A STUDY OF FACTORS IMPACTING SOVEREIGN CREDIT RATINGS

Abstract

Sovereign Credit Ratings are independent opinions of a sovereign's ability to repay its debt obligations in a timely manner. Ability is a synthesis of capacity and willingness to repay. While the capacity to pay is generally determined through analysis of quantitative macroeconomic data, the willingness to pay is analyzed through study of various qualitative variables. (Ozturk, 2016) SCRs influence a sovereign’s access to and cost of international debt funds. SCRs can also influence flow of money into the economy, including foreign direct investment (FDI). SCRs also impacts availability and cost of borrowing for corporates and banks within the country through concepts like country ceiling. SCRs help international investors to choose and optimally price credit risk, while lending to sovereigns and corporate & banking entities domiciled within the sovereign. A study of the methodologies of the three large credit rating agencies (CRAs – S&P, Moody’s & Fitch) shows that they evaluate both quantitative and qualitative factors to arrive at their sovereign credit rating decisions. However, most existing academic studies analyses only quantitative factors, without considering the CRA methodologies. While there is largely a consensus on which quantitative variables are important for determining SCR, a similar consensus on qualitative variables has not been achieved. Also, there is substantial literature which establishes the link between banking sector risk and sovereign credit risk in general but work on the qualitative aspects of banking sector risk which contribute to build-up of NPLs is limited. Overall, this work finds gaps in previous research on the issues of selection of variables impacting SCR; impact of qualitative variables individually and as a group on sovereign credit ratings; consistency in application of rating criteria across nation-groups; and qualitative aspects of banking sector risks. This work proposes to address some of these gaps, especially in the context of India. All these gaps offer a vital opportunity for researchers to make a significant contribution to the related research stream. While we will do an international study on the quantitative and qualitative factors impacting SCR, we have laid special emphasis on ix comparison of India across nation groups. This first work analyses the impact of qualitative factor “rule of law” on the sovereign credit rating. Thorough analysis has been done on the complete developed dataset using linear regression, R squared value and the correlation coefficient. The results indicate a positive linkage, having 82% positive correlation between the “Rule of Law” percentile ranking of a country and its sovereign credit rating across various income groups and regions. The finding suggests that countries striving for higher sovereign credit ratings should consider ways to improve their world standing on qualitative variables like the ‘Rule of Law” and not only concentrate on improving macroeconomic factors. While this paper studies only one variable, there are many other qualitative variables which could be important in determining sovereign credit ratings, which can subject of future research. For further analysis, two different datasets were developed which comprises of 55 countries from all income groups and geographical locations with SCR obtained from two major CRA’s for a period of 10 years. In these two different datasets, various factors were replaced by their contemporary factors along with the data source. This was done to perform correlation analysis on these datasets individually to assess the importance of different parameters and to predict the sovereign credit rating using extra tree classifier. An important outcome is that all factors with low correlation are quantitative in nature while qualitative factors have high-moderate correlation with SCR. This indicates that the qualitative (socio- political) factors, individually and as a group, are more important in determining SCR than quantitative (economic) factors. Comparative analysis of results for these 2 datasets indicates the importance of the qualitative factors remains the same in determining SCR irrespective of its data source. This also finds the possibility of a bias in favor of “high-income” nations while assigning SCR. Moreover, banking sector factors appear to have moderate correlation with SCR. The results analysis reflects that given the importance of qualitative factors in determination of sovereign credit ratings; sovereigns particularly developing/low-middle income might be better placed by focusing on socio-political reforms instead of focusing only on economic factors. The third task analyses data related to NPLs and other banking performance parameters taken from institutions like RBI and World Bank. The findings of this work reveal that bank ownership in India is a major factor impacting levels of stressed assets with PSBs having relatively worse asset quality than private and foreign banks operating in India. Moreover, quality of regulatory system plays a key role in timely stress recognition and maintaining the health of a country’s banking system. x The fourth task analyses the evolution of the stressed assets resolution framework in India from 1985 to 2020 and its impact on the recovery rate, recovery time and amounts recovered. It shows that a pro-creditor stance to resolution has worked better in India than a pro-debtor stance. Though time to recovery has improved substantially, most cases under IBC are breaching the timeline stipulated under law. In an international context, post-IBC, India has made substantial improvement in recovery rates, which are now much higher than developing country peers and moving towards developed countries standards. Also, the time to recovery has substantially reduced and is now closer to developing country peers though still poor compared to developed countries. Indian cost of recovery has meanwhile remained stagnant and in the middle of the stack in the comparison.