Critical Factors for Evaluating Sovereign Credit


David RileyAt the 65th CFA Institute Annual Conference, Fitch Ratings Group Managing Director David Riley discussed the critical factors for evaluating sovereign credit. In particular, Riley drew upon lessons learned in the ongoing European sovereign debt crisis.

Here are some of the key questions he highlighted that are used by Fitch in evaluating sovereign credit:

  • Can a sovereign exercise primary authority over a recognized jurisdiction? More specifically, does it wield the power of violence? Can it collect tax? Does it have the ability to print money?
  • What is the probability of default on its public debt? In answering that question past defaults can be useful.

  • How willing is the government, not the country, to pay its obligations?
  • How much financing flexibility does the nation have? One specific factor is whether or not the country’s currency has reserve status.
  • What is the nature of structural factors, such as the level of income and wealth in the nation (for instance, GDP per capita); political and social stability; and the payment and principal repayment record?
  • What is the level of macroeconomic stability and the condition of the nation’s external finances? Specific measures include: low and stable inflation; level and stability of economic growth; the state of the balance of payments accounts; levels of foreign debt; and the commodity dependence of the nation.
  • What is the condition of the public finances of the nation? Key factors include the budget and debt position; overall interest costs; and the structure of the government’s debts (i.e., what percentage of the debt is in local versus foreign currency and the maturity structure of debts).
  • Lastly, what is the nature of the monetary sovereignty of the nation? Fitch considers central bank holdings of government debt, the level and volatility of inflation, and other factors. (One interesting data point that Riley shared with conference delegates is that according to his models, the United States would have to have inflation of 25% to inflate away its debt.)

On the Enterprising Investor blog, published by CFA Institute, we recently wrote about alternatives to credit ratings, making for a nice comparison with the factors noted above.

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