Importance of Sovereign Rating for Debt Management

1. Importance of Sovereign Rating for Debt Management Ravi Abeysuriya, CFA

2. Discussion Topics Brief Introduction to sovereign ratings Role of sovereign ratings Sovereign rating process Credit spreads by rating category Determining factors of sovereign ratings Sound public debt management practices for a higher sovereign rating

3. What is a Sovereign Rating? A Sovereign credit rating is an opinion of a rating agency of a sovereign government�s capacity and willingness to service its obligations in full and on time It is a forward-looking assessment of default probability and a universally recognised measure of creditworthiness

4. Overview of Ratings Scale

5. Default Rates by Rating Category

6. Sovereign Ratings in Asia Pacific

7. Questions raised on rating Sri Lanka Timing - wait for a better Economic & Political climate Does not need funds � massive aid flows & raised funds cheaper without a rating through FRNs, SL Dev. Bonds It is costly - require to pay Advisor fees and fees to at least two Rating agencies Once assigned it is difficult to obtain upgrades without substantial improvements in macro economic management Rating agencies downgrade in bad times � could precipitate adverse herd-like behaviour of capital flows Externally imposed fiscal discipline on the Government to manage the macroeconomic framework in a sustainable fashion does not work in Sri Lanka Lead to more commercial borrowing in hard currencies

8. Role of Sovereign Ratings A strong signal of commitment to transparency and that the country is ready to benchmark itself and not shy of being scrutinised Countries are informally ranked/risk-assessed in any case without the benefit of dialogue with the government; a professional independent public rating is better Differentiate the country from its peers and overcome the perception/prejudice problem A sovereign rating is often used as a proxy for country risk It is a public relations document, first point of reference of a foreign investor � convenient and easily comparable benchmark for cost of capital, based on which the internal rate of return of a potential project could be evaluated

9. Role of Sovereign Ratings Cont. Improve chances of attracting substantial foreign direct investments (versus peers) to raise capital Sovereign ratings are key ingredients in the credit ratings of resident entities (the �sovereign ceiling� concept) and help develop domestic capital markets In the absence of public credit ratings on banks or Corporates, international investors and creditors assign their own credit ratings to their counterparties The rating reach thousands of potential investors through worldwide coverage in the Financial news wires and supporting research through analyst coverage Instil discipline and shift focus towards improving key economic fundamentals Sovereign ratings reflect and affect country�s competitiveness � Many factors that rating agencies consider when assigning a sovereign rating are the same as those that reflect a country's competitiveness

11. Typical Rating Process

12. Typical Rating Process Cont. Based on objective and independent analysis Meetings with top policymakers to identify main policy issues, constraints and challenges Cooperation of �working level� officials for Technical sessions to identify detail trends and developments in key economic & financial indicators Private meetings with commentators such as the political opposition, representatives international financial institutions, leading private sector representatives, political analysts and press

13. A Success Story

14. Credit Spreads by Rating Category

15. Credit Spreads by Rating

16. Emerging Market Bond Issuance

17. Determining Factors Political Risk � durability, stability and legitimacy of the government, imminence of war local conflicts, public security, willingness to pay Income & Economic Structure � quality of economic policies, policy coherence, income disparities, size and efficiency of the public sector/public enterprises, diversity and degree to which economy is market oriented, labor market flexibility & militancy of trade unions, productivity trends, robustness of the economy to shocks, effectiveness of the educational system Economic Growth Prospects - rate and sustainability of growth, size and composition of savings and investment, Fiscal Flexibility - government. revenue & expenditure, revenue raising flexibility and efficiency, expenditure effectiveness and pressures, timeliness, coverage and transparency in reporting, deficit financing, pension obligations Monetary Stability � central bank independence, range and efficiency of monetary policy tools, price behavior, money & credit expansion, sophistication and efficiency of financial intermediation Empirical studies have tried to identify factors that explain over 90 per cent of the cross sectional variance of sovereign ratings. The most potent factor was GDP per capita in US dollar terms. High ratings were associated with high per capita income. High level of economic development measured by the IMF�s classification as an industrial country accounted for a full rating increase. The history of default played a major role. For instance, a recent history of default set a rating back by about two notches. The rate of growth in Gross Domestic Product was a positive factor. High inflation was a negative factor. A country�s net foreign debt position was also negative. The political factors, especially political stability and willingness as well as ability to ensure appropriate macro economic policies do weigh heavily in rating. Empirical studies have tried to identify factors that explain over 90 per cent of the cross sectional variance of sovereign ratings. The most potent factor was GDP per capita in US dollar terms. High ratings were associated with high per capita income. High level of economic development measured by the IMF�s classification as an industrial country accounted for a full rating increase. The history of default played a major role. For instance, a recent history of default set a rating back by about two notches. The rate of growth in Gross Domestic Product was a positive factor. High inflation was a negative factor. A country�s net foreign debt position was also negative. The political factors, especially political stability and willingness as well as ability to ensure appropriate macro economic policies do weigh heavily in rating.

18. � Link to Debt Management Public indebtedness Extent of public debt as percentage of GDP Outstanding off-budget & contingent liabilities External debt as a percentage of exports of goods and services and of GDP Maturity profile, currency composition and sensitivity to interest rate changes Access to concessionary funding Empirical studies have tried to identify factors that explain over 90 per cent of the cross sectional variance of sovereign ratings. The most potent factor was GDP per capita in US dollar terms. High ratings were associated with high per capita income. High level of economic development measured by the IMF�s classification as an industrial country accounted for a full rating increase. The history of default played a major role. For instance, a recent history of default set a rating back by about two notches. The rate of growth in Gross Domestic Product was a positive factor. High inflation was a negative factor. A country�s net foreign debt position was also negative. The political factors, especially political stability and willingness as well as ability to ensure appropriate macro economic policies do weigh heavily in rating. Empirical studies have tried to identify factors that explain over 90 per cent of the cross sectional variance of sovereign ratings. The most potent factor was GDP per capita in US dollar terms. High ratings were associated with high per capita income. High level of economic development measured by the IMF�s classification as an industrial country accounted for a full rating increase. The history of default played a major role. For instance, a recent history of default set a rating back by about two notches. The rate of growth in Gross Domestic Product was a positive factor. High inflation was a negative factor. A country�s net foreign debt position was also negative. The political factors, especially political stability and willingness as well as ability to ensure appropriate macro economic policies do weigh heavily in rating.

19. Debt Management Objectives Effective and strategic public debt management to increase the country�s credit worthiness and investor & credit rating agency confidence Minimize debt service costs and to reduce the overall debt burden to a sustainable level To raise adequate levels of deficit financing through market based non-inflationary sources consistent with a prudent degree of risk on behalf of the Government Provide a benchmark yield curve

20. Sound Public Debt Management Policies Achieve and maintain a more cautious debt structure Use of variety of instruments and a range of maturities to limit the risk to the debt portfolio arising from currency and interest rate movements and to minimize costs Use hedging mechanisms to minimize the portfolio�s vulnerability to possible adverse movements in currencies Further diversify the debt portfolio Tap the domestic retail investor base through security design to meet the needs of the market and promotional campaigns, i.e. product market development Tap international capital markets in wider geographic areas Seek Schedule B �Shelf� registration in US SEC to increase flexibility and ability to access the international capital markets at very short notice Reduce the debt service burden Convert high cost debt to more favorable terms, lengthen maturity profile, smoothen interest payments to minimize cash flow impact Apply asset and liability management methods Avoid asset liability maturity mismatches in foreign debt Minimize projects being financed in foreign currency unless they generate revenue in foreign currency Empirical studies have tried to identify factors that explain over 90 per cent of the cross sectional variance of sovereign ratings. The most potent factor was GDP per capita in US dollar terms. High ratings were associated with high per capita income. High level of economic development measured by the IMF�s classification as an industrial country accounted for a full rating increase. The history of default played a major role. For instance, a recent history of default set a rating back by about two notches. The rate of growth in Gross Domestic Product was a positive factor. High inflation was a negative factor. A country�s net foreign debt position was also negative. The political factors, especially political stability and willingness as well as ability to ensure appropriate macro economic policies do weigh heavily in rating. Empirical studies have tried to identify factors that explain over 90 per cent of the cross sectional variance of sovereign ratings. The most potent factor was GDP per capita in US dollar terms. High ratings were associated with high per capita income. High level of economic development measured by the IMF�s classification as an industrial country accounted for a full rating increase. The history of default played a major role. For instance, a recent history of default set a rating back by about two notches. The rate of growth in Gross Domestic Product was a positive factor. High inflation was a negative factor. A country�s net foreign debt position was also negative. The political factors, especially political stability and willingness as well as ability to ensure appropriate macro economic policies do weigh heavily in rating.

21. Reforms Proposed Clear separation of debt management from from political sphere and monetary policy responsibilities i.e. public debt management office Discontinue captive investor arrangements Removes an important fiscal discipline Distorts flow of investment funds Inhibits secondary market development It is ultimately costly and inefficient Rely primarily on market-determined instruments for domestic debt issuance Promote a more liquid and efficient secondary market at the long end of the yield curve with few standard maturities i.e. bond fungibility Increase the transparency and predictability of primary market debt issuance i.e. publication of annual calendar Maintain continuous dialogue with domestic and international investors, market makers i.e. conference calls, presentations, road shows Empirical studies have tried to identify factors that explain over 90 per cent of the cross sectional variance of sovereign ratings. The most potent factor was GDP per capita in US dollar terms. High ratings were associated with high per capita income. High level of economic development measured by the IMF�s classification as an industrial country accounted for a full rating increase. The history of default played a major role. For instance, a recent history of default set a rating back by about two notches. The rate of growth in Gross Domestic Product was a positive factor. High inflation was a negative factor. A country�s net foreign debt position was also negative. The political factors, especially political stability and willingness as well as ability to ensure appropriate macro economic policies do weigh heavily in rating. Empirical studies have tried to identify factors that explain over 90 per cent of the cross sectional variance of sovereign ratings. The most potent factor was GDP per capita in US dollar terms. High ratings were associated with high per capita income. High level of economic development measured by the IMF�s classification as an industrial country accounted for a full rating increase. The history of default played a major role. For instance, a recent history of default set a rating back by about two notches. The rate of growth in Gross Domestic Product was a positive factor. High inflation was a negative factor. A country�s net foreign debt position was also negative. The political factors, especially political stability and willingness as well as ability to ensure appropriate macro economic policies do weigh heavily in rating.

22. Rating Groups Investment grade - Higher savings rates & lower debt levels - Stronger GDP and export growth - Stable politics BB - Modest public and external financing needs - Less reliance on market finance than �B�s - Mixed record on politics B and lower - Narrow economic base & vulnerable to shocks - Heavy public and external debt and fiscal imbalances - Low GDP and export growth prospects

23. Current Account Balance (% of GDP)

24. General Government Debt (% of GDP)

25. General Government Balance (% of GDP)

26. Real GDP Growth (% YoY)

27. CPI (% Change YoY)

28. Concluding Remarks A low rating is better than no rating Sound debt management matters! - will lead to a higher rating or upgrading of the rating of the Country by rating agencies Higher rating allow for more favourable financing terms in the international capital markets