Country Risk: Huge differentials in risk among similarly rated sovereigns

Jeremy Weltman
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Sovereigns assigned with identical investment grades must be considered to have very similar, if not the same, levels of risk, otherwise those ratings would be a misleading indicator of creditworthiness, Jeremy Weltman reports.

However, according to Euromoney’s Country Risk Survey – using triple-B rated sovereigns for comparison – substantial variation in risk exists between sovereigns within the same agency category.

Similarly rated sovereign bonds should offer similar risks to investors. A triple-B rated sovereign should be equivalent in risk-terms to another triple-B, assuming their ratings are stable (not on review for an upgrade or downgrade).

However, a careful inspection of the B ratings currently assigned by the three main agencies – Fitch, Moody’s and Standard & Poor’s (S&P) – shows this is not always the case.

Euromoney’s Country Risk Survey reveals considerable variation in risk assessments among similarly rated sovereigns. Its detailed factor analysis, spanning 15 political, economic and structural risk indicators, helps to explain why.

Within the lowest investment grade (BBB-/Baa3), Colombia is 40 places and one tier higher than Azerbaijan. The dispersion of scores within the BBB/Baa2 and BBB+/Baa1 categories is also considerable, even among countries with stable ratings. The views of economists and other country-risk experts are pinpointing substantial failings in the credit-ratings approach, it would appear.

Disparities among the lowest investment grades

Fitch has 10 sovereigns within its lowest (BBB-) investment grade category and S&P has seven. Moody’s has 12, all of which are rated Baa3, which is equivalent to the Fitch and S&P categorization (see table, below).

However, the countries score very differently in the ECR survey. At present, 15.3 points separate Colombia – a tier-three sovereign on a total score of 58.6 out of 100, and ranking 41st out of 185 countries on the ECR global risk data table – from tier-four Azerbaijan, some 40 places lower on 43.3 points.

Interestingly, Colombia and Azerbaijan are the least and most risky sovereigns, respectively, within the lowest (BBB-/Baa3) investment-grade category of all three rating agencies.

Of course, the agencies sometimes also place their ratings on a positive or negative watch/outlook, signalling subtle differences in risks and acting as an early warning indicator to a potential upgrade or downgrade.

S&P, to be fair, does makes that distinction where Colombia and Azerbaijan are concerned; the latter is stable, but the former is marked out on review for an upgrade. This will come as no surprise to regular ECR users, who have witnessed a rapid rise through the rankings for Colombia in recent years. The sovereign has climbed 37 places since 2007 – a turning point for other countries affected by the global crisis. In response, a recent ECR piece proclaimed that Colombia’s time has come.

Yet neither Fitch nor Moody’s makes a similar distinction – in their eyes, Colombian and Azerbaijani sovereign bonds are inseparable from a risk perspective.

But is this true? Not according to S&P, and neither is it the case according to the majority of experts taking part in the ECR survey, where the differences between similarly rated sovereigns are clear from their score differentials. In all, 15 separate factors are surveyed every quarter, with economists and other country-risk experts asked to evaluate the main political, economic and structural risks that could contribute to a sovereign bond default.

These evaluations are combined with information on debt, access to capital and credit ratings to give an overall score. A tiered ranking approach is used to give an approximate credit rating equivalent. Tier-three sovereigns, on a score of between 50 and 65, are an indication of a BB+ to A- rating, ranging from highest-speculative grade to low-investment grade. Tier-four sovereigns, on a score of 36 to 50, equate to a B- to BB+ rating, which is junk/speculative status, or sub-investment grade.

In the BBB-/Baa3 example, above, Fitch has four countries – Romania, Namibia, Morocco and Azerbaijan – seemingly over-valued in risk terms. They all reside in ECR’s tier four and are more of a speculative than investment grade, according to the survey contributors. Romania, unchanged in 2012, has fallen eight places in the ECR rankings since 2007; Morocco’s instability has seen it plunge, too. Namibia and Azerbaijan have ascended in recent years, but not sufficiently to be considered for investment grade – the latter is little more than a mid-range tier-four sovereign.

Tier-four sovereigns Azerbaijan and Morocco also stand out in S&P’s ratings, whereas in Moody’s case there are five examples – Latvia, Romania, Namibia, Tunisia and Azerbaijan. The ECR survey is more cautious about these countries’ solvency prospects than the raters.

So what distinguishes Colombia from Azerbaijan?

Investors in Colombian and Azerbaijani debt encounter identical levels of risk according to Fitch and Moody’s – there is no perceived difference in creditworthiness by the two agencies. Yet the ECR survey highlights score differentials of 27.1, 13.7 and 25.7 points, respectively, for their political, economic and structural risk assessments, all in Colombia’s favour (see chart, below).

Azerbaijan is clearly a riskier prospect than Colombia, in spite of its hydrocarbon wealth. Even on that count there are concerns after a worrying decline in oil output (Eastern Europe and CIS).

In fact, Azerbaijan scores lower than Colombia on all 15 sub-factors of risk (see chart, below). The biggest discrepancies are for its soft infrastructure – a measure of the health of the economic, medical and cultural/social institutions (where the two differ by 3.9 points), information access/transparency (a 3.7 point gap), and the risks associated with government non-payments/non-repatriation and demographics (both scoring 2.9 points each).

Burcu Hacibedel, an economist at the European Investment Bank, though positive on Azerbaijan’s overall prospects, has highlighted some of the challenges in Banking in the Eastern neighbours and central Asia, noting that “a major source of vulnerability in the Azeri economy is the lack of economic diversification, which might lead to unsustainable dependence on oil production and revenue”.

He goes on to mention vulnerabilities in the banking system connected to the International Bank of Azerbaijan, high dollarization, a rising level of non-performing loans and the need for improved banking-sector supervision.

While all of these issues weigh on the country’s risk profile, the rating agencies appear to largely ignore them, perhaps focusing more exclusively on the health of the government finances – the core fiscal metrics underlying solvency – where the scores in this case differ the least (although it must be said that Colombia still has a higher score, even for that particular indicator).

Other B-rated sovereigns just as puzzling

Score dispersions are evident in other B-rated categories. However, in this case the rating agencies differ in their assessments. Unlike the BBB-/Baa3 category, in which Colombia is the safest and Azerbaijan the riskiest among all three agencies, they differ when it comes to their BBB/Baa2 and BBB+/Baa1 rated sovereigns.

Brazil is the safest BBB sovereign, according to Fitch, and Latvia the riskiest. The latter, on review for an upgrade, is a tier-four sovereign based on its ECR score of just below 49 points. A total of 11.2 points separate Latvia from Latin America’s largest economy, with Brazil scoring higher than Latvia on almost all factors. The main exception is corruption, but this is outweighed by superior Brazilian scores for a range of other indicators, including its demographics and economic assessment, notably concerning bank stability (with Latvia more exposed to Europe’s crisis), employment/unemployment (currently very favourable in Brazil) and government finances.

The chasm between middle triple-B sovereigns is even larger where Moody’s is concerned. Currently 14.8 points and 38 places separate Slovenia, its safest Baa2 (a tier-three sovereign ranked 37th on the ECR scoreboard), from Kazakhstan, a tier-four sovereign, and its riskiest in 75th place. Slovenia is admittedly on review for a downgrade but the next two safest sovereigns, Brazil and Peru, have been marked for an upgrade, so Moody’s would at least seem to be cottoning-on to the changing risks.

However, 13 points and 34 places separate the Bahamas from Latvia, the two most extreme S&P BBB-rated sovereigns, according to their ECR scores. The safer of those two, the Bahamas, is on review for a downgrade, while Latvia, deemed riskier by ECR experts, is on a positive review, contradicting their relative placings. An upgrade to Latvia would also appear strange in comparison with Brazil and Mexico, two sovereigns that are also higher up the scale, but with identical credit ratings.

Surely Malta and Kazakhstan are not the same as well?

Similar discrepancies exist in the safest (or least risky) B-category, denoted as BBB+/Baa1. S&P’s ratings are particularly noteworthy because they span three of ECR’s five tiers, with a whopping 23.2 points and 49 places separating Malta from Kazakhstan. The tiny EU/eurozone island state might have been affected by Europe’s crisis, but its default risk is not considered to be a present danger, compared with other peripheral euro users, or weighed against Kazakhstan’s risks (highlighted in recent years by its own banking sector problems).

Malta has withstood the euro crisis quite well – rising six places in the ECR rankings since 2007 as other eurozone sovereigns have plummeted. This includes Cyprus, which joined the euro with Malta and is a similarly sized country, but which has encountered considerable debt-financing difficulties lately, mainly because of its exposures to Greece.

According to the latest economic forecasts from the European Commission, Malta is predicted to grow by 1.5% this year after a rise of 1% in 2012. This is low, perhaps, but considerably better than other European nations. The general government deficit is also predicted to rise, but only to 2.9% of GDP in 2013, and with the structural deficit narrowing this year, the debt burden is stabilizing at around 73% of GDP. A gloomier outlook might develop, of course, if the external climate becomes more unfavourable, and Malta did slip three places in ECR’s rankings last year, it must be said. However, the country does not appear to be facing the same solvency issues now causing such anguish across other parts of the eurozone and in the halls of Brussels.

Kazakhstan, on the other hand, has fallen 11 places in the rankings during the same period. Although it scores more highly than Malta for its employment/unemployment and government finances indicators, the largest (ex-Russia) sovereign among the Commonwealth of Independent States is considered inferior on 13 other sub-factors, notably for its soft infrastructure and bank stability, as well as its political assessment. The S&P rating seems to focus almost exclusively on the fiscal metrics, ignoring these other aspects of risk.

A close look at B-rated sovereigns unearths some surprises, it seems, with large score differentials among sovereigns commanding the same credit ratings. The ECR survey identifies the particular risks that are contributing to these differences and why a casual comparison of credit ratings alone can so often prove misleading.

This article was originally published in Euromoney Country Risk.