What is sovereign credit?
Most people know what a country is but may need to learn what a sovereign entity or state is. A sovereign state is any country whose government has the highest power or authority over the state. Like countries, sovereign states have their own permanent population, defined territory, and the ability to interact with other sovereign states.
Sovereign credit is the credit rating of a country or sovereign state. Sovereign credit ratings provide valuable insight to investors/other countries before they decide to invest or lend to a country. Like a consumer credit rating, sovereign credit ratings provide an overview of financial stability. Sovereign credit or sovereign credit ratings have a long history and play an important role in global economics. Continue reading to learn more about its history and the ins and out of this rating tool.
History of Sovereign Credit
Currently, three bureaus overlook the global credit rating industry: Moody’s, Fitch, and Standard and Poor. These “sovereign credit bureaus,” just like the major credit bureaus for consumers (Equifax, Experian, TransUnion), have a long history.
Moody’s was founded by John Moody in 1900 as a published manual called Moody’s Manual of Industrial and Miscellaneous Securities. John Moody wanted to establish a language for global credit and widen access to information on this topic. Since then, the company has taken off and currently has a global presence.
Fitch began as a small publishing house in 1913 in New York City. Three investors founded the company; John Knowles Fitch, Henry P. Clancy, and Fabian Levy. They launched a few products; the most popular was the Fitch Bond Book, a detailed and easy-to-read book about bond data, which was directly distributed to investors. This delivery service became known as the Fitch Investors Service. Since its founding, Fitch has undergone further growth and expansion, acquiring new businesses and domains and exploring different product suites and local and global regions. Today they are a massive company that provides data to credit market issuers, servicers, trustees, and investors.
Standard and Poor’s beginning is similar to the consumer credit bureaus that started in the railroad industry. Standard and Poor was founded in 1941 but actually began as Standard Statistics when Henry Varnum Poor published the History of Railroads and Canals in the United States, a securities and reporting analysis. From here, they began publishing corporate bonds, sovereign debt, and municipal bond ratings. In 1941 Standard Statistics and Poor’s Publishing Merged to form Standard and Poor’s Corporation.
1970 was a big year for all of these companies and the credit ratings industry. Before this time, all of the data, research, and analytics that these credit companies were proceeding with was done for free. However, as things in financial markets got more complicated, and demand rose due to the success that these ratings provided, the industry decided to monetize these services for investors or any other clientele.
Types of Sovereign Credit/Debt
An important factor with Sovereign credit is Sovereign debt, which impacts sovereign credit ratings. Here are the different types of sovereign debt:
- Domestic Debt— Domestic debt is any debt that a country or sovereign state gains from borrowing funds within their own borders.
- Foreign Debt — This type of debt is also pretty straightforward; it is any debt that is acquired from borrowing from other countries or sovereign states.
- Short-term Debt— Short-term debt is usually considered any debt that can be repaid in the course of less than one year.
- Long-term Debt — Long-term debt is usually longer than a year.
Risks of Sovereign Credit
There are definitely risks when one country lends money to another or domestically. Here is more information on the different types of risks that are involved with debt obligations (for government debt and otherwise):
With any lending, the lender takes on the risk that the borrower will not be able to repay the debt in its entirety. A default can mean losing thousands or even more, depending on the size of the loan. This is why credit analysis is so important for global and domestic lenders and investors, so they figure out the sovereign credit risk and make an informed decision.
Credit risk measures the amount of risk that a lender is taking when they give out money. In the context of sovereign credit, it will usually be domestic or international lending. A sovereign credit rating will give those looking to lend or invest a good idea of what kind of risk they are taking.
Political risk is unique to sovereign credit because it can operate in the global economy. Because every country or sovereign state may operate differently and laws can change, or outside factors can impact the economy or lending practices, investors and lenders will have to factor in political risk.
Another thing that is unique to sovereign lending is that there is a currency risk. Currency risk is the risk of unpredicted currency changes that can cause gains and losses.
Regulations of Sovereign Credit
There are some regulations of sovereign credit that you should know about:
- Basel III — Basel III is a set of measures/regulations that are put into place to regulate international banks. They were a response to the 2008 financial crisis.
- International Monetary Fund (IMF) Guidelines — The International Monetary Fund, or IMF, is a financial agency of the United Nations, and it operates as an international financial institution. IMF guidelines help regulate all kinds of financial systems, including sovereign debt.
- Sovereign Debt Restructuring Mechanism (SDRM) — An SDRM is a tool whose role is to safeguard the worth of assets and uphold the rights of creditors. Along with that, an SDRM facilitates an agreement that enables debtors to regain stability and foster economic growth. For example, one part of SDRM supports international bond markets.
Rating System of Sovereign Credit
To completely understand Sovereign credit and sovereign credit ratings, you will need to learn more about how the credit ratings system works; below is an explanation of that, along with more information on the major credit rating agencies:
Major Credit Rating Agencies
As mentioned above, there are three major credit rating agencies that provide sovereign credit rating data: Moody’s, Fitch, and Standard and Poor’s. These credit rating agencies play an essential role in determining whether a country is seen as a sovereign credit risk. They use several factors and tools to come up with these ratings and have refined their systems throughout the years and continue to do so. For example, as AI makes its way into most technologies, some are beginning to incorporate that into their research. Continue reading to learn more about what factors influence sovereign ratings with these credit rating agencies.
Factors Affecting Sovereign Credit Ratings
GDP Growth Rate
When a particular country has a high GDP growth rate, it usually indicates that the economy is prospering. And so, a higher rate can mean a lower sovereign credit risk and, therefore, a higher rating.
The fiscal balance of a government or country is the total taxes collected along with assets sold minus the current spending. A fiscal deficit occurs when that balance is negative, while a fiscal surplus occurs when the balance is positive. If a country has a high fiscal deficit, it can bring down its credit rating, while a fiscal surplus can bring up that rating.
External balance is a measure of a country’s dependence on others by looking at its external deficits. The higher these balances, the lower a credit rating may be.
Per Capita Income
This factor may not seem that obvious as it has to do more with the people of the nation rather than the country’s individual finances. But per capita income definitely will impact credit ratings. This is because the more income the people of a country make, the more taxes they will have to pay. And more paid taxes mean more money for the country, increasing chances of debt repayment.
A Country’s Inflation Rate
Inflation may indicate an economy that is headed for a recession and sometimes the government’s inability to regulate its economy through other measures. Along with that, inflation may lead to political unrest, all impacting a country’s financial system. And so, a high inflation rate may lower a country’s rating.
This factor is pretty similar to how default history impacts consumers. A country or sovereign state that has a long history of default will decrease its credit rating. While a country that has few or no defaults will have a higher credit rating.
Economic development encompasses a range of initiatives, policies, and actions designed to enhance economic prosperity and overall quality of life within a community. Its primary goal is to foster an improved state of economic well-being. The more economically developed a country is, the higher its credit rating may be.
Debts Owed Externally/Sovereign Debts
When a country owes a lot of debt, it may indicate heavy reliance on outside finances to build and run the country. Along with that, simply, a lot of debt takes away from a country’s income and may mean a higher risk of default for an investor/lender.
Importance of Credit Ratings
Credit ratings for countries and consumers are essential. When it comes to countries, it helps other nations and investors figure out their risks before they lend money, which is essential for both global growth and global financial security. Credit ratings are also crucial to fostering economic growth, especially for developing countries, and measuring the economic impact of political, financial, and societal events.
Sovereign Credit and Global Markets
Sovereign credit has a huge impact on Global Markets. When countries have high credit ratings, it increases investor interest and boosts growth in the world economy. For countries that don’t have the best credit rating, sovereign credit gives them tangible routes for improvement.
When countries invest in one another, it can help build strong financial relationships and help both parties out. Another thing that sovereign credit does is act as a monitoring system for potential global Financial crises.
Impact of Sovereign Credit on Economic Growth
Sovereign credit has a massive impact on economic growth and vice versa. Sovereign credit really focuses on overall financial stability, and when a country does not have that, it cannot invest in its infrastructure, healthcare, education, social services, community development, and more, which are all key drivers of economic growth and measure economic health.
Investing and Sovereign Credit
Investors (whether individuals or countries) definitely have the option to tap into foreign markets. They can do so in several ways: purchase sovereign bonds, international stocks, real estate, etc.
When investing internationally, there are many considerations that investors have to make, including credit ratings, risk of default, currency risk, political risk, and more. However, when done right, sovereign investments may have benefits, including lowered costs, higher profit margins, gaining reputability and experience on global markets, accessing untapped capital, and more.
The Future Outlook For Sovereign Credit
The major credit rating agencies for sovereign credit often analyze and look into the future to predict trends and outlooks for the global market. When it comes to the outlook for the rest of 2023, According to Fitch, unfortunately, the outlook for 2023 does not look great, as high inflation rates globally, monetary policy tightening, and elevated geopolitical tensions decrease economic stability.
Regarding the future of how sovereign credit is analyzed and predicted, it shouldn’t be too surprising that AI is beginning to be tested in the realm of sovereign credit. For example, there was a recent study led by the University of Cambridge, done with (in which S & P was involved) where. In this study, AI looked at the effects of climate change over the course of several years and how those changes would impact sovereign credit ratings and global debt. This type of predictive work is groundbreaking and comes with valuable insights that risk analysts failed to predict in the past, for example, the 2008 financial crisis.
Key Takeaways With Sovereign Credit
Sovereign credit is an essential part of global economics and investing. A county or sovereign state’s credit limit provides a quick and concise overview of a country’s financial reliability, an essential tool for investing in countries and individuals. Just like with any kind of lending or investing, there are risks involved with sovereign investments; however, there may be unique benefits too. There are three major sovereign credit rating agencies: Moody’s, Fitch, and Standard and Poor.
- The IMF and Sovereign Debt | IMF
- What Is Sovereign Debt? | IMF
- The first climate smart sovereign credit ratings | PreventionWeb
- Fitch Ratings’ 2023 Outlook: Most Sovereign Sector Outlooks Deteriorating | Fitch
- History | Fitch Group
- S&P Global: Our History | S&P Global
- History | Moody’s
- Determinants and Impact of Sovereign Credit Ratings | NewYork Fed
- Sovereign Credit Rating: Definition, How They Work, and Agencies | Investopedia