Country and sovereign ratings: new risks, new methods ?
We feel a need to outline some significant changes in the nature of risks – changes that have been unfolding for the past several years – as well as some powerful trends that have been emerging with the current public health crisis and that are likely to affect country and sovereign ratings over the next few years.
Over the past few years, the gradual broadening of risk categories has already highlighted a few blind spots in current approaches to calculating country ratings.
- Methods used to analyse sovereign risk are traditionally based on a macro-financial approach to default risk by a state and entities guaranteed by that state. This approach is underpinned by an array of ratios and institutional, political, social and societal criteria that ultimately serve to clarify a few major categories of risk, revolving around the funding requirements of the sovereign entity under consideration (liquidity, solvency, foreign exchange, political, institutional and regulatory risk). Meanwhile, country risk includes not only sovereign risk but also all risks that could create shocks affecting the macroeconomic, political and regulatory environment in which investors operate. These categories of risk remain an essential element of any assessment of country risk and continue to form the core components of country risk analysis. However, they are likely to increasingly be informed by criteria based on climate transition and compliance with environmental, social and governance (ESG) standards.
- One upshot of globalisation is that it has made all crises – not only economic, financial and public health crises but also political ones – more systemic. To put it plainly, this means the slightest shock can instantly propagate inside or outside a country, whatever the arena of risk in which it arises – finance, the real economy, politics, geopolitics, the climate, etc. In the financial arena, risk is propagated in two ways: through liquidity effects from bank to bank, or from market to market; and as expectations are revised, tipping the scales towards a new equilibrium. In the political arena, political ideas and behaviours are instantly spread online thanks to “influence” effects. In the real economy and the public health field, shocks propagate through value chains and the movement of people. In fact, systemic risks have become the true hallmarks of our globalised societies, and the further globalisation reaches, the deeper and more complex it becomes, the greater the risk of the whole system breaking down.
- The new geopolitical environment is also affecting country ratings, not only because it constitutes a major long-term risk capable of generating shocks but also because it is now having a much more tangible influence on economic policy choices in some countries. This is obvious in Russia and China, but in reality it’s true for most countries, developed or otherwise. Rating agencies struggle to factor geopolitics into their methodologies because they treat it like an exogenous shock, whereas it is, in fact, a risk that is endogenous to the global system (i.e. a result of global economic and political forces in a context of globalisation). Clearly, the country-based approach to rating methods and models doesn’t make it any easier to factor in this kind of cross-cutting, systemic risk. Country ratings thus tend only to measure geopolitics through geopolitical shocks suffered by countries or sectors; the underlying distortion in economic policies and behaviours is underestimated or poorly understood.
- Furthermore, the expansion of market economies and societies has itself increasingly been a source of endogenous shocks – notably due to growing inequality and financial instability – calling for stricter regulation. Readjustments are in progress but key risks remain in various segments that have escaped such regulation. In this day and age, risk analysis must take into account the endogenous nature of this instability so characteristic of market economies, which may increasingly have implications in areas other than economics and finance (e.g. climate, zoonosis, health) and, indirectly, affect economic activity.
- Political risk in more advanced countries is also hard for rating systems to capture because it has as much to do with perception (notably of inequality) as with reality. In fact, although democratic crises and populist mechanisms are major, cross-cutting historical phenomena endogenous to liberalism, international rating agencies have done a very poor job of capturing them.
- Lastly, the prospect of stronger, more frequent and, above all, unpredictable climate shocks means we are truly entering into a new universe of risks, where forecasting and calculating probabilities will carry less and less weight as the focus increasingly shifts towards individual and institutional preparedness.
The public health crisis has highlighted four powerful trends.
- Excess global liquidity, combined with an environment of uncertainty, has increased the risks of both overvaluation and volatility. These risks particularly affect those less advanced countries that depend for their liquidity and solvency on external capital. For advanced economies, excess liquidity and a strong central bank presence in sovereign and corporate markets, both via quantitative easing (QE) and as liquidity providers of last resort, have implications in terms of redistribution between economic agents and between countries (creditors/debtors), which also reshuffles the deck in terms of sustainability and resilience.
- The distinction between advanced and less advanced countries, which sometimes seemed to have lost some of its relevance, has to an extent been revived.
In fact, the level of wealth of countries and individuals has been a key factor determining resilience to the public health crisis. While the vulnerability of healthcare sectors in so-called developed countries initially seemed to raise questions as to just how developed those countries really were, vaccination campaigns have subsequently given high-income countries a distinct advantage. The world today is increasingly divided into a vaccinated zone and a zone characterised by endemic public health risk.
Similarly, the liquidity safety net unfurled by the most advanced nations’ central banks has redefined debt in such a way that the solvency and liquidity constraints on those countries are not at all the same as those that apply to less advanced nations. This has a direct impact on the study of sovereign risk.
Lastly, greater institutional credibility in advanced economies allows for greater coordination between fiscal and monetary policy, which can help fiscal and monetary authorities regain some room for manoeuvre. Such coordination appears more difficult in emerging economies, justifying greater divergence between fiscal and monetary policy.
- A new category of analysis will become increasingly important in assessing sovereign and country risk: resilience. Indeed, growing awareness that we are moving into a period when major risks will be both more numerous and less predictable means we are going to have to be able to estimate how resilient states and societies are to shocks.
Resilience refers to an individual’s or a society’s ability to respond after a shock so as to be able to bounce back and find a new trajectory that is better than or at least equal to the previous one.
This idea turns the approach to risk management on its head by shifting the focus from avoiding risk to absorbing it. Taking resilience into account as a category of analysis forces us to pay more attention to the question of trade-offs between insurance and flexibility.
- The ability of a society and a state to innovate has always been an important element of risk analysis: potential growth trajectories depend on it. However, in a world where the digital transition has become a key marker of investor appetite, this factor is also set to take on a particularly important role in the analysis of country risk.
For so-called emerging countries, but also for the least advanced economies, digital transition is now a required part of the development path. In advanced economies that lie closer to the technological frontier, the challenge is not so much one of directing public spending towards innovation but rather of lengthening the horizon of public policy and changing the instruments at its disposal. This means ensuring that public and private regulatory and financial initiatives are mutually consistent, providing adequate price signals, and identifying and making redistributive choices. It also means being able to mobilise stakeholders in an environment in which representatives of management and labour are becoming weaker and civil society – and sometimes unrepresentative but highly motivated actors – is more involved in debate, against a backdrop of increasing threats to institutional legitimacy.
In advanced and less advanced countries alike, taking account of a country’s ability to innovate when assessing that country’s risk will thus depend on states’ ability to effectively guide behavioural change, steer the national debate and build a legitimate consensus.