Few months back, S&P downgraded US rating creating havoc in financial markets. Financial market tanked in the range of 10% throughout the world. Not much time has passed since the market digested that unprecedented downgrade and we are standing on the verge of another collapse. This time, S&P is ready with news which can have even bigger implication on the health of financial markets. It’s threatening to downgrade the whole Euro zone, if there are only words and no actions from the European leaders towards solving the debt crisis. How exactly S&P or any other rating agency decides the sovereign rating? Is it such an easy task or a lot of pain involved in this revelation? Let’s try to find out the answer.

What is this Sovereign Rating?

A sovereign credit rating is the credit rating of a country or a national government. It’s basically evaluation of the capacity of a national government to pay its debt obligations. It also indicates the level of risk an investor is exposed to, while investing in that particular country.

Parameters used for Sovereign Rating

Rating agencies takes into account the economic risk and the political risk involved while assigning a sovereign rating. A careful analysis is done and based on the outcome a rating downgrade or upgrade is recommended.

The Economic Risk: This is risk which is the measure of a nation’s capacity to pay its debt obligations is short term and long term. While measuring the economic risk rating agencies take into account economic growth prospects, living standard, inflation rate, liquidity, income level, strength of currency and public debt burden (Pensions to be paid, Heath services cost). Together with these factors high weight age is given to the monetary and fiscal flexibility applied by the country.

The Political Risk: As economic risk measures ability and capacity to repay debt, political risk is the measure of government’s willingness to repay its debt obligation. This all depends on the stability of the government and acceptance of economic policy goals. This risk is quite evident on global trade platform and is indicated by the trust shown in national financial system. Unlikely events like War and crisis enhances this risk. The unavailability of any legal alternative in case of default by a nation makes it even more important to analyze the political risk.

Conclusion

It’s not an easy task to downgrade a nation’s credit rating as a lot is at stake for both the parties. If the rating agencies assessment is correct, the whole financial market tailspins and if the assessment is not so correct, the future of the rating agency gets darker. But in any case as a smart investor, we should raise the red flag once such news flows into the market. It’s time to be cash rich and keep away from risky investment instruments like stocks and commodities. Wait for the storm to subside and you will get a chance to purchase these assets at better prices.

Author

The author Bimlesh Singh is a financial consultant and is the lead partner at Vertical Grass. He can be reached at bimlesh@verticalgrass.com.