Friday, April 4, 2008

Credit Rating: National vs. Global Scale

Distinguishing national scale credit ratings from global scale ratings are of critical importance due to the potentially large difference in implicit default risk between the two scales. For example, a company's local currency bonds issue may get a global scale local currency rating and a significantly different national scale rating.

National scale credit ratings provide opinion on an obligor's creditworthiness (that is, issuer credit ratings) or overall capacity to meet specific financial obligations (that is, issue credit ratings), relative to that of other entities and specific obligations in a given country. In contrast to global scale ratings, national scale ratings are based on a comparative credit risk of active obligors, including the sovereign government, within one country, and exclude direct sovereign risks of a general or systemic nature. Given the focus on credit quality within a single country, national scale ratings are not comparable between countries.

National scale ratings typically provide a finer demarcation of credit risk among local obligors than is possible with global scale, as the latter spans the full range of global credit quality and incorporates international comparative risk factors, including direct and indirect sovereign risk considerations. National rating scales are of the most value where sovereign and other credit risks skew global scale ratings to low levels in the country and where local issuers and investors are predominant players on the domestic markets. Such a compression of ratings at lower levels is fairly common among the emerging market economies.

Sovereign risks (for example, direct constraints such as potential exchange controls) and country risks (for example, indirect effects from government policies affecting exchange rates, interest rates, taxation, regulations, infrastructure and labour markets) may compress the range of global scale ratings of obligors in the country, reducing or even obscuring differences in credit standing that would otherwise be evident in the absence of these sovereign and country risks. For example, sovereign and country risk factors in Mexico result in a narrow range of global scale ratings, with many of global scale ratings compressed in the 'BB' and 'BBB' rating categories. While the potential impact of sovereign risk is a critical consideration for cross-border financing, direct sovereign risks of a general or systemic nature, which affect most national obligors to a similar degree, are of less importance to local participants in the national financial markets who find that national scale ratings are useful in providing the most precise ranking of relative credit risk available for obligors within their country. Even though national scale ratings are meant to confer an opinion of relative credit risk within a domestic context that is not to say that they are fully isolated from sovereign risk considerations and other international comparative risk factors.

Key Characteristics of National Rating Scales
National rating scales exclude certain direct sovereign risks of a general or systemic nature, including the potential risk of foreign exchange controls. As a result, obligors and obligations with global scale ratings constrained by systemic, direct sovereign risk may have national scale ratings that are higher than the sovereign's rating on that scale, though such cases would necessarily be limited to countries where the sovereign's national scale (ns) rating is less than 'nsAAA'.
• National and global rating scales are broadly consistent in terms of the rank order (from highest to lowest credit quality) of ratings.
• National scale ratings are an expression of the relative creditworthiness of obligors and obligations in a particular country, and are based on a comparative analysis of that country's active obligors (this is in contrast to the all-encompassing international comparative context of global scale ratings).

Given the focus on relative creditworthiness, the strongest entities in the country, including the sovereign, often receive the highest possible rating on the national scale, provided the country is not experiencing an acute and widespread financial crisis that imperils the debt service capacity of even the strongest local debt issuers.

Underlying default risk differs from that of global ratings
The global scale and national scale rating usually imply substantial variations in the default probabilities associated with any particular rating category on the global and national scales. For example, the implicit default risk associated with a global scale rating of 'AA' could be significantly lower than the risk inherent to a national scale rating of 'nsAA'.

The difference in implicit default risk between global scale and any given national scale is a function of the degree of sovereign and country risks in the economy and, to a lesser extent, the distribution of credit risks among active obligors in the country. In order for the national scale to provide adequate differentiation in credit risks for obligors active in the local market, it follows that the higher the sovereign and country risks associated with the national economy, the higher the default risk that is embedded in the national scale. For example, a national scale serving an economy with medium sovereign risk and a predominance of low-grade, global scale ratings for active obligors (for example, Russia) would have lower global scale, local currency ratings corresponding to each category on the national scale than would be the case for a national scale serving an economy with low sovereign risk and a predominance of intermediate grade, global scale ratings for active obligors (for example, Taiwan).

It is important to note that the methodology underlying national rating scales results in a nonlinear relationship between the global scale rating grade and its corresponding national scale rating grades as one moves down the credit risk spectrum from high to low credit quality. That is, one cannot simply add a certain number of rating levels to a global scale local currency rating to determine the corresponding national scale rating. Rather, the degree of difference between the two rating scales in terms of the assigned letter-grade generally increases as one moves up the rating scale towards the strongest credit rating assigned in the country. For example, an entity carrying a global scale local currency rating of 'BBB' in a medium-risk sovereign nation may well be rated as high as 'nsAA' or even 'nsAAA' on that country's national scale, underlining not only the higher degree of default risk embedded in the national scale but, most important, the inherent quality of national scales to provide greater differentiation in credit standing, particularly at the upper end of the rating spectrum. On the other hand, the rating gap is smaller, if it exists at all, at the bottom end of the rating spectrum, pointing to the ability of national scales to provide an adequate warning of the risk of default.

Reflecting the increased scope for differentiation of credit risk, national scale ratings are more sensitive to changes in credit risk and, in turn, are likely to change more frequently and to a larger degree than global scale ratings. That is, a given change in the business or financial profile may affect an issuer's national scale rating but not its global scale rating, or alternatively may translate into a revision of both ratings but one that is more pronounced on the national scale.