Sovereign credit analysis: the key ratios

Why do sovereign ratios divide by GDP or revenue?

Quantitative sovereign analysis asks whether the government can meet its fixed obligations, and the answer comes from ratios, as it does for companies. The denominator differs. A company is measured against sales or assets. A government is measured against GDP, the economic activity it can tax, or government revenue, the money it actually collects.

Government figures are less reliable than company accounts. They vary in quality and timing, are revised, are hard to compare across countries and carry political considerations. Detailed public-sector balance sheets therefore help little, and analysts use a top-down, macroeconomic set of ratios in three groups: fiscal strength, economic growth and stability, and external stability.

Sovereign quantitative factorstop-down ratios built on GDP, revenue and FX reserves

• Fiscal strength Use it how heavy and how affordable the debt is
  • Debt burden Use it similar to leverage, a solvency measure; higher is weaker
    • Debt to GDPdebt ÷ GDP
    • Debt to revenuedebt ÷ revenue
  • Debt affordability Use it a coverage measure; higher is weaker
    • Interest to GDPinterest ÷ GDP
    • Interest to revenueinterest ÷ revenue
• Economic growth and stability Use it size, income and steadiness of growth
  • Size of economy GDP in purchasing power terms; larger is stronger
  • GDP per capita GDP ÷ population; higher is stronger
  • Average real GDP growth higher is stronger
  • Real GDP growth volatility standard deviation; higher is weaker
• External stability Use it ability to pay foreign creditors
  • FX reserves to GDP higher is stronger
  • Reserve ratio reserves ÷ external debt; higher is stronger
  • External debt burden long-term external debt ÷ GDP; higher is weaker
  • External debt due debt due in 12 months ÷ GDP; higher is weaker

How do you measure fiscal strength?

Fiscal strength has two halves. Debt burden ratios compare the stock of debt with the economy or the tax base. They work like leverage and say something about solvency. Debt affordability ratios compare the yearly interest bill with the same denominators. They work like coverage. For both, higher means weaker credit.

$$\text{Debt to GDP} = \frac{\text{general government debt}}{\text{GDP}}$$

$$\text{Debt to revenue} = \frac{\text{general government debt}}{\text{government revenue}}$$

$$\text{Interest to GDP} = \frac{\text{government interest payments}}{\text{GDP}}$$

$$\text{Interest to revenue} = \frac{\text{government interest payments}}{\text{government revenue}}$$

Debt to GDP shows the size of the burden against the whole economy. Debt to revenue shows it against what the government collects, which is lower when tax collection is poor. The yearly fiscal deficit (or surplus) as a percentage of GDP tells you which way the burden is heading: a deficit adds to debt, so a persistent deficit raises the ratios over time.

Take two invented countries. All figures are in USD billions unless stated.

	Norvia	Talmar
GDP	400	150
Government debt	240	120
Government revenue	120	30
Interest paid	9.6	7.2
Foreign exchange (FX) reserves	60	12
External debt (of which long-term)	100 (80)	75 (60)
Population (millions)	20	30

Go deeper Why not use the government's assets?

A sovereign’s assets, such as roads, land and state firms, are hard to value and cannot be sold to repay bondholders. What matters is the flow of taxes the government can raise from the economy. That is why every denominator is GDP (the tax base) or revenue (the tax actually collected).

What do growth and size tell you?

Larger, richer economies handle economic and political shocks better, so analysts look at the size of the economy (GDP, often in purchasing power terms) and at GDP per capita . They also look at average real GDP growth over a decade or more and at its variability. Steady growth supports revenue. Real GDP growth volatility , measured by the standard deviation of annual growth, makes revenue harder to predict, so more volatility is weaker. A country that grows a little more slowly but very steadily can be a better credit than one that grows fast with big swings.

$$\text{GDP per capita} = \frac{\text{GDP}}{\text{population}}$$

How do you measure external stability?

A sovereign that can borrow in a reserve currency has little to fear from foreign-currency debt. One that cannot must earn or hold foreign currency to repay what it owes abroad. The external ratios compare external debt with the resources that can repay it: GDP, and above all foreign currency reserves.

$$\text{FX reserves to GDP} = \frac{\text{FX reserves}}{\text{GDP}}$$

$$\text{Reserve ratio} = \frac{\text{FX reserves}}{\text{external debt}}$$

$$\text{External debt burden} = \frac{\text{long-term external debt}}{\text{GDP}}$$

$$\text{External debt due} = \frac{\text{external debt due within 12 months}}{\text{GDP}}$$

Higher FX reserves to GDP and a higher reserve ratio are stronger. A higher external debt burden and a higher share of debt falling due within 12 months are weaker.

Ratios are a starting point, not a verdict. A country can look weak on reserves yet be supported by large remittances from citizens working abroad, or hold large reserves that depend on one commodity price that could fall. The first reading comes from the numbers, and the second asks where the foreign currency comes from.

Exam tip If the numerator is interest, it is affordability. If it is debt, it is burden. If it is reserves, the higher the better.

Go deeper Euro-area members and the missing exchange-rate tool

A member of a currency union cannot devalue its own currency or set its own interest rate to ease a crisis. Its adjustment must come through the budget and the economy, which is one reason high debt and rising deficits inside a union can widen yield spreads quickly.

Go deeper Commodity exporters: reserves can vanish

When foreign currency comes mainly from one export, a price fall reduces reserves and tax revenue together. A country can go from a comfortable reserve ratio to a thin one in a few years, which is why analysts look at the trend in reserves and not only the level.