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Event risk, fiscal worries: How are a country’s sovereign ratings decided?

  • June 01, 2020

Reports of a possible downgrade of India’s sovereign ratings had been doing the rounds since the past few weeks as Covid-19 pandemic stalled economic activity. The developments saw most experts sharply revise their economic growth projections for India.

In this backdrop, the possibility of a possible downgrade in India’s sovereign credit rating by Moody’s Investor Service (Moody’s) and Fitch had gained momentum. India’s Achilles heel on ratings, according to Nomura, is its parlous state of fiscal affairs. A potential spike in its general government debt from around 70 per cent of GDP to around 75-80 per cent of GDP, it believes, may possibly trigger a reassessment of ratings, particularly for Moody’s.

So, how do these rating agencies go about assigning a country’s sovereign credit rating and what factors do they consider before taking such a call?

While major credit rating agencies have well-defined frameworks for deciding on sovereign ratings, the methodology of ultimately arriving at the final award remains a black box, said analysts at Nomura in an April 29 report titled ‘India: At the cliff edge of a rating downgrade’.

ALSO READ: Moody’s downgrades India’s ratings to Baa3; maintains negative outlook

“A highly simplified version of the methodology involves the rating agency first assessing the country over a number of sub-categories – economic, institutional, fiscal and external, by observing trends in a pre-decided set of indicators. Typically, each indicator’s performance attracts a rating, which contributes to the overall rating of the sub-category,” they said.

The next step, they said, which is arguably more subjective, involves ‘adjustment’ of these scores to reflect the agencies’ proprietary judgement.

“As a result, the final rating for the sovereign, which is an aggregate of how the country performs in each sub-category, is difficult to summarily predict based on data solely,” Nomura says.


To assess the impact of Covid-19 on India’s sovereign rating, Nomura believes, there are three key aspects of the ratings discipline that are worth noting.

First, there will be a ‘sticky’ component of the ratings that will be linked to economic fundamentals – which are unlikely to change unless fundamentals are expected to deteriorate sharply.

“For example, the size of the economy, or quality of institutions are likely to remain unaffected with the Covid-19 outbreak. This provides a relatively strong anchor to the ratings,” Nomura says.

Second, even within the ‘flexible’ component of the rating, some indicators are relatively ‘elastic’, i.e. they will adequately react to Covid-19 to trigger a ratings change.

“Be it real GDP growth or fiscal ratios, rating agencies typically consider an average involving past years’ performance and projected performance in the next couple of years. As a result, even a sharp outlook deterioration for next year may not necessarily be adequate to bring down the overall average to warrant a ratings downgrade,” wrote Sonal Varma, managing director and chief India economist at Nomura in a co-authored report with Aurodeep Nandi.

Lastly, rating agencies are typically sensitive to ‘event risks’, Nomura said, so this assessment inherently assumes that flash-points such as a banking sector credit event, or a liquidity freeze for government, or a political risk flare-up are largely avoided.

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