Ratings

Standard & Poor's sovereign foreign currency recovery ratings will reflect our opinion on the extent to which a sovereign government will be willing and able to repay creditors under one or more scenarios where there is a future default on commercial foreign currency debt obligations. At least initially, sovereign recovery ratings will not be assigned to investment-grade issuers. Moreover, these ratings will not be assigned to secured debt or debt guaranteed by third parties, nor will they differentiate between different types of commercial creditors, or on the basis of other features such as different maturities. Therefore, our analytical approach will focus on the issuer rather than on specific debt instruments, with the same recovery rating typically assigned to all of the sovereign's rated senior unsecured foreign currency commercial debt.

In essence, the main features of this proposal are that:

• We will apply the outlined sovereign recovery analytics to commercial senior unsecured foreign currency debt. At this stage, we plan to assign recovery ratings to speculative-grade issuers only.
• For sovereign debt, we propose to express the future recovery rate based on the estimated net present value (NPV) debt adjustment. The anticipated recovery rate would be expressed on Standard & Poor's proposed global recovery rating scale (see table 1). Market participants are particularly invited to comment on whether this definition of recovery rates will meet their needs.
• The analysis will begin with the identification of likely sovereign default scenarios. These set the relevant parameters for the subsequent recovery analysis, as they envisage the economic, fiscal, and political conditions around default.
• The fundamental recovery analytics will consist of estimating the issuer's payment ability and willingness under the default scenario. They conclude by taking into account potential features of subordination of commercial debt to multilateral lending (loans by the IMF or the World Bank, for example), as well as potential bailout expectations (see table 2).
• Key differences between assessing a sovereign's probability of default in the first instance, and estimating recovery in the event of default, will be related to crisis dynamics and knock-on effects (such as currency depreciation, economic contraction, and political stability) surrounding the default scenario. These may lead to conclusions on debt service payment ability and willingness in the event of default that are distinct from those in a predefault situation.

Table 1

Standard & Poor's Global Sovereign Recovery Rating Scale
Recovery rating	Recovery expectations	Recovery range
1+*	Highest expectation, full recovery	100%+
1	Strong expectation, full recovery	100%
2	Substantial recovery	80%-100%
3	Meaningful recovery	50%-80%
4	Average recovery	30%-50%
5	Modest recovery	15%-30%
6	Negligible recovery	0%-15%
*The '1+' recovery rating is assigned to differentiate unusually-well-protected issues wherein a combination of factors--collateral quality, coverage ratio, and deal structure, among others--increase the overall likelihood of full recovery, even compared with other issues on which full recovery is expected.

Table 2

Factors Involved In Sovereign Recovery Analysis*
Ability to make payments	Willingness to make payments	Enhancement and subordination features
Comparison of stressed debt levels with debt capacities	Default and restructuring history	Proportion of official bilateral lending
Impact of default crisis on financial system and economic activity in general	Recent recovery precedents of other sovereign defaulters	Proportion of existing IMF debt
Potential for currency depreciation	Importance of access to global goods and capital markets	Bailout
Fiscal and external flexibility	Exposure of domestic financial sector to sovereign debt
Nature of financial inflows	Proportion of resident to nonresident debt holders
Potential for additional debt to be added to that of the sovereign	Expected political attitude to world economic order
	Bargaining power
*After the identification of the specific sovereign default scenario.

We would like to encourage all market participants to submit written comments on one or more aspects of the proposed criteria. During the consultation period, which will end on Jan. 22, 2007, we will also be meeting with various market participants to solicit their views on this proposal, and reviewing comments received via e-mail. After that time, we will publish a final methodology for assigning sovereign recovery ratings. Subsequently, we would then assign and publish recovery ratings to rated speculative-grade sovereigns.

Comments on this proposal may be sent through Jan. 22, 2007, to SovereignLondon@standardandpoors.com, or by contacting any of the individuals listed at the top of this article.

While some market participants look at postdefault trading prices, Standard & Poor's recovery ratings will focus on the NPV of ultimate recovery, similar to the empirical sovereign recovery research data presented in table 3.

Table 3

Sovereign Net Present Value Recovery Rates 1998-2005
	Bank of England*	Sturzenegger/Zettelmeyer¶
(%)	Average rate of recovery	Average rate of recovery	Recovery range
Argentina	30	27§	18-36
Dominican Republic	>95	N.A.	N.A.
Ecuador	60	73**	53-81
Grenada	60¶¶	N.A.	N.A.
Pakistan	65	69§§	68-71
Russia	50	37***	37
Russia	50	47¶¶¶	46-48
Ukraine	60	72**	65-78
Uruguay	85	87§§§	80-95
*Data from Bedford, Paul, Adrian Penalver, and Chris Salmon: “Resolving The Sovereign Debt Crises: The Market-Based Approach And The Role Of The IMF,” Financial Stability Review, Bank of England, June 2005. ¶Data from Sturzenegger, Federico, and Jeromin Zettelmeyer: “Haircuts: Estimating Investor Losses In Sovereign Debt Restructurings 1998-2005,” IMF Working Paper, 2005. §2005 external debt exchange. **International bonds. ¶¶Data for Grenada is based on an estimate by Standard & Poor's. §§Eurobonds. ***MinFin3--a domestically issued, but dollar-denominated bond. ¶¶¶Principal notes/interest accrued notes. §§§External debt. >--Greater than. N.A.--Not available.

Standard & Poor's starts its recovery analysis by identifying the likely default scenarios. These scenarios set the relevant parameters for the subsequent recovery analysis, as they envisage the economic, fiscal, and political conditions around default. Policy failure default scenarios, for instance, comprise a heterogeneous group of cases where a debt crisis is the result of gradually increasing economic or fiscal pressures. In such cases, policy fails to respond adequately, ultimately triggering a loss of credibility and default. Alternative scenarios may be linked to commodity price shocks, force majeure events, poor debt management, or changes in repayment willingness. Each of these has different implications for the postdefault restructuring environment.

Our analysis of sovereign recovery ability is based on a simulation of macroeconomic stresses that are expected to occur in a crisis situation. The simulated postdefault debt indicators are then compared with debt capacity benchmarks to assess the need for debt adjustment after default (see chart 1). The economic stresses and debt capacity benchmarks are based on cross-sectional empirical evidence from 21 sovereign economic crises (see chart 2 for an illustration of GDP stresses).

 Chart 2

The severity of the stresses is evaluated in light of the future default scenario. Contraction of GDP growth during a sovereign debt crisis may be exacerbated by a simultaneous financial sector crisis, for instance, possibly caused by extensive holdings of sovereign debt instruments. Similarly, the exchange rate stress may be considered particularly severe if the default scenario is likely to entail the end of a fixed exchange rate regime, as happened in Argentina in 2001. By contrast, membership in a monetary union may mean that the exchange rate is not affected by the sovereign default. For instance, three of the eight members of the East Caribbean Central Bank have experienced default without creating significant pressure on the East Caribbean dollar.

Standard & Poor's has derived debt capacity benchmarks from empirical data, using median debt indicators that were characteristic of sovereigns emerging from a default or crisis situation (see table 4). In the years immediately surrounding the crisis, a defaulting sovereign may more closely resemble other past defaulters than its own individual precrisis history. This assumption is supported by empirical evidence, which shows that debt indicators of postdefault or postcrisis sovereigns were closer to each other than to each issuer's individual history three years prior to the central crisis year (see table 5).

Table 4

Sovereign Postdefault Debt Capacity Levels 1995-2006
	Derived from historic crisis episodes*	'B' median
Public sector debt (% of GDP)	51	64
Total external debt (% of GDP)	50	57
Total external debt service (% of GDP)	16	7

Table 5

Comparison Of Sovereign Debt Constraint Indicators
Cross-Section Versus Individual History
Average difference between country-specific indicator (t+3, t+4)…	Public Sector Debt/GDP (%)	Total External Debt/GDP (%)	Total External Debt Service/GDP (%)
... and cross sectional median of indicator in t+3 and t+4	19.3	13.6	6.4
... and issuer-specific pre-crisis indicator in t-3	24.4	17.2	8.2
t--The default or core crisis year.

Nevertheless, the suitability of the debt capacity constraint is evaluated in light of the sovereign's recent debt servicing record, with some sovereigns demonstrably more capable of withstanding higher levels of debt than others. From this perspective, it is important to note that we by no means view the debt capacity levels as debt sustainability measures above which a specific sovereign would default. Rather, these are considered levels of debt that sovereigns historically have had under postcrisis conditions.

The difference between the debt burden at default, as simulated by the economic stress scenario, and the debt capacity benchmarks, gives an indication of the haircut that the sovereign may need to impose after default. That said, Standard & Poor's does not interpret its recovery ability analysis as setting a cap on the ultimate recovery rate estimate. Rather, we view our analysis as a first step, benchmarking sovereigns against both historical experience and against each other.

Our ability analysis is concluded by examining other characteristics of the sovereign that may influence its recovery ability. These characteristics include the issuer's postdefault capacity to generate primary surpluses in order to fund higher recovery levels. Whether or not the sovereign will be willing or able to exercise this flexibility (with political considerations the most likely distraction) is also considered. Historical evidence on the issuer's ability to run primary fiscal balances provides prima facie support for the analysis. From a more forward-looking perspective, the issuer's fiscal flexibility will depend, among other things, on the default scenario and associated output contraction, on its current tax rates and tax productivity, and on the composition of expenditures.

To offer recovery on foreign currency debt, the sovereign must secure foreign exchange. Consequently, an assessment of postdefault external flexibility is important. The capacity to increase current account receipts (CARs) will depend on the country's export structure under the assumed default scenario. If the default results from a shock to commodity prices, for instance, the assumed postdefault foreign-currency earning capacity will need to be discounted. Equally, the capacity to increase CARs after currency depreciation may be limited if exports have a high import content.

External flexibility is also influenced by the nature of financial inflows. Capital flight will typically increase in all countries following a default, but the nature of prevailing financial inflows may suggest that this occurs to varying degrees, with remittances and foreign direct investment (FDI) likely to be more supportive of external flexibility. That said, capital that flows in as FDI might flow out in a different form. Foreign investors may use the assets they have bought with FDI as collateral to borrow money within the country and then repatriate it. During a crisis, FDI investors may also choose to repatriate their profits more quickly or reduce the liabilities of affiliates to their mother company. In these cases, the distinction between FDI and portfolio flows is often blurred.

The ability analysis finally addresses the possibility that additional debt may be included within the restructuring. This may involve the incorporation of state-owned enterprise debt, private sector external debt, or debt issued to help recapitalize the financial sector.

The second stage of Standard & Poor's recovery analysis takes into account the factors that signal the sovereign's payment willingness after default. Payment willingness is likely to be affected by the sovereign's own default and restructuring history, as well as by recent restructuring precedents of other sovereign defaulters, particularly if the latter are sovereigns with economic or regional similarities. If the sovereign was a frequent defaulter in the past, this can indicate a low reputational cost of future defaults and low recoveries.

Payment willingness will also depend on the importance, for both the government and the domestic economy, of access to global goods and capital markets. Underdeveloped local currency domestic capital markets or a reliance on trade finance, for example, would tend to underpin higher levels of willingness, ceteris paribus.

A sovereign's willingness to offer recovery following default may also be influenced by its postdefault political priorities. Willingness could be bolstered by the need to maintain international goodwill (in an effort to secure a free trade agreement, for instance). On the other hand, the diversion of resources toward domestic economic agents, such as social groups or financial institutions that have been particularly impacted by the sovereign default, indicates a lower willingness to repay external commercial creditors.

Governments that pursue less market-oriented economic concepts may be less willing to accept the validity of international investor claims. In its recovery analysis, Standard & Poor's factors in the likelihood that a regime change may occur under the default scenario, particularly if a cooperative attitude to the outside world is not shared across the political spectrum, or if the there are strong and radical opposition movements in the country.

The distribution of bargaining power between the sovereign and the creditors is also taken into account. In general, we expect the government's bargaining power to benefit from higher amounts of outstanding debt, suggesting that its recovery payment willingness may decline. By contrast, if the sovereign has issued smaller absolute stocks of debt, or if the sovereign (or indeed country as a whole) is reliant on certain banks for its financing, this may be detrimental to the government's bargaining power. Therefore, the government may be encouraged to display a higher willingness to repay creditors following default.

Standard & Poor's completes its recovery estimate with an appraisal of expected subordination or enhancement features.

Sovereigns have often treated the repayment of their Paris Club debt (bilateral loans extended by governments and government-related entities) more flexibly than that owed to other creditors, suggesting that higher levels of Paris Club debt reduce the burden of adjustment for commercial creditors. However, we also assess the likelihood of a requirement by Paris Club creditors for comparability of treatment in light of the assumed default scenario and specific country characteristics.

Multilateral financial institutions such as the IMF and the World Bank are usually treated as preferred creditors. Therefore, a large stock of debt owed to such creditors may imply that the burden of adjustment will be borne by private creditors, which are in a subordinate position, leading to a lower rate of recovery.

The potential for debt relief extended by other sovereign creditors or international financial institutions is also assessed. Factors considered here will cover the defaulter's geopolitical importance, the circumstances behind the default (a natural disaster, for example), or the degree of political affinity.

The likelihood of an effective bailout from any source will be affected by the absolute value of debt outstanding. Very large absolute stocks of debt suggest that support from international financial institutions or bilateral creditors would need to be significant to have any noticeable impact on recovery, whereas more moderate levels of support could have a significant effect in sovereigns with low absolute debt levels.