R&I's Analytical Approach to Sovereigns

R&I's Analytical Approach to Sovereigns February 20, 2018 1. Sovereign Issuer Ratings The term sovereign means ruler and generally refers to the central government that governs a single country. R&I analysis includes central banks in sovereigns. In assigning a sovereign credit rating, R&I first determines Issuer Rating, which is based upon an analysis of the probability of debt default (default risk), such as the issuer falling into fiscal bankruptcy. Then it determines issue rating according to an analysis of the possibility of losses (recovery risk) arising from individual debts at the time of default. The principal component of evaluation of a sovereign credit rating is, as with other issuers like corporations, an analysis of default risk. A central government s fiscal position is based on determining expenditures necessary to sustain and manage the state and then gathering the revenue needed through taxes and other measures. If a balanced budget expenditures and revenue are equal is achieved, then no funds must be borrowed. However, public investments that offer benefits over very long periods, such as infrastructure facilities, should be most rationally financed by issuing mid- to long-term bonds. A government also issues bonds to cover revenue shortfalls that may occur from a drop in tax revenue when the economy suddenly worsens. Although a government generally issues bonds in the local currency of the issuing country, it also issues foreign currency-denominated bonds for purchase by overseas investors in order to diversify the investor base and because of a dearth of investment funds domestically. Borrowings from foreign governments and international institutions such as the World Bank also generally constitute foreign currency-denominated government debt. Tax revenue is the primary source of funds for repaying government debt. Central governments have the authority to levy taxes, and this can be considered collateral for repayments. Proceeds from the sale of natural resources and assets that belong to the state can also be used to fund repayments. Further, the central bank has the right to issue currency (seigniorage), and the central bank could print currency and use this to purchase and redeem government bonds. However, in order to repay foreign currency-denominated debt, governments must convert the local currency to foreign funds or procure foreign funds on the market. No matter how much the central bank can print the local currency, the government cannot procure foreign funds if confidence in the local currency has been lost, and as a result, the country would default on its foreign currency-denominated obligations. In view of this, sovereign Issuer Ratings, which reflect the ability to repay all financial obligations, imply the evaluation of foreign currency-denominated debt. Further, even if a government has the right to levy taxes, once government debt has risen in an undisciplined manner, a government cannot easily increase tax revenue with a sudden big tax rate hike. Economic activity could stall because of a tax increase, and tax revenue may not increase as much as expected. This could also lower the economy s potential growth and weaken the tax base. 1/11

The country s economic fundamental strength and its basic stance regarding fiscal management effectively collateralize the repayment of government debt. This is why R&I performs a wide range of analysis, covering from a country s fiscal conditions and funding structure to economic and sociopolitical fundamentals and policy management ability. Note that R&I also assigns local currency-denominated ratings which exclude the evaluation of risks associated with conversion to foreign currency or foreign fund procurement. Domestic Currency Issuer Ratings should be the same as Foreign Currency Issuer Ratings in principle for the countries whose Foreign Currency Issuer Ratings are in the AA rating category or above. This is because countries with such high creditworthiness are, with some exceptions like oil-producing countries, largely advanced countries. Their local currencies are often key currencies used for international settlements, and their internal financial and foreign exchange markets are most likely sufficiently developed. R&I thus feels that the risks involved with converting to foreign currencies and procuring foreign funds are sufficiently low. Conversely, countries with a Foreign Currency Issuer Rating in the A rating category or lower face risks with converting to foreign currencies or procuring foreign funds, and these risks are factored into the Foreign Currency Issuer Rating. Thus, Domestic Currency Issuer Ratings can be higher than Foreign Currency Issuer Ratings in some cases. 2. Long-term Issue Ratings Ratings for individual long-term bonds, or Long-term Issue Ratings, are based on Foreign Currency or Domestic Currency Issuer Ratings. However, the possibility of default may vary by the obligation, as only some obligations may be selectively rescheduled. Further, when the borrower has difficulty repaying debt, the borrower and the lender may negotiate debt rescheduling and repayments of individual obligations may vary as a result. Therefore, individual obligations even by the same issuer may be assigned ratings that differ from the Issuer Rating. 3.Short-term Ratings Short-term Ratings are R&I s opinions on the certainty of the fulfillment of an issuer's short-term financial obligations as promised. Short-term ratings are assigned to an issuer s ability to repay short-term financial obligations, among others, and those views are based on the Rating Methodology R&I s Analytical Approach to Short-Term Ratings. 4.Outline of determining sovereign Issuer Rating A sovereign s ability to repay debt differs depending on the government s fiscal balance and debt burdens and their prospects, as well as potential fiscal burdens (fiscal conditions). Further, if smooth refinancing is impossible because of worsening financing conditions, the government s liquidity position could worsen and repaying debt could become more difficult, even if the government appears to be solvent over the medium to long-terms (funding structure). Central governments do not operate their own businesses to generate cash flow and cover its finances. Taxes levied on various economic entities (primarily companies) and individuals, social security payments, and wealth generated from natural resources within the country s economic 2/11

sphere cover government finances. Given such characteristics of government finances, the economic size and income level, stability and potential of economic growth, stability of funds supplying functions and financial system (economic fundamentals), the stability of political structure, the extent of the rule of law and control of corruption, and stability of society, civil order and international relations (socio-political fundamentals) are all analyzed. Furthermore, it is also critical to analyze whether a government and central bank clearly recognize policy issues, economic and political conditions allow them to implement necessary policies, and the government has strong and clear willingness to repay debt (policy management capacity). Figure 1. The Framework for Determining Sovereign Issuer Ratings Domestic Currency Issuer Rating Foreign Currency Issuer Rating Risks associated with conversion to foreign currency or foreign fund procurement Analysis of fiscal conditions and funding structure Analysis of economic and socio-political fundamentals Analysis of policy management capacity 5.Analysis methodology of individual assessment components 5-1. Fiscal conditions and funding structure Government fiscal conditions and the funding structure that supports government finances are assessed. Central government fiscal conditions are linked to the fiscal conditions of other domestic government bodies through local government tax allocations and social welfare transfers. Therefore, analyzing fiscal conditions should address not only the central government, but general government, which includes local governments and social welfare funds (based on the definition of Government Finance Statistics, or GFS), as much as information obtainable allows. 5-1-1. Fiscal conditions Assessing fiscal conditions involves examining Debt burden, Fiscal balance, and Potential fiscal burden. 3/11

Component Sub-component Qualitative/Quantitative Assessment Fiscal conditions Debt burden Fiscal balance Potential fiscal burden Debt tolerance Debt outstanding (to GDP) Per capita GDP Debt outstanding trend Fiscal balance (to GDP) Appropriateness of tax system (or revenue system) Probability of maintaining fiscal discipline Potential fiscal burden 1) Debt burden Assessing debt burden involves examining how much debt burden the government can tolerate, or debt tolerance. The assessment involves first grasping the size of debt outstanding vis-à-vis gross domestic product (GDP). In addition, per capita GDP, an important quantitative indicator of the strength of economic fundamentals, is considered. Although a lighter debt burden is desirable, the debt level that can be borne should vary depending on the strength of the country s economic fundamentals. R&I believes that countries with stronger economic fundamentals have greater debt tolerance. Therefore, even if the ratio of debt outstanding to GDP is low, as long as income level (as reflected by per capita GDP) is also low, the assessment of debt tolerance is discounted by that much. The ratio of debt outstanding to GDP trend is assessed in terms of debt sustainability. Concerns may arise regarding the sustainability of debt even if the current debt level is low if it is still rising and not expected to peak out for some time. Therefore, the current trend of the ratio of debt outstanding to GDP rising or falling is first determined, then the future trend is analyzed. This is qualitatively factored into the assessments. 2) Fiscal balance Fiscal balance is determined first using the ratio of the balance to GDP as a quantitative indicator. Although the fiscal balance can be no better than a surplus, a surplus alone does not mean a high assessment of fiscal balance. Similarly, a fiscal deficit does not in itself imply a low assessment. The revenue and expenditure structure that gives rise to a fiscal balance surplus or deficit must be analyzed, and whether fiscal discipline can be maintained or restored determined. Based on these views, both quantitative (ratio of fiscal balance to GDP) as well as qualitative (the appropriateness of the tax system or revenue system and the probability of maintaining fiscal discipline) factors are evaluated. The tax system is one factor supporting fiscal conditions and is assessed by reviewing points including: can the tax system ensure sufficient revenue to meet socio-economic needs; is a sufficient tax base ensured or can a sufficient base be ensured as needed; and is the tax administration efficient. A strong economy can make the fiscal balance a surplus through increased tax revenue. In this case, unless fiscal discipline can be maintained, a fiscal deficit could result if economic conditions worsen and fiscal conditions deteriorate. Analyzing the fiscal management history is the starting point for determining whether a state will be able to maintain fiscal discipline or not. Maintaining a 4/11

disciplined fiscal management stance regardless of strong or weak economic phases means a high probability that fiscal affairs will be managed tightly in the future as well. Further, it is unlikely that fiscal discipline will loosen even in the event of a fiscal deficit if the government has a history of implementing necessary policies according to a fiscal consolidation strategy it drew up for a several year period and achieving commensurate results. Fiscal rules (such as fiscal consolidation targets) and the introduction of and commitment to a medium-term fiscal management framework are one benchmark of determining whether a state has fiscal discipline. 3) Potential fiscal burden Even if current fiscal conditions are strong, if the government has a potential fiscal burden, then the future cannot be considered secure. The size of the potential fiscal burden must be determined and the impact on fiscal conditions determined. In order to gauge any potential fiscal burden, the size of the government s guarantees for liabilities of public enterprises and local governments must first be determined. The debt outstanding referred to in assessing the debt burden does not include such guarantees. If a government is required to perform guaranteed obligations, such transactions will be recorded as government expenditure, and as a result the debt burden could increase. Also, heightening concerns about a financial crisis or an actual occurrence could cause government fiscal conditions to worsen substantially because of injections of public funds into financial institutions. Examining whether such risk would arise based on the Stability of funds supplying functions and financial system as assessed in the Economic fundamentals is extremely important. Countries facing major structural problems in developing their economies and ensuring safe livelihoods for their populations such as lagging economic infrastructure, an inadequate social welfare system, or insufficient social welfare system to address projected population ageing must introduce measures needed to avoid a bigger fiscal burden in the future. Whether such efforts have been made must be examined. 5-1-2. Funding structure Assessing funding structure involves examining Availability of domestic funds and Accessibility to domestic/foreign funds and tolerance against changes in the financial environment. Component Sub-component Qualitative/Quantitative Assessment Availability of domestic funds Current account (to GDP) Current account trend Funding structure Accessibility to domestic/foreign funds and tolerance against changes in the financial environmental Net international investment position (to GDP) Accessibility to domestic/foreign funds 5/11

1) Availability of domestic funds The ratio of the current account balance to GDP is an indicator used to determine the availability of domestic funds, or the savings-investment balance. The balance between savings and net investments based on National Accounts Statistics (SNA) figures is equivalent to the current account balance. In other words, a current account surplus reflects domestic savings exceeding investment. In such case, a government deficit is covered by a surplus of savings in the private sector (non-financial corporation and household savings). In addition to this quantitative indicator, current account trends over the past five years and the next two to three years are considered. This is because, assuming that even if the current account has been positive recently, if a current account deficit persisted for a long period prior to that, domestic funds available in aggregate terms could be very different from the case where a current account surplus persisted for a long period. 2) Accessibility to domestic/foreign funds and tolerance against changes in the financial environment Even if the savings-investment balance shows a current balance surplus, the government cannot necessarily procure all funds domestically. Conversely, there are some countries that can raise funds smoothly on financial markets outside the country even with a savings-investment balance deficit. Therefore, it is also necessary to assess not only the availability of domestic funds, but also the accessibility to domestic and foreign funds and tolerance against changes in the financial environment. Assessing the accessibility to domestic and overseas funds involves examining not only the government but also the economy as a whole, including the private sector. The main points in the assessment are: fundraising cost trends (shown by long-term interest rates), the degree of development of the domestic financial markets, and the ease of converting to foreign funds and raising funds in foreign currencies. Key currency countries can usually raise funds smoothly on both domestic and foreign financial markets and are rated highest. Other countries with currencies used for international settlements are also rated highly, but in a common currency region like the Eurozone, not all member countries necessarily have the same accessibility to funds. Fundraising costs differ depending on the strength of the country s economic fundamentals and fiscal conditions. Further, not all domestic financial markets are developed to the same degree. Therefore, other points are more important for the purposes of assessment of common-currency countries than whether the currency is used for international settlements. Tolerance against changes in the financial environment is assessed based on the country s international investment position. The main point is the ratio of net investment (assets minus liabilities) level to GDP. The overall economy s (including government and private sector) external assets and liabilities reflects the international investment position. Countries with liabilities so large as to exceed assets are considered to have low tolerance to big changes in foreign exchange markets and international financial markets. 6/11

5-2. Economic and socio-political fundamentals The economic and socio-political fundamentals are assessed by examining economic fundamentals and socio-political fundamentals separately. 5-2-1. Economic fundamentals Economic fundamentals are assessed by examining Economic size and income level, Stability and potential of economic growth, and Stability of funds supplying functions and financial system. Component Sub-component Qualitative/Quantitative Assessment Economic fundamentals Economic size and income level Stability and potential of economic growth Stability of funds supplying functions and financial system Nominal GDP Per capita GDP Real GDP growth rate Changes in the consumer price index Sophistication of industrial structure Cross-country indicators showing international competitiveness Funds supplying functions Domestic credit (% of GDP) Adequateness of credit supply (domestic credit growth) Stability of financial system 1) Economic size and income level Economic size and income level are assessed using nominal GDP and per capita GDP. Countries with large economies tend to have large domestic markets and low dependence on external demand. Therefore, they are considered to have some degree of tolerance to shocks from outside. Further, countries with high income levels except for some countries with industrial structures that depend on natural resources like oil-producing countries usually have very mature and highly stable economies. Therefore, the economic size and income level of countries with large nominal GDPs (which shows economic size) and high per capita GDP (which shows income level) are rated highly. Some countries with extremely high nominal GDP but huge populations and thus low per capita GDP, or vice-versa, often have special factors regarding economic development stage or geographical conditions, population structure, or economic/industrial structure. These components are assessed using qualitative assessments of those structural factors. 2) Stability and potential of economic growth High economic growth supports fiscal conditions through higher tax revenue, and also results in a lower debt burden as a share of GDP. Further, funds flowing in from abroad, attracted by high economic growth, support a stable funding structure. However, countries with high GDP growth are not necessarily rated high merely because their growth rates are relatively high, as the real GDP growth rates of low-income countries tend to be higher than high-income countries. Therefore, analyzing economic growth rate depends on the level of recent real GDP growth versus the average 7/11

growth rate, with the economic size taken into account. Although economic growth on par with the past average or higher is desirable, there is a risk of losing economic growth stability with high growth, such as from overheating domestic demand. Overheating domestic demand driving the economy to grow well in excess of the potential growth rate results in high inflation. R&I uses changes in the consumer price index (CPI) to gauge whether stable economic growth can be achieved. It is doubtful whether high economic growth that is not accompanied with improvement in economic growth potential in other words, strengthening of the economic growth base can be sustained. The main point in evaluating whether economic growth potential is improving or not is whether the industrial structure is becoming more sophisticated. In order to determine this, R&I analyzes the stage of industry (in terms of the intensiveness of natural resources, labor, and capital), the economic infrastructure supporting an evolving industrial structure, and whether aggregation of production technology and human capital is occurring. R&I further analyzes labor market conditions and demographics, as well as whether sufficient investment is being made not in nonproduction-related fields like housing, but in raising productivity. Since 2000, a number of countries have set goals to develop financial services-related industries and become financial powerhouses. However, increasing the weighting of financial services-related industries does not necessarily reflect a more sophisticated industrial structure. The operations and financial strength of financial institutions, the main players of the financial services industry, must be examined, because a bloated financial sector risks triggering economic instability. The industrial structure must be assessed based on the Stability of funds supplying functions and financial system. Important components of economic growth potential to be assessed include not only whether the production structure is becoming more sophisticated, but also the level of international competitiveness and whether this level can be maintained. R&I uses cross-country indicators of international competitiveness compiled by reliable public institutions. Countries that are highly competitive internationally promote external demand through exports of goods and services. Thus, economic growth can still be expected even if domestic demand is weak. On the other hand, countries that can sustain high economic growth even despite weak international competitiveness may be driven by excessive consumption or real estate investment. Such countries face the risk of such growth factors diminishing and extended economic weakness due to big changes in economic conditions. 3) Stability of funds supplying functions and financial system A stable financial system and a smooth supply of funds are critical to stable economic growth. The ratio of financial institutions outstanding domestic credit to GDP is an indicator of funds supplying functions. A higher ratio reflects stronger funds supplying function. However, ballooning outstanding credit is very likely due to overheating internal demand, for example from real estate investment, and fund supplying functions could be destabilized with a sudden deterioration in the economy. Therefore, in addition to the ratio of outstanding credit to GDP, R&I also makes a qualitative assessment of whether funds are flowing either excessively or insufficiently. R&I assesses the stability of the financial system based on a number of factors, including the size 8/11

of financial system external debt, loan-to-deposit ratios, NPL ratios and trends, financial institutions core capital ratios, and degree of development of the financial system. 5-2-2. Socio-political fundamentals Socio-political fundamentals are assessed by examining Stability of political structure, Extent of the rule of law and control of corruption, and Stability of society, civil order and international relations. Component Sub-component Qualitative/Quantitative Assessment Socio-political fundamentals Stability of political structure Extent of the rule of law and control of corruption Cross-country indicators of extent of the rule of law Cross-country indicators of extent of corruption control Stability of society, civil order and international relations 1) Stability of political structure Maintaining a stable political structure is the basis of solid government policy management. Types of political system are not differentiated in the assessment, but the basis of determination is whether the system sufficiently reflects the will of the people and whether the government gains the confidence of international society based on that political system. Political systems that do not reflect the will of the people are not assessed highly because of concern that they face potential destabilization risk, even if they are able to maintain structural stability over long periods. 2) Extent of the rule of law and control of corruption Countries that can maintain transparent governments and stable business conditions are likely to be able to have more vigorous economic activity including investment. As a result, the probability that fiscal conditions can be maintained will rise. Reliable public institution cross-country indicators are used to assess the extent of the rule of law and control of corruption from these perspectives. 3) Stability of society, civil order and international relations Large-scale unrest, coup d etats, internal strife or widespread armed conflict or rising danger of such could cause economic chaos or fiscal deterioration. Whether there are such risks or potential factors that could induce such events (religious or ethnic conflicts, political corruption, wide disparities between rich and poor, etc.) is assessed. 5-3. Policy management capacity Policy management capacity is assessed by evaluating Fiscal and economic policy management capacity, mainly of the government, and Monetary policy management capacity, primarily the realm of the central bank. 9/11

Component Sub-component Qualitative/Quantitative Assessment Policy management capacity Fiscal and economic policy management capacity Monetary policy management capacity Clear recognition of fiscal and economic issues Environment for policy implementation Clear recognition of monetary policy issues Environment for policy implementation R&I assesses a country s capacity to execute fiscal/economic policy and monetary policy, maintain or improve fiscal conditions and funding structure, and bolster economic fundamentals. The main point in this regard is whether the government and central bank clearly recognize fiscal/economic and monetary policy issues. If issues concerning improving fiscal conditions/funding structure and strengthening economic fundamentals are clearly reflected as policy issues to be addressed by the government and central bank, then the country is considered to have a strong will to take on those issues. The government is assessed in terms of whether the budget factors in these issues and whether clear measures have been drafted as government strategy. For the central bank, the assessment point is whether monetary policy targets appropriate to the economic structure have been set. Assessing clear recognition of fiscal and economic issues also involves examining the government s resolve to repay debt. Even if the government is able to repay its debt, it could choose to default on its obligations. In particular, if repaying debt becomes difficult because of worsening economic and fiscal conditions, the possibility of defaulting on debt could depend on the government s resolve regarding debt repayment. Second, in addition to recognition of such issues, whether the country s economic and political conditions allow the government or central bank to implement necessary policies is also gauged. Even if the government has clearly recognized issues and instituted policy measures, the possibility of such measures not being carried out fully rises as the economy and financial conditions deteriorate. Heavy interest payment burdens, a high ratio of compulsory expenditures (like social welfare spending), and limited room for spending all raise the hurdles to implementing measures to address these policy issues. In the meanwhile, even if domestic demand overheats and inflationary pressures grow as excess capital inflows continue from abroad, some monetary policy targets may not be sufficiently met, such as hiking the policy interest rate, which is highly likely to encourage further fund inflows. Also, whether fiscal rules are effective, the strength of the administration and head of state s authority, or systematic guarantees like central bank autonomy are all points in gauging the policy implementation conditions. 6. Weighting the assessment components As explained herein, R&I uses a comprehensive approach in determining sovereign Issuer Ratings. Five assessment components Fiscal conditions, Funding structure, Economic fundamentals, Sociopolitical fundamentals, Policy management capacity are addressed and each component is 10/11

examined both quantitatively and qualitatively. R&I does not set a predetermined weighting for each component. This is because the assessment components that should be emphasized differ depending on stage of economic development, economic size, political system, and the international economy and financial conditions of the time. * This report replaces all previous versions that have been released to date. R&I has reviewed this rating methodology and made no change to the version dated March 16, 2012. The Rating Determination Policy and the Rating Methodologies R&I uses in connection with evaluation of creditworthiness (collectively, the "Rating Determination Policy and Methodologies") are R&I's opinions prepared based on R&I's own analysis and research, and R&I makes no representation or warranty, express or implied, as to the accuracy, timeliness, adequacy, completeness, merchantability, fitness for any particular purpose, or any other matter with respect to the Rating Determination Policy and Methodologies. Further, disclosure of the Rating Determination Policy and Methodologies by R&I does not constitute any form of advice regarding investment decisions or financial matters or comment on the suitability of any investment for any party. R&I is not liable in any way for any damage arising in respect of a user or other third party in relation to the content or the use of the Rating Determination Policy and Methodologies, regardless of the reason for the claim, and irrespective of negligence or fault of R&I. All rights and interests (including patent rights, copyrights, other intellectual property rights, and know-how) regarding the Rating Determination Policy and Methodologies belong to R&I. Use of the Rating Determination Policy and Methodologies, in whole or in part, for purposes beyond personal use (including reproducing, amending, sending, distributing, transferring, lending, translating, or adapting the information), and storing the Rating Determination Policy and Methodologies for subsequent use, is prohibited without R&I's prior written permission. Japanese is the official language of this material and if there are any inconsistencies or discrepancies between the information written in Japanese and the information written in languages other than Japanese the information written in Japanese will take precedence. Rating and Investment Information, Inc. TERRACE SQUARE, 3-22 Kanda Nishikicho, Chiyoda-ku, Tokyo 101-0054, Japan Sales and Marketing Division, Customer Service Dept. TEL: 03-6273-7471 FAX: 03-6273-7926 https://www.r-i.co.jp E-mail: infodept@r-i.co.jp 11/11