S&P did not revise soverign rating of India but Fitch had a slightly different view this time. Few months back S&P downgraded US and European Union resulting in crash of financial markets across the globe. Financial market tanked in the range of 10% throughout the world, such was the impact of this news. How exactly S&P or any other rating agency decides the sovereign rating? Why the rating downgrades or upgrades impacts investor’s sentiment so much? 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. The process is similar to the credit rating of any company and the main objective is to evaluate the capacity of a national government to pay its debt obligations. Credit rating also quantifies the level of risk an investor is exposed to while investing in that particular country.

Assigning Sovereign Rating

Rating agencies basically focus on economic risk and political risk involved while assigning a sovereign rating. Detail analysis is done using various standard procedures 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 in 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 way monetary and fiscal measures are exercised by the country.

The Political Risk: While 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

A very careful and detail analysis is required while assigning 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 credibility of the rating agency gets questioned. We are not required to go into finer details of the process as investors. Only thing we should be bothered about is the credibility of the credit rating agency. If news flow is from a authentic source downgrades means sell and get out of equities and vice versa till the situation evens out.

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