Methodology outline and road-mapping framework
The credit rating assessment of a sub-sovereign government starts with analysing external factors that impact its creditworthiness. The first external factor is the institutional framework the government operates in, which influences its operating revenue and expenditure. We analyse the composition of the sub-sovereign’s operating revenue including transfers, tax-sharing arrangements and local taxes, as well as its responsibilities in providing certain public services. We assess to what extent the funding arrangements and expenditure mandates are predictable and stable for the level of sub-sovereign government, which the entity being rated belongs to. Other considerations are the degree of budget revenue and expenditure flexibility allowed for by this particular level of the RLGs and the extent to which the rated entity can realise this potential given its socio-economic profile or the political constraints its leadership may have. The second external factor is the social and economic profile of the RLG where we look at the robustness and growth prospects of the government’s tax base (if the sizable part of the budget revenue depends on the taxes generated locally) and the socio-economic profile of the RLG, which shape its expenditures.
Both external factors are essential rating drivers, as they help to understand the evolution of the subsovereign’s budget and financial positions and evaluate its requirements for external funding. Moreover, certain features of the institutional framework can indicate the range of credit ratings that sub-sovereign governments can potentially receive. For instance, heavy reliance on a particular level of RGLs on the transfers or transfer-like revenue from the central government obscures the difference in socio-economic profiles among the sub-sovereigns. Ratings of the weaker RLGs become closely aligned with stronger ones indicating that sovereign default increases probability of defaults of both sub-sovereigns regardless of differences in their socio-economic profiles.
Other institutional factors – like the central government’s oversight in RLGs reporting and accounting standards, monitoring of early warning signs of budget and debt positions deterioration and extraordinary support to distressed RLGs – serve as essential parts of the overall framework for understanding the subsovereign’s budget, debt policies and priorities.
We consider the RLG’s budget performance as a key internal rating factor with the level of operating balance being the most important element indicating the RLG’s own capacity to service its debt without relying on the debt financing. Our estimation of the RLG’s level of indebtedness and debt affordability may be different from that of the official statistics and the government itself, as we pay special attention to debt-like instruments and contingent liabilities.
We will assign lower ratings to sub-sovereigns with higher levels of debt-like instruments and higher likelihood of contingent liabilities’ materialisation relative to their budget revenue or GDP – all other factors being equal. Another internal factor that drives the rating is the quality of the government’s management and budgeting, which we analyse using the criteria we outline in our analytical framework.
We take the following steps to finalise a recommendation for a sub-sovereign credit rating:
- Examine the range of all the data and information available – both from public sources and the subsovereign government itself – to make sure that it is sufficient; lack of sufficient relevant data and information may lead Scope to discontinue the rating assessment process,
- Determine the appropriate peer groups for the RLG being rated – national (the same layer of the subsovereign governments) and cross-border (based on the similarities of the institutional framework like expenditure mandates or the sub-sovereign’s specific features like wealth level),
- Compare the RLG being rated with the peer group going through external and internal factors as they outlined in our analytical framework.