Emerging nations urged to cut debt

Emerging economies should give priority to slashing their external debt to get a good sovereign credit rating that will give them easier access to global funding, according to the International Monetary Fund (IMF).

In a working paper published this week, the Washington-based Fund said sovereign credit ratings play an important role in determining countries' access to international capital markets and attracting global institutional investors to bonds issued by local governments.

For those countries with speculative grade ratings, identifying the main determinants of investment grade status can help guide policies towards achieving an upgrade, the paper said. The paper identified five core variables that are relevant for the determination of investment grade status, namely external public debt, domestic public debt, political risk, exports and broad money – all variables as a share of GDP, except for political risk.

"Emerging market countries seek investment grade status to lower financing costs for the sovereign, expand the pool of potential investors to institutional investors, and allow corporates the possibility of reducing their borrowing costs. This paper finds investment grade ratings by the three major credit agencies can be explained by a small number of variables," it said.

"The findings suggest efforts by emerging markets to increase the likelihood of an upgrade to investment grade must focus on a faster pace of public debt reduction, in particular external public debt."

The paper noted while efforts to improve on all fronts would be desirable, progress on trade, financial depth and political risk is likely to be gradual and not directly linked with macroeconomic policies. "In contrast, a strong process of fiscal consolidation could result in a steady reduction in debt levels," it said.

"Given the larger weight assigned by rating agencies to external debt over domestic debt in their assessments, a sharper fall in external debt is likely to have greater impact on increasing the near-term probability of achieving investment grade status."

According to the report, the three major credit rating agencies – Moody's, S&P Fitch – indicate that their assessments of government risk are based on the analysis of a broad set of economic, social and political factors, but are not explicit about the weights given to those variables in their final assessments.

"Sovereign credit ratings are important for at least three reasons. First, they are a key determinant of a country's borrowing costs in international capital markets. Second, the sovereign rating generally sets a ceiling for the ratings assigned to domestic banks and companies, and therefore affects private financing costs. And third, some institutional investors have lower bounds for the risk they can assume in their investments and will choose their portfolios taking into account the credit risk signalled by the rating notations."

According to the report, basic requirements for a good credit rating cover per capita income in US dollar, high real GDP growth and low inflation and unemployment rates. It said higher per capita income suggests a larger potential tax base and a greater ability to repay debt. It also serves as a proxy for the level of economic development, which might influence default risk.

"Higher economic growth tends to decrease the relative debt burden and may help in avoiding insolvency…a low inflation rate reveals sustainable monetary and exchange rate policies. It can also be seen as a proxy of the quality of economic management. A country with low unemployment tends to have more flexible labour markets making it less vulnerable to changes in the global environment," the report said.

External sector variables involve the ratio of exports to GDP as a higher ratio suggests a greater capacity to obtain hard currency to repay foreign currency denominated debt, it said.

Another requirement is the current account to GDP as a large current account deficit suggests a high dependence on foreign capital, which can be a source of risk to macroeconomic stability.

"As for debt, the higher the external indebtedness, the higher the risk of fiscal or balance of payments stress. Another factor is the country's net global reserves to GDP as the higher the ratio, the more resources are available to service foreign debt. It reduces a country's vulnerability to liquidity shocks. Also a low primary balance of payment indicates that the government lacks the ability or the will to raise taxes to cover current expenses. A weak fiscal position implies a higher likelihood that external shocks result in a default."

"Also the higher the debt burden, the larger the transfer effort the government will have to make over time to service its obligations, and therefore a higher risk of default," it said.