Sovereign credit analysis: qualitative factors

How is a government different from a company as a borrower?

A government borrows to run fiscal policy and pay for public goods such as infrastructure, health and education. It does not borrow to build assets that earn a profit. That changes where repayment comes from. Sovereign debt is repaid from taxes, fees and tariffs, and sometimes from the profits of state-owned firms, where a company repays from operating cash flow.

The power to tax every private activity inside its borders is why a sovereign is normally the lowest-risk borrower in its own country. In the most advanced economies its bonds are often treated as default risk-free. Emerging and frontier market governments carry real default risk, especially as they develop.

Analysts split the question in two. The ability to pay is whether the government has the resources: a tax base, a budget it can adjust, foreign currency if it owes foreigners. The willingness to pay is whether it will choose to repay. For a company the second question hardly arises, because creditors can force the issue. For a sovereign it is critical because of sovereign immunity : national law limits bondholders’ power to force a government into bankruptcy or liquidate its assets.

	Company	Sovereign
Use of proceeds	Working capital and assets that earn a profit	Fiscal policy and public goods
Repayment from	Operating cash flow	Taxes, fees, tariffs
If it cannot pay	Bankruptcy, liquidation	Negotiated restructuring

When a sovereign cannot pay, many lenders and often the International Monetary Fund (IMF) negotiate. Investors typically agree to longer maturities, lower coupons or both, over a set period. A restructuring that looks voluntary can still be a default if investors end up with a poor deal, for example a maturity extension with no compensation for the delay.

Go deeper Why defaults often follow a currency collapse

Many emerging market governments owe foreign currency. When the home currency falls, the cost of that debt in home currency rises in step, while tax revenue is collected in the weak currency. A fall in the currency can therefore turn a manageable debt into an unmanageable one within months. That link is why a government’s currency standing, covered below under external status, matters so much to its creditors.

Go deeper Restructurings: extensions, haircuts and collective action clauses

A restructuring can stretch maturities (an extension), cut the amount owed (a haircut) or lower the coupon. Many modern bonds carry collective action clauses, which let a qualifying majority of bondholders bind the rest to an agreed restructuring. That makes it harder for a few holdouts to block a deal.

What are the five qualitative factors?

Analysts group the non-numerical side of a sovereign into five factors. Each describes one source of strength or weakness in the government’s ability or willingness to pay.

Institutions and policy covers the legal and political setting: rule of law, property rights, transparency, reliable financial data, political stability and a culture of repaying debt. This is where willingness to pay is judged. Fiscal flexibility asks how well the government keeps discipline over time and can adjust revenue and spending, judged mainly by what it has done in past downturns. Monetary effectiveness looks at the central bank. A central bank that is independent of the treasury is less likely to print money to pay the government’s debts, which would drive inflation up and the currency down. The exchange rate regime and the depth of the local bond market belong here too.

Economic flexibility is about the economy that supplies the tax revenue: its size, income per head, diversification, competitiveness and ability to absorb shocks. The strongest sovereigns have large, advanced, diversified economies with sustainable growth. Weaker ones often depend on one industry or commodity, have few trading partners, a large informal economy or trouble collecting taxes. Finally, external status covers the country’s international standing: the global status of its currency, its access to foreign funding and geopolitical risk.

Sovereign creditworthinessability and willingness to pay, judged by five factors

• Institutions and policy Use it stable, predictable rules and a record of repaying
  • Rule of law and property rights contracts and claims are enforced
  • Stable political institutions executive, legislature and courts
  • Culture of debt repayment this is the willingness to pay
• Fiscal flexibility Use it room to adjust the budget
  • Raise revenue or cut spending tax collection is enforceable
  • Fiscal discipline over the cycle past adjustments are the evidence
  • Prudent use of debt debt relative to the economy
• Monetary effectiveness Use it central bank credibility and the currency regime
  • Independent, credible central bank will not simply print money to pay debt
  • Exchange rate regime floating, pegged or shared currency
  • Financial system and debt market depth a deep local bond market
• Economic flexibility Use it the economy that supplies the taxes
  • Size and income per head a bigger, richer tax base
  • Diversification not reliant on one industry or commodity
  • Competitiveness and adaptability resilience to shocks
• External status Use it standing with foreign lenders and markets
  • Global currency status reserve currency or not
  • Access to external funding markets, or the IMF as a last resort
  • Geopolitical risk conflict and trade disruption

The factors overlap. A weak legal system usually goes with weak tax collection and weak enforcement of contracts, so one fact can hurt several factors. For the exam, match each fact to the factor it most directly describes.

Why does a reserve currency matter so much?

A reserve currency is one that is fully convertible and held by foreign central banks and other investors as part of their foreign exchange reserves. If foreigners are willing to hold a country’s cash, bonds and other assets, the government can borrow from them in its own currency. It never has to repay in a currency it cannot create, and it can sustain larger structural deficits and a higher debt level.

Countries without one often have exchange-rate restrictions, capital controls or limited convertibility. That limits their foreign-currency borrowing. When markets are closed to them, they turn to supranational lenders such as the IMF to finance development or reforms. Geopolitical shocks can push a country to that point quickly.

Exam tip When a question gives a fact, ask which of the five boxes it belongs in, then whether it helps or hurts. That is nearly always the whole question.

Go deeper Why capital controls do not make a sovereign safer

Capital controls can stop money leaving a country in a crisis, and some people read that as a strength. Analysts see it differently. Controls and limited convertibility restrict the government’s ability to borrow abroad and signal that foreign investors do not trust the currency. For external status they count as a weakness.