Why a sovereign rating is not the last word on a nation’s creditworthiness

(Mint)SummaryA sovereign credit rating is a composite measure of several elements that affect a country’s ability to service its debt obligations. Instead of treating it as a badge of national prestige, it is more useful to engage with its many dimensions.Gift this articleCheck your portfolioThis is a Mint Premium article gifted to you.Subscribe to enjoy similar stories.

In August, Fitch Ratings affirmed India’s long-term sovereign risk rating at ‘BBB-’ with a stable outlook—a rating level India has held for 20 years. This is a notch lower than the ‘BBB’ and ‘Baa3’ ratings assigned by S&P Global and Moody’s, respectively.

On the Fitch ratings scale, India is at the minimum investment grade, any lower and it would fall into the speculative category. The other two rating agencies place India a notch above investment grade. India’s prolonged stay at the minimum investment grade rating level has come in for much discussion.

An often-heard view is that the country is rated harshly by global credit rating agencies given its size, economic growth and political stability. What methodology do these rating agencies follow for sovereign ratings? Does that methodology faithfully capture what it sets out to capture?

Where does India fare well and where does it lag? Are ratings the start and end point of this conversation, or is there more? A sovereign rating is the opinion of a rating agency on a nation’s ability and willingness to service its debt obligations.

Ratings are represented by symbols ranging from D (default grade, worst rating) to AAA (highest rating). India’s BBB lies somewhere in the middle. Plus (+) and minus (-) symbols are added to indicate tiers within each rating category.

A sovereign’s ability to pay is gauged by assessing if its revenue generating capacity is enough to service its debt. In order to make this evaluation, rating agencies analyse metrics on growth, per capita GDP, debt, fiscal balance, external vulnerability, inflation and monetary management.

Willingness to repay is assessed on the basis of qualitative factors such as political stability, prevalence of rule of law, civil society activity, and the credibility and independence of institutions—all fairly subjective in nature.

S&P Global, the largest of the big three international rating agencies, bases its sovereign ratings on five assessment pillars: institutional, economic, external, fiscal and monetary factors. Each is assigned a value on a scale of 1 to 6, with 6 being the weakest.

These are then combined and adjusted to generate a final rating. Other rating agencies follow a broadly similar methodology. A BBB rating, which India has, implies the country has adequate capacity to repay debt, but faces moderate economic vulnerability.

In effect, the BBB group includes countries that are stable enough to avoid default, yet are sensitive to major shocks. As of end-July, there were 25 countries in S&P’s BBB universe. The group is fairly diverse. It includes Asian emerging market peers such as Thailand, Philippines, Indonesia; some emerging European economies, including Hungary, Bulgaria and Serbia; Mexico, Uruguay and Paraguay from the Americas, and Morocco from North Africa.

The list also includes two distinctly richer countries: Italy and Sharjah, one of the seven emirates that constitute the UAE. The GDP per capita of this set of 25 countries ranges from $2,810 (India) to $46,710 (British Virgin Islands).

There is no unique combination of attributes to achieve a BBB (or any other) rating. Countries within the same rating category have distinct economic, political, socio-institutional and geopolitical profiles. Consider India and Italy, which are both in the BBB group, despite their very different economic structures (strictly speaking, S&P rates Italy as BBB+, India as BBB; Fitch rates Italy as BBB+ and India as BBB-).

Over the last three years, India has grown at 6–7% a year, while Italy grew at less than 1%. India runs a current account deficit, while Italy has a surplus. Italy’s per capita GDP is 17 times India’s. Yet, Italy is assessed to be weaker on the external front because of its huge government debt (133% of GDP versus 80% for India), and large external creditor position to the rest of the world.

India’s low external debt partially makes up for other weaknesses in its economic profile. Differences like this create distinct economic vulnerabilities across the group. For example, Sharjah and India, both BBB-, are differently impacted by the US-Iran war.

Sharjah is directly affected by air strikes on UAE, and will probably face a growth slowdown from the war-induced drop in consumer and investor sentiment. India, on the other hand, faces gas shortages and higher energy import bills.

Sharjah’s pegged exchange rate reduces monetary flexibility, while India’s central bank remains in control of monetary policy even though the Indian rupee has plummeted. Sharjah’s centralized power structure leads to non-transparent decision making; India is a democracy with a federal structure.

That explains why Sharjah scores worse than India on S&P’s monetary and institutional assessments. Consequently, in spite of having a per capita GDP that is 10x of India, Sharjah and India have identical sovereign ratings.

The takeaway is that a sovereign credit rating is not simply a measure of how strong or rich an economy is. Rather, it is a composite measure of several elements that affect a country’s ability to service its debt obligations.

Therefore, instead of treating a sovereign rating as a badge of national prestige, it is more useful to engage with it along five key dimensions. One, real per capita GDP (in US dollars) is a vital input to the rating process.

Countries with higher per capita GDP tend to cluster in higher rating categories. The connection is straightforward: higher per capita income reflects a higher standard of living, which means a government has a large base to draw tax revenues from.

This, in turn, makes it...