Last Updated: February 10, 2009

Sovereign and Public Sector Entities
I. Sovereign
Importance of credit rating which is internationally accepted and highly relied on in the bondmarkets as a basis for investment decision-making has been increasing, along with the rapid progress ofglobalization and blurring of state borders of financial markets. Against this backdrop, JCR intends tocontribute not only to the development of the yen-denominated bond markets but also to further
international use of the yen, through an aggressive expansion in the internationally recognized and correct
rating activities. It would be indispensable to establish a systematic rating methodology in order to makecredit ratings reliable and correct. JCR adopts the self-developed “multi-stage evaluation system forsovereign ratings” in assessing the debt-service capacity of a sovereign government.
1.

Characteristics of Multi-Stage Evaluation System
The system has two salient features: first, a risk factor called foreign currency illiquidity
highlighted on the occasion of the Asian currency crisis can be properly evaluated and reflected in a
rating under the system; and second, the evaluation process is orderly classified into five steps, as thename of the system implies. Thereby, JCR aims at establishing a consistent and sophisticated system forcredit rating. A brief explanation on the two characteristics of the system will be made in the following
sections.

2.

Evaluation of Foreign Currency Liquidity Crisis(1) Lessons from East Asia Currency Crisis and Responses
The East Asian currency crisis which had started in Thailand in July 1997 revealed theunexpectedly rapid emergence of a serious liquidity crisis. Broadly speaking, two intrinsic causes ofcrisis can be pointed out: one is attributable to poor fundamentals of the East Asian countries, and theother to dramatic outflows of short-term international capital from them. We will not probe theintrinsic cause of the crisis here. But it can be safely said from broad perspective that the interaction
between the above-mentioned two causes brought about the crisis.
Since the 1980s, the international financial system has rapidly developed, boosted by the progressof information technology. In the course of the 1990s, this system has become further sophisticatedand complicated, involving developing countries with huge flows of international capital. The current
economic situation under the highly developed international financial system is likely the one depictedby the late professor Giichi Miyazaki in his book titled “The Twilight of the National Economy”. Thatis the global economy driven mainly by capital movements rather than by trade of goods and services,or to put it another way, the world economy under the “casino capitalism”. Effectiveness of macro
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economic policy of a country has become apt to be negatively influenced by unexpected fluctuationsin interest rates and exchange rates caused by international capital movements. Besides, the possibility
has gotten higher nowadays that a country with latent economic problems like weak industrial
structure is easily targeted by speculators, making them emergent at once, though in the past these
problems came to the fore by degrees. Speculative capital movements have been more frequently
taken place recently, taking into account such factors as the financial situation or levels of foreignexchange and disregarding the economic fundamentals of a country. As a result, once a crisis happens
in a country, this brings about a contagion effect, spreading risk of the crisis rapidly to other countries.
This makes the current international financial system extremely unstable, thus leading to increased
instability in macro economic management of each country. Such changes in the international
economic environment, therefore, should be taken into account in analyzing sovereign risk. The East
Asian currency crisis implies that factors which prompt emergence of foreign currency liquidity crisishave become more complicated. A sovereign credit rating should properly reflect this.
JCR has made efforts to improve correctness of its sovereign risk assessment with an awarenessof those issues. The establishment of the “multi-stage evaluation system for sovereign ratings” reflects
its efforts. Systems for credit risk evaluation in a longer perspective and for liquidity risk assessment
are set up in it. In addition, the evaluation system is designed to properly respond to complicatedevents possible to happen by crosschecking the longer term credit risk evaluation and the liquidity risk
assessment.
(2) Major Risk Factors EvaluatedLiquidity risk factors out of the major risk factors incorporated in the evaluation system whichwere formulated taking into account lessons from the East Asian currency crisis are: first, theauthorities’ capability to appropriately respond to crisis; and second, risk factors which may induce acurrency crisis.
The first should include the following:• The authorities’ capability of appropriate response
It is important to see whether the government and central bank can take quick measures to avoida currency crisis when that occurs. Accurate macro economic data must be provided to the financial
authorities so that they can do so,• Management of foreign exchange reserves
An appropriate level of foreign exchange reserves is needed to cope with a risk of rapid outflow
of capital from a country. Under the Bretton Woods (fixed exchange rate) regime, a level ofexchange reserves covering three months of imports was considered appropriate. But this does not
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make much sense under the present economic circumstance where international capital flows intoand out of the country freely. Appropriateness of exchange reserves should be assessed against theexpected size of volatile money in the country.
The second risk factors inducing a currency crisis are itemized as follows:• Foreign exchange-rate policy
A country which adopts the pegged exchange-rate system with its currency value fixed with thekey currency is prone to overvaluation of its currency leading to a fall in export competitiveness andan expansion in trade deficit. In addition, given that the country can keep the level of interest rates
low under that exchange-rate system, there is a possibility that it will induce a rapid rise in
short-term external debt of the private sector (dependence on short-term debt is particularly a matterfor deep concern), resulting in disturbances in its banking system. Consequently, the country could
be forced to depreciate its currency and face serious problems to be arisen in its real economy.
• External debt structure
In an analysis of the external debt structure of a country, attention should be paid to that of theprivate sector, because the public sector may have to take over external debt held by the privatesector, when the external debt position worsens. The short-term debt position should be also focusedon, because short-term debt is very sensitive to risk and easily flees as well.
• Financial system
The East Asian countries afflicted with the currency crisis obviously needed inflows of foreign
capital to sustain their economic growth covering the gap between investment and saving.
Mismatch in maturity between lending and funding of financial institutions, however, provokeda worsening of their balance sheets. Excess liquidity caused by foreign capital inflows brought about
the bubble economy particularly in the property market of those countries. Poor risk management ofboth the monetary authorities and financial institutions caused instability to the financial system. And
this made the crisis more serious. Therefore, it is important to evaluate the degree of soundness ofthe financial system of a country.
• Industrial structure
The analysis should also be focused on the characteristics of the industrial structure of a country.
For example, the cohesion of the government and industry or unsound financial structure of majorindustries, because these are likely to provoke financial disturbances, once a latent problem comes tothe fore. And the structure of export industry which depends too much on imported materials,
because this is prone to make the currency unstable when the balance of payments worsens. These
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are typically seen in Korea involving problems of conglomerates (chaebol).
3.

Five-Stage Evaluation System
Another salient feature of JCR’s sovereign rating evaluation system can be summarized as follows.
Formulated to systematize the rating methodology, this is composed of five stages of the evaluation
process. Starting with the quantitative evaluation as the first stage, the process proceeds with thesynthetic analysis as the second stage, the qualitative evaluation as the third stage, then the overallevaluation as the fourth stage, and the predictive evaluation as the final stage.

(1) The first stage: the process of quantitative evaluation
The rating process is basically composed of the quantitative and qualitative evaluation.
Under JCR’s evaluation system, a level of risk is first measured quantitatively. Actually, this isdone using a computerized evaluation program. JCR has evaluated quantitative risks of more than 100
countries making use of outside database. The evaluation process at this stage consists of thelong-term credit risk evaluation program and the foreign currency liquidity risk evaluation program.
JCR evaluates the two risks separately (the liquidity risk evaluation is made only to developing
countries).
(2) The second stage: the process of synthetic analysis
To sum up, a credit rating is an evaluation of risks involved in debt service of an entity.
At this stage, the underlying circumstances under which major economic indicators selected at thefirst stage stand as they are recognized. And then a synthetic analysis is made necessary to proceedwith the next stages. Accordingly, it can be said that this stage is the most important process of thewhole evaluation system. We omit detailed explanation on its contents here for want of space andoutside of the purpose of this paper. Just for reference, major analytical items are cited as follows.
• Past and present political situation(including foreign relations and the international political and economic position of a country)• Gross domestic product in terms of both supply and expenditure sides(including history of industrial development)• Public finances• Monetary and fiscal policies• Financial system• Balance of payments• External debt
(3) The third stage: the process of qualitative evaluation
At this stage, the qualitative evaluation is made, based on a perception of the country under
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review built at the previous stage. The qualitative evaluation also consists of the credit risk evaluation
in longer perspective and the liquidity risk evaluation. The separate evaluation programs are applied toeach of them.
(4) The fourth stage: the process of overall evaluation
The overall evaluation is made based on certain procedures, following a quantitative and aqualitative evaluation made at the first and third stages respectively. Here again, the overall evaluationof credit risk in longer perspective and that of liquidity risk are separately made. And then, both arecrosschecked based on the corresponding relation between the two separate evaluation set by us. JCR’sevaluation system has the mechanism that activates a warning signal to the credit risk evaluation, if theliquidity risk heightens to a certain degree.
(5) The fifth stage: the process of predictive evaluation
At the final stage, a one-year predictive evaluation is made as to the same items for quantitativeevaluation as applied at the first stage, based on the analyses made at the preceding steps. At the sametime, a one- year prediction on qualitative evaluation is similarly conducted as well. Strictly speaking,the evaluation process from the first to fourth stages, particularly that of quality contains prospective
variations in the near future. Accordingly, there may be duplication in the system. Knowing that,
however, we dare to make the one-year prediction to obtain the overall evaluation based on theprevious analyses. This overall evaluation obtained under the system is used as the important tool forassessing the outlook for a credit rating. The evaluation process at the fifth stage makes it possible toconduct a scenario analysis. Developments of big events such as the chaebol reform and the financial
system reform in Korea can have great influences on the outlook for a credit rating. In such a case,
JCR conducts a scenario analysis to obtain a correct predictive evaluation as much as possible.
4.

Conclusion
As mentioned initially, it is very important for an improvement in reliability and correctness ofcredit ratings to establish a systematic rating methodology. Changes in the world economic
circumstances seem to gather pace increasingly. This implies that credit rating agencies are required tomake incessant efforts to respond appropriately to such changes. JCR admits that its rating evaluation
system as described above cannot be perfect. To respond better to the changing economic circumstance,
JCR will continue to make efforts to improve the system.

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The Multi-Stage
Sovereign Risk Evaluation System

Quantitative Evaluation Process
First Stage

Second Stage

Long-Term Credit Risk

Liquidity Risk

Evaluation

Evaluation

Synthetical Analysis Process

Qualitative Evaluation Process
Third Stage

Long-Term Credit Risk

Liquidity Risk

Evaluation

Evaluation

Overall Evaluation Process
Fourth Stage

Fifth Stage

Long-Term Credit Risk

Liquidity Risk

Evaluation

Evaluation

Predictive Evaluation Process

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II. Public Sector Entities
1.

Outline of Methodology
For the rating of government-affiliated institutions such as state-owned banks and enterprises, JCR
gauges the strength of their relationship with the relevant government by reviewing if they have legal
support, their importance in the government’s industrial policy, etc., and judges to what extent thegovernment’s creditworthiness should be reflected in their ratings. At the same time, JCR analyzes andassesses the financial position and business risks of such entities to draw the judgment. As a result,
ratings on public-sector entities can be equal to or lower than those of the relevant government. Thisrating methodology is mainly applied to foreign public sector entities.

2.

Key factors in the evaluation
JCR measures the strength of relationship between the public entity and the relevant government
from various angles, with attaching importance to the following five factors. Each factor has its own
evaluation weight. Basically, JCR considers that factor (1) weighs most among the five factors below,
but such weightings are not strictly fixed. When appropriate, JCR may change the weights depending ontypes and situations of the entities reviewed.

(1) Strength of legal protection including regulatory protection
If government protection of a public-sector entity is stipulated under legislation including the law
for its inception, that can be a positive factor in assessing the strength of its relationship with thegovernment. Such protection may include, for example, (i) explicit guarantees by law, (ii) government
support defined by law, and (iii) laws to provide budgetary support such as operational subsidies,
official loans, and interest payment allowances for bond issues.
In addition, the existence of protective governmental regulations can also be a positive factor inevaluating the strength of the entity’s relationship with the government. For example, the government
can restrict new market entry with a licensing system to control competition in the domestic market. It
is also necessary to foresee future of the government’s regulatory moves. The forecast takes into
consideration matters such as the regulatory authority’s policy towards privatization, and the externalenvironment and the existence of social or political organizations which may influence the authority’spolicies.
(2) Strength of government support other than the above-mentioned
It is also necessary to analyze the measures for credit enhancement by way of economic andregulatory supports by the government, which do not necessarily have clear legal grounds such as afounding law. Such supports may include: (i) explicit guarantees not based on any legislation, (ii) thegovernment’s will to support the entity to fulfill its liabilities in case it falls into a financial difficulty
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and (iii) an indirect subsidy and assistance in a broad sense such as creation of a general economic andsocial environment that can contribute to enhancing the credit quality of the entity. With regard to thegovernment supports other than explicit guarantees, it is important how the government sets up andmaintains the overall regulatory, economic and political environment. In that case, it is necessary toanalyze whether the government has capacity and will to create a business environment to the future
managerial advantage of the entity.
(3) Strength of capital relationshipIf the government intends to continue holding an equity stake in a public-sector entity, that can beevaluated positively in assessing its relationship with the government as it may indicate thegovernment’s will to maintain its power to control the management of the entity. However, it should be
noted that the government’s equity holding does not necessarily mean it is fully responsible for theentity’s obligation of debt repayment. If the government holds more than 50% of the entity’s shares, it
is generally considered more likely than not to intervene in its management when it falls into afinancial difficulty, as compared to the case where a government stake is less. This may not be the case
all the time, however.
Also important is the purpose of government’s equity holding. For example, if it is to prevent
foreign companies from controlling the entity, it can be expected that the government will promote
policies to protect the entity’s market and keep its business environment secured. Furthermore, it isnecessary to check if the government has plans to privatize the entity or change the shareholding ratio.
3.

Importance in the government’s industrial policy
It is necessary to analyze the importance of a public-sector entity in light of the government’s
national policies including energy policy, industrial policy, social security policy and defense policy. If
the entity is given a greater importance, that can be positively evaluated in assessing the strength of its
relationship with the government or vice versa.

4.

Strength of personnel relationship with government
A public entity’s strong personnel relationship with the government can be positively evaluated inassessing the strength of its relationship with the government. It is necessary to check whether thegovernment participates in the management of the entity, whether it has the power to appoint
management of the entity, and when it does, whether there is any legal ground for it.
In assigning the credit standing of a public-sector entity, JCR judges the strength of its relationshipwith a government by analyzing and evaluating the above-mentioned five factors. However, it should be
noted that the entity’s strong relationship with the government can be a negative factor from theviewpoint of creditworthiness on the basis of its financial and operating performance. For example, ahigh government equity stake can be an impediment to the entity’s efforts to enhance its management
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efficiency and run its business in keeping with market principles. It can also lead to moral hazard. Inaddition, a regulation that restricts investment in the entity by foreign companies can be a negative
factor in a long-term perspective as it may restrain its overseas fund raising. Therefore, a comprehensive
evaluation based on all these factors is required in the final phase of the rating process for agovernment-affiliated entity.

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