or hinder private businesses in investing, creating jobs, and becoming more productive.

Property rights and rule-based governance rating by CPIA assess the extent to which private economic activity is facilitated by an effective legal system and rule-based governance structure in which property and contract rights are reliably respected and enforced.

Transparency, accountability, and corruption in the public sector rating by CPIA assess the extent to which the executive can be held accountable for its use of funds and for the results of its actions by the electorate and by the legislature and judiciary, and the extent to which public employees within the executive are required to account for administrative decisions, use of resources, and results obtained. The three main dimensions assessed here are the accountability of the executive to oversight institutions and of public employees for their performance, access of civil society to information on public affairs, and state capture by narrow vested interests.

The Rule of law estimate by WGI captures perceptions of the extent to which agents have confidence in and abide by the rules of society, and in particular the quality of contract enforcement, property rights, the police, and the courts, as well as the likelihood of crime and violence.

Control of corruption estimate by WGI captures perceptions of the extent to which public power is exercised for private gain, including both petty and grand forms of corruption, as well as "capture" of the state by elites and private interests.

Voice and accountability estimate by WGI captures perceptions of the extent to which a country's citizens are able to participate in selecting their government, as well as freedom of expression, freedom of association, and a free media.

The average score of the six ratings is used for further analysis.

Stable juridical and transparent institutional environment that provide sufficient protection of property rights and investors interests manifest themselves in the level of capital markets development. The latter is highly reliant upon well-functioning juridical system and set of institutions that guarantee investors rights. Therefore, the CPIA and WGI scores would also be tested against following quantitative indicators:

  • Market capitalization/GDP;
  • Capital markets concentration;
  • Corporate debt duration;
  • Pension funds & pension system.

5.1.1.  Market capitalization / GDP

Stock market capitalization to GDP is a proxy for the overall level of development of the country’s financial markets. The higher that ratio, on a sustained basis, the more likely are investors to have trust in those markets. Such trust is often based on the predictability of the judicial system as well as well as a general predictability of the economic environment.

5.1.2.  Capital markets concentration

The concentration or diversification of the capital market is a complimentary indicator to 6.1.1. The higher the level of concentration, the more likely a market may be subject to excessive influence by a few, large, domestic companies. This may increase investor risk. The lower the level of market concentration, the more likely we would find competition based on performance, and not on political or financial clout.

5.1.3.   Corporate debt duration

The average duration of corporate debt in the national economy illustrates the level of trust domestic investors have in the stability and continuity of economic and political polices. The longer the duration, the more faith creditors are likely to have in that economy’s medium-to-long-term stability.

5.2.  Social cohesion

The social cohesion section of forward looking indicators addresses such issues as social stability and income and wealth inequality. Societies with very broad distribution of income and wealth, are often far more cohesive than countries with a massive income and wealth divide between the public and the elite. The higher social cohesion, the more easily are societal conflicts resolved. Although social cohesion may not suggest an immediate impact on the creditworthiness of the government, in the long run, societal stability and social conflict mitigation generally result in a more stable economic environment; something that is conducive to higher economic growth. Since social cohesion reduces the severity of domestic conflicts, such cohesiveness may also be a proxy for measuring political stability.

The assessment of the social cohesion is based on the following indicators:

  • CPIA social protection and labor rating;
  • CPIA policies for social inclusion/equity rating;
  • CPIA building human resources rating;
  • WGI Political Stability and Absence of Violence/Terrorism estimate.

Social protection and labor rating by CPIA assess government policies in social protection and labor market regulations that reduce the risk of becoming poor, assist those who are poor to better manage further risks, and ensure a minimal level of welfare to all people.

Policies for social inclusion and equity rating by CPIA that encompasses gender equality, equity of public resource use, building human resources, social protection and labor, and policies and institutions for environmental sustainability. Building human resources rating by CPIA assesses the national policies and public and private sector service delivery that affect the access to and quality of health and education services.

Political Stability and Absence of Violence/Terrorism estimate by WGI measures perceptions of the likelihood of political instability and/or politicallymotivated violence, including terrorism.

Similar to the Rule of Law and Transparency assessment, the scores from the above ratings would be tested against the following quantitative indicators:

  • Poverty rates;
  • Live expectancy;
  • Infant mortality.

5.2.1.  Poverty rates

In order to evaluate the equality of income and wealth distribution, the poverty rate should be assessed. One could also analyze the Gini coefficient of wealth distribution in the society as a more refined measure of socio-economic equality. The wider the gap between the wealthiest and the poorest, the greater the chances of social tension in that society. The risk is that at some point such tensions may reach critical levels, sometimes even resulting in widespread social unrest.

5.2.2.  Life expectancy and Infant mortality rates

Measures of life expectancy and infant mortality rates illustrate accessibility to primary healthcare services. The higher life expectancy and the lower infant mortality rates are, the more likely the society will be socially cohesive.

5.3.  Education & Research

The education section of forward-looking indicators deals with the issues regarding the effectiveness of government policy in fostering future growth opportunities and creating stimuli for resource enhancement. This category closely resembles social cohesion in that it provides no immediate impact upon the creditworthiness of the government. However, it is crucial in helping to determine the long-term outlook for the country.

5.3.1.  Education spending (% of GDP)

Expenditure on education is one of the basic indicators regarding how much a government dedicates resources to future growth prospects. This measure should be taken as total spending on education, both public and private, as a percentage of GDP in order to account for organizational differences in education system funding practices. High-income countries often demonstrate relatively low percentage of public spending on education due to the fact that educational system substantially relies upon private sources of funding. Low-income countries, on the other hand, often demonstrate low levels of private education because the cost of private education is often prohibitive for middle- and low-income families living in low income countries.

5.3.2.   Education attainment levels

Education attainment levels demonstrate not only accessibility to the educational system from a social justice point of view, but also serve as a characteristic of social mobility within a society. Effective educational systems that provides an adequate level of education are a potential source of a skilled and efficient labor force.

5.3.3.   R&D spending and personnel

This particular indicator is often correlated with success within the educational system. High levels of education spending, coupled with high R&D spending, imply that the country is likely to be less dependent upon foreign sources of invention and innovation. This is a credit positive.

5.3.4.   Science and Technology Degrees

The proportion of science and technology degrees as a percentage of the overall number of graduates serves as a complimentary indicator to both the R&D and education indicators. It bridges the educational system to R&D process. These particular degrees are usually the most capital intensive in terms of provision and the most productive in terms of transferring scientific and research potential into value-added products.

5.4.  Government efficiency

This indicator takes into account, not the amount of organizational, human and financial resources available to the government, but rather its efficiency in achieving the declared objectives on a sustained basis. The primary assessment comes from an analytical comparison of the objectives declared by the government and actual resources at the disposal of the government, and is based on expert judgement.

Highly ambitious objectives (with a low probability of successful implementation) may be evidence of flaws in strategic planning and resource management. On the other hand, modest objectives that assume a deterioration in the efficiency of organizational, human and financial resources (in contrast to assumptions about the negative effect of external factors), may also negatively affect the government’s efficiency. The government efficiency indicator may also be affected by observed deviations in the past regarding declared objectives.

The initial assessment is carried out on the basis of the following indicators:

  • CPIA public sector management and institutions rating;
  • CPIA quality of public administration rating.

Public sector management and institutions rating by CPIA includes property rights and rule-based governance, quality of budgetary and financial management, efficiency of revenue mobilization, quality of public administration, and transparency, accountability, and corruption in the public sector.

Quality of public administration rating assesses the extent to which civilian central government staff is structured to design and implement government policy and deliver services effectively.

When assessing CPIA rating and WGI estimate, the Agency also takes into account multiple sources of quantitative and qualitative information:

  • Transparency of budget planning and implementation, deviation of actual revenues and expenditures compared to budgeted revenues and expenditures (the prior year’s actual revenues and expenditures are usually considered as a reference point);
  • A transparent and competitive process for civil service appointment/selection, along with a rational justification based on professional criteria such as dismissal procedures and observations of actual dismissals are also considered;
  • Expenses of the state related to maintaining its overall functions and services, including personnel, administrative and representative expenses.

Similar to the assessments of all other forward-looking indicators, which initial assessment is based on external World Bank ratings, the Agency reserves the right to adjust the final score with regards to the relevant quantitative and qualitative factors.

5.5.  Adaptability

The adaptability indicator can be described as an assessment of government and state institutions’ ability to change in response to the following:

  • Changes in global standards and best practices of governance;
  • Own past experience, both positive and negative;
  • Advice and consultation with academics and professional consultants.

Ability to change doesn’t necessarily assume imminent change in reaction to the factors listed above, replication of other practices, or following external advice. In general, a positive evaluation of the adaptability indicator includes:

  • Evidence of scientific grounds behind the implemented policies and transparent metrics that justify their implementation and allow for monitoring;
  • Demonstration of flexibility through change, or replacement of failed policies and institutions, with the ability to move towards more innovative policies/institutions.

In the evaluation of this indicator, a systemic approach to policy changes (with implemented mechanisms that support innovation in governance and policy-making) is preferred to the manual approach, where policy learning occurs ad hoc. However, the manual approach is preferred to a system where no learning is evident and where failed policies remain in force.

The scope of application for this indicator often depends on the separation of political and economic powers within the country. In a highly decentralized environment, lack of adaptability within an important institution cannot be offset by adaptability of other institutions and may become a bottleneck for both political and economic change.

The initial assessment is carried out on the basis of the following indicators by WGI:

  • Government Effectiveness estimate;
  • Regulatory Quality estimate.

Regulatory quality estimate captures perceptions of the ability of the government to formulate and implement sound policies and regulations that permit and promote private sector development.

Government effectiveness estimate captures perceptions of the quality of public services, the quality of the civil service and the degree of its independence from political pressures, the quality of policy formulation and implementation, and the credibility of the government's commitment to such policies.

Similar to the assessments of all other forward-looking indicators, which initial assessment is based on external World Bank ratings, the Agency reserves the right to adjust the final score with regards to the relevant quantitative and qualitative factors.

6. Modifiers

Modifiers are additional assessment tools that provide an evaluation of government efficiency during periods of stress. They are based both on an analysis of events previously faced by the government and assumptions about current anti-crisis mechanisms already in place. Each of the modifiers may have a score from -2 to +2 notches (although a range from -1 to +1 is more common). The maximum modifier range is between -3 and +3 notches.

6.1.  Past crisis track-record

This modifier is considered if a government has faced substantial economic and/or political shocks in the last ten years. As different governments may have demonstrated different abilities to manage past shocks, the effect of this modifier may be multidirectional:

  • If an effective track record of crisis management was evidenced, demonstrated by stabilization or improvement in macroeconomic dynamics, and if past crises may be assessed as largely caused by external factors, positive notching may be applied.
  • If the government has shown an inability to manage economic and political shocks effectively, negative notching may be applied. This factor doesn’t evaluate the “lessons” learned from past shocks – those are assessed in the rating factors and other modifiers.

6.2.  Timing of the response and early signaling mechanisms

This modifier takes into account the following aspects of a government’s reaction to crisis events:

  • Mechanisms for monitoring any deviations between expected and actual economic results. The independence of the monitoring institution and the accuracy of measures taken are assessed – regular downward revisions of past performance to ‘boost’ current dynamics would reflect poorly on the monitoring process.
  • Recognition of crisis events – the reluctance of authorities to admit to the existence of crisis events can significantly delay the discussion and implementation of anti-crisis measures.
  • Early signaling mechanisms – the presence of early signaling mechanisms may substantially improve the timing of reactions to crisis events. These may include metrics or indicators normally considered by the authorities and regulators.

A track record of delayed timing in reacting to crisis events may lead to a negative modifier, while evidence of quick responses in the past coupled with active monitoring and implementation of early signaling mechanisms may result in a positive modifier.

6.3.  Effectiveness of crisis remediation and precautionary policies

This modifier factors in the existence of certain policies, the absence of which doesn’t necessarily affect the financial standing of companies and individuals in a non-crisis environment. In the course of substantial macroeconomic distress these policies can support crisis remediation, and vice versa, a need for development and implementation may be costly during a downturn. Deposit insurance and bankruptcy procedures are examples of such policies. Legitimacy, acceptance and the feasibility of implementation of such policies is also always considered. However, a formal presence of those may not guarantee efficiency in a crisis environment.

In general, since there are already widely accepted precautionary policies in place in many jurisdictions, a positive value for this indicator is less likely. However, a lack of legally anchored policies may justify a negative modifier.

6.4.  Existence and effectiveness of automatic stabilizing policies

Automatic stabilizing policies may improve the predictability of the government’s financial standing through the course of an economic cycle and to react to crisis events without lags related to policy changes. Such automatic stabilizers may include:

  • Reduced corporate taxes during a recession coupled with a higher tax burden during the growth phase;
  • Personal income tax that are structured in a way to relieve the tax burden on individuals during periods of personal income stagnation or income decline;
  • Unemployment or other social insurance funds that accumulate funds during a period of growth and which help reduce stress on personal income during crisis periods.

A lack of automatic stabilizers is normally a credit negative, while the presence of multiple, legitimate, automatic stabilizers might justify a positive modifier. The presence of poorly applied automatic stabilizers (through either constant revision of the stabilizers, or deliberate non-enforcement of stabilizers) doesn’t represent a positive modifier.

7.  Country ceiling assessment

Country ceilings were put in place to take into account foreign-currency transfer risk. Transfer risk represents the possibility that a government might impose restrictions on capital flows during a crisis period, which negatively affect the ability of domestic borrowers to meet their foreign-currency debt servicing obligations.

Country ceilings were traditionally equal to the foreign-currency rating of the government. The reason for that practice was that during the period of widespread defaults to foreign bank creditors in the 1980s, as part of the rescheduling process, governments usually imposed some sort of foreign-currency payments moratorium on foreign-currency payments, including foreign-currency debt. Therefore, it was assumed that the creditworthiness of the government represented the highest foreign-currency rating that could be assigned to any entity domiciled in that country. That was the origin of the foreign-currency ceiling.

However, in the late 1990s, as governments began to default on foreign-currency bonds (for the first time since the 1930s), it was observed that in many instances, governments did not impose foreign-currency payments moratoria. As such, piercing the country ceiling began to become normal practice.

Although in most countries, governments still represent one of the lowest risk borrowers, this is not always the case, especially in monetary unions. However, in non-monetary union countries, using expert opinion, a combination of observation of recent practice around the world, and the historical practice of a particular country’s government regarding the imposition of foreign currency moratoria during past crisis periods, it is then possible to assign the likelihood (probability) a payments moratorium might be imposed when a government defaults on its foreign-currency debt.

Using the idealized default tables (created by structured finance), the risk associated with the foreign-currency rating of the government is then multiplied by the risk of the imposition of a moratorium. Using that result, the final foreign-currency rating for a borrower is established by reverting back to the idealized default table.

7.1.  Other sources of positive notching

There are other sources of foreign support, which may justify piercing the country ceiling. One possibility is a guarantee by a foreign-domiciled entity. Such guarantees may come from international financial institutions such the World Bank or other regional development banks, or the foreign parent of the local issuer. Then the country ceiling per se is no longer the dominant determinant of the foreign-currency rating of a domestic issuer. The foreign-currency rating of the guarantor prevails.

Another possibility centers on structured finance. In many cases, foreign-currency earned abroad might be directed to offshore accounts dedicated to repayment of foreign-currency debt. Since the entire transaction escapes domestic law, a government cannot easily interfere with such debt servicing. As such, the rating of the structured finance security equals the rating of the structure, with no reference to the foreign-currency rating of the government, unless that rating affects the ability of the source of foreign exchange to earn foreign currency.

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