Sovereign Credit Ratings: What They Reveal (and Miss) About Global Capital Flow

Background

The United States – the preeminent global power and financial backbone of the world through the ubiquitous Dollar — saw its credit rating downgraded earlier this year by Moody’s.

This isn’t the first time, as it was most recently downgraded in 2023 by Fitch.

Historically, a debt issuance from the U.S. Treasury is essentially seen as risk-free. When investors, from individuals to foreign nations purchase a Treasury bill, note, or bond, there is an understanding that the principal will be protected and returned.

While that still remains the case, this article seeks to examine what a rating tells us, what it doesn’t, and how that might aid someone interested in global capital flow and systemic risk.

Ratings as a Signal

According to Investopedia, “a sovereign credit rating is an independent assessment of the creditworthiness of a country or sovereign entity.” They are issued by credit rating agencies that are conceptually similar to the ones for individual consumers.

Rating changes can serve as an indicator that credit risk has increased. Investors may demand higher yield for the corresponding increase in risk and may look elsewhere for safer stores of value.

Interestingly, rating changes may lag investor sentiment. It is not uncommon for the market to be aware of increased risk, well in advance of a formal rating adjustment.

Zooming out a bit, sound strategic analysis should consider the direction of ratings changes, frequency, how they compare to peers, and what assumptions are baked in.

From Rating Changes to Capital Flow

Many institutional investors (e.g. pension funds, sovereign wealth funds, insurers) have ratings-based parameters they must abide by. For example, they may be required to hold “investment grade” assets, and avoid those that do not meet this threshold.

If a rating falls below that level, forced selling may result. If a rating rises to become investment grade, tremendous capital inflow can occur, greatly benefiting that country.

What Ratings Tell Us, and What They Miss

According to one study, there are six key factors that strongly influence ratings: per capita income, GDP growth, inflation, external debt, level of economic development, and default history.

Importantly, a sovereign’s “willingness to pay” may be more important than the “ability to pay”.

As stated previously, the market is home to savvy investors who may not need to see a ratings revision to confirm what they already know. Consequently, asset pricing may occur at levels above or below the value that a rating indicates it should.

Additionally, political risks and shocks (e.g. war, sanctions) to the system may not be well-captured in the slower moving ratings process.

Final Thoughts

While ratings can be used to forecast future capital flow and allocation, they are just one piece of data. Most importantly, their role in assessing systemic risk is important, but small. It must be combined with additional qualitative and quantitative data in order to be useful.

Additional Resources