Credit ratings: criteria under the direct mandate of a city vs. national and other stakeholders
Rating agencies often categorize their criteria as being either ‘institutional framework’ or under the ‘individual credit profile’ of a city (as seen in Figure 2 above). Institutional framework includes all those factors that constitute transparent, accountable and predictable government at both the local and national level. Individual credit profile constitutes the set of factors – economic, managerial and of performance – that relate to the local authority’s financial capacity to pay its debt obligations.
However, the factors that determine creditworthiness can also be divided into endogenous and exogenous subsets. Endogenous factors would be those that are under the direct mandate of a local government, whereas exogenous factors are those to which there is often limited scope for direct action by the municipality. In essence, exogenous factors are those often termed “enabling environment”.
Some examples of exogenous factors affecting municipal creditworthiness:
Economic: national & international economic growth inhibiting factors, such as interest rates; commodity prices; changing demands of international economy; environmentally induced shocks to the economy; wars & other destabilizing events
Institutional & regulatory frameworks: unreliable intergovernmental transfers; inadequate decentralization to cities of core revenue generating functions; inadequate balance of oversight from the national government
Access to finance enabling environment: Unclear regulations governing municipal debt and Public-Private Partnerships; overzealous restrictions on local government borrowing; poorly developed capital and credit markets - while a city can be creditworthy, its access to finance relies on the capacity of the local capital and credit markets to provide the right appetite and debt & equity investment options.
Reviewing the partial list above, it is clear that exogenous factors are some of the thorniest issues relating to city creditworthiness. The problems are varied in nature, as is the potential for a local authority to influence them to its benefit. Perhaps the key factor in assessing the city’s ability to act on these areas is time. For example, in the short term, there is little that can be done about something as arbitrary as commodity prices. However the policy-maker on a long-term schedule could see the risk of an urban economy overly dependent on commodity production and initiate diversification strategies to lessen the impact of future shocks.
Many of the exogenous factors that fall more closely within the mandate of a local government – in particular nationally controlled regulatory issues and procedures – require the creative, dedicated use of political persuasion and advocacy. Often-times regulatory issues are common for many municipalities within a country. In addition there could be other types of subnational entity with similar interests. This affords the ability for groups of organizations to coalesce around a given issue and propose solutions as a class of entities.
Shadow vs. public credit ratings
The ultimate goal of a rating is to demonstrate creditworthiness to the marketplace. Inherently then, the credit rating is a document for publication. However, it is often the case that a city is unsure of its creditworthiness position and therefore reticent to make a detailed analysis public.
In such cases, a shadow credit rating can be performed by an agency. These have the same methodology and rigor as a public rating with the benefit that it will remain undisclosed until the city is ready. Shadow ratings are beneficial as an early stage analysis to see what are the areas of strength and weakness in a city’s creditworthiness status and also provide a basis for a reform program if necessary.
‘Investment grade’ ratings
While a city’s creditworthiness is a position on a continuum of possible states, markets and rating agencies also often define the point when a city has reached ‘investment grade’. Usually it is the case when an entity or instrument is rated at ‘BBB’ or higher.
This is an important inflection point: ‘investment grade’ is the point at which many institutional investors – such as pension funds and insurance companies – can legally invest. These institutions are legally prohibited from investing in any debt that is rated lower than this threshold, for example BB or lower, as this debt is considered ‘speculative’ (i.e. medium to high probability of default).
Credit enhancement: General Obligation (GO) vs. structured or revenue based transactions& guarantees
Credit ratings for municipalities generally fall under two categories: General Obligation or Structured Transactions/Securitizations.
General Obligation: GO ratings are based on the full faith and credit of the city. A GO rating reflects the ability and willingness to pay once all of the assets, liabilities and revenue & expenditure streams of the entire city have been taken into account. The long-term GO rating can be considered the truest metric of creditworthiness of a city as it analyzes the full balance sheet of a city’s administrative capacity, finances and socioeconomic profile.
Because of the full perspective of the GO rating, it is often the case that a city receives a lower rating than would be desirable, resulting in higher costs of financing from the marketplace. In such cases it is possible for a city to improve the creditworthiness of a particular transaction, and therefore achieve cheaper terms of financing for a specific debt instrument.
One method to achieve this is to dedicate (as a legal arrangement of the transaction) a depend-able stream of revenues to the financing of debt payments. In such instances, the creditworthiness of the transaction’s structure can actually exceed that of the host city’s GO pledge. In effect, the rating is based on the expected adequacy of the revenue stream itself and the strength of the legal regime that directs it toward the financing of the debt.
Guarantees & credit enhancements: In addition to a structured approach, guarantees from the central government and/or international donor partners can improve the creditworthiness of a particular transaction for a city. In such cases, whole or partial default risk can be assigned to the partner. This allows a city to take advantage of the superior balance sheet quality of the creditworthy partner, which in turn gives greater comfort to the investors.
For example, if a AAA rated entity (GO) agrees to guarantee 50% of the obligation of a BBB- rated city, investors will take the quality of the guarantor’s pledge and upgrade the creditworthiness assessment accordingly. The debt will be rated above BBB- with consequent improved terms for financing. The exact measure of benefit will depend on the quality and robustness of the guarantee (i.e. how creditworthy is the guarantor and how likely is it that they will actually honor the arrangement?).
Central governments or donors can provide such guarantees. However, central governments often are constricted in their ability to take on new financial obligations and donors usually charge a fee for such services, which will need to be assessed in terms of the overall economics of the proposed investment.
The scale of a rating: National vs. International
Credit ratings can be assessed on either of two rating scales: global or national. A global scale rating is benchmarked against international comparators and is appropriate for assessing the risk of default on hard currency debts, whereas a national scale rating is always benchmarked against the risk that the sovereign government might default on its local currency debt.
On the national scale, sovereigns are normally rated AAA, assuming they have the ability to print money and therefore have unlimited ability (if not willingness) to repay local currency obligations. The default risk of all other entities entering into local currency debt within a country will therefore be compared to the sovereign’s AAA national scale rating. Of course, this means that national scale ratings are not appropriate for comparing credit-worthiness across international borders.
On the global scale, normally a municipality cannot exceed the rating of its sovereign. If a municipality is located in a country with a sovereign rated BBB on the global scale, then it is generally impossible for the city to be rated higher than BBB on the global scale (unless substantial measures to mitigate country risk have been implemented). This is because, as an entity subject to the sovereign’s authority, a municipality is also therefore subject to the same country level risks that constrain the sovereign’s ability and willingness to pay.
Why local authorities should first focus on National Scale ratings
As a rule, municipalities will want to first acquire a national scale rating for several reasons:
- Since the revenues of local authorities are in local currency, they need to avoid foreign exchange risk by using local currency debt obligations. Therefore, since the national scale rating measures default risk on local currency obligations, it is the most appropriate type of rating for a local authority.
- Due to the FX and other transnational risks, the primary non-governmental investors that might be interested in financing municipal infrastructure will be local banks, pension funds, and insurance companies. Before providing financing to municipalities, local investors will want to understand the comparative risk of holding municipal debt compared to holding extremely low risk national government bonds. A national scale rating makes that comparative risk clear, and therefore facilitates financing from local investors.
- Global scale ratings do not offer adequate differentiation for local investors to judge comparative risk among alternative local currency investments, because all ratings will be lower than the sovereign’s global scale rating which is not indicative of the risk associated with local currency debt.
From a development perspective: what credit ratings do not include
There are however, important development objectives for cities that are not mentioned in rating criteria for cities. Two obvious examples of this relate to climate change (greenhouse gas (GHG) mitigation and resilience to climate change) and pro-poor policies that seek to improve the quality of life of low income residents, but may not hold the promise of immediate financial return for the city’s bottom line.
It is true that rating agencies do not explicitly list these factors in their criteria for developing a credit rating. However, it should be stressed that ratings are not cookie-cutter products; the best agencies will consider all factors on a contextual basis that affect the ability of cities to manage crises and weather financial shocks that could affect a city’s ability & willingness to service its debt obligations.