Japan Credit Rating Agency, Ltd.
JCRs Sovereign Rating Methodology :Multi-Stage Evaluation System
Importance of credit rating which is internationally accepted and highly relied
on in the bond markets as a basis for investment decision-making has been
increasing, along with the rapid progress of globalization and blurring of stateborders of financial markets. Against this backdrop, JCR intends to contributenot only to the development of the yen-denominated bond markets but also tofurther international use of the yen, through an aggressive expansion in theinternationally recognized and correct rating activities. It would be indispensable
to establish a systematic rating methodology in order to make credit ratings
reliable and correct. JCR adopts the self-developed “multi-stage evaluation
system for sovereign ratings” in assessing the debt-service capacity of asovereign government.
1. Characteristics of Multi-Stage Evaluation SystemThe system has two salient features: first, a risk factor called foreign currency
illiquidity highlighted on the occasion of the Asian currency crisis can beproperly evaluated and reflected in a rating under the system; and second, theevaluation process is orderly classified into five steps, as the name of thesystem implies. Thereby, JCR aims at establishing a consistent andsophisticated system for credit rating. A brief explanation on the twocharacteristics of the system will be made in the following sections.
2. Evaluation of Foreign Currency Liquidity Crisis
2.1 Lessons from East Asia Currency Crisis and Responses
The East Asian currency crisis which had started in Thailand in July 1997
revealed the unexpectedly rapid emergence of a serious liquidity crisis,
Broadly speaking, two intrinsic causes of crisis can be pointed out: one is
attributable to poor fundamentals of the East Asian countries, and the otherto dramatic outflows of short-term international capital from them. We will
not probe the intrinsic cause of the crisis here. But it can be safely said frombroad perspective that the interaction between the above-mentioned two1

causes brought about the crisis.
Since the 1980s, the international financial system has rapidly developed,
boosted by the progress of information technology. In the course of the1990s, this system has become further sophisticated and 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 depicted by the late professor Giichi Miyazaki in his
book titled “The Twilight of the National Economy”.
That is 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 “casinocapitalism”. Effectiveness of macro economic policy of a country has
become apt to be negatively influenced by unexpected fluctuations ininterest rates and exchange rates caused by international capital movements.
Besides, the possibility has gotten higher nowadays that a country with latenteconomic problems like weak industrial structure is easily targeted byspeculators, making them emergent at once, though in the past these
problems came to the fore by degrees. Speculative capital movements havebeen more frequently taken place recently, taking into account such factors
as the financial situation or levels of foreign exchange and disregarding theeconomic fundamentals of a country. As a result, once a crisis happens in acountry, 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 analyzingsovereign risk. The East Asian currency crisis implies that factors which
prompt emergence of foreign currency liquidity crisis have become more
complicated. A sovereign credit rating should properly reflect this.
JCR has made efforts to improve correctness of its sovereign risk assessmentwith an awareness of those issues. The establishment of the “multi-stageevaluation 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 toproperly respond to complicated events possible to happen by crosschecking
the longer term credit risk evaluation and the liquidity risk assessment.
22.2 Major Risk Factors EvaluatedLiquidity risk factors out of the major risk factors incorporated in theevaluation system which were formulated taking into account lessons fromthe East Asian currency crisis are: first, the authorities’ capability toappropriately 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 takequick measures to avoid a currency crisis when that occurs. Accurate
macro economic data must be provided to the financial authorities so thatthey can do so,• Management of foreign exchange reserves
An appropriate level of foreign exchange reserves is needed to cope witha risk of rapid outflow of capital from a country. Under the Bretton
Woods (fixed exchange rate) regime, a level of exchange reserves
covering three months of imports was considered appropriate. But thisdoes not make much sense under the present economic circumstance
where international capital flows into and 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 the key currency is prone to overvaluation of
its currency leading to a fall in export competitiveness and an expansion
in trade deficit. In addition, given that the country can keep the level ofinterest rates low under that exchange-rate system, there is a possibilitythat it will induce a rapid rise in short-term external debt of the privatesector (dependence on short-term debt is particularly a matter for deepconcern), resulting in disturbances in its banking system. Consequently,
3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 shouldbe paid to that of the private sector, because the public sector may haveto take over external debt held by the private sector, when the external
debt position worsens. The short-term debt position should be also
focused on, 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 growthcovering the gap between investment and saving.
Mismatch in maturity between lending and funding of financial
institutions, however, provoked a worsening of their balance sheets.
Excess liquidity caused by foreign capital inflows brought about thebubble economy particularly in the property market of those countries.
Poor risk management of both the monetary authorities and financial
institutions caused instability to the financial system. And this made thecrisis more serious. Therefore, it is important to evaluate the degree ofsoundness of the financial system of a country.
• Industrial structure
The analysis should also be focused on the characteristics of theindustrial structure of a country. For example, the cohesion of thegovernment and industry or unsound financial structure of majorindustries, because these are likely to provoke financial disturbances,
once a latent problem comes to the fore. And the structure of exportindustry which depends too much on imported materials, because this isprone to make the currency unstable when the balance of payments
worsens. These are typically seen in Korea involving problems ofconglomerates (chaebol).

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3. Five-Stage Evaluation System
Another salient feature of JCR’s sovereign rating evaluation system can besummarized as follows. Formulated to systematize the rating methodology,
this is composed of five stages of the evaluation process. Starting with thequantitative evaluation as the first stage, the process proceeds with thesynthetic analysis as the second stage, the qualitative evaluation as the thirdstage, then the overall evaluation as the fourth stage, and the predictive
evaluation as the final stage.
• The first stage: the process of quantitative evaluation
The rating process is basically composed of the quantitative andqualitative evaluation.
Under JCR’s evaluation system, a level of risk is first measured
quantitatively. Actually, this is done using a computerized evaluation
program. JCR has evaluated quantitative risks of more than 100countries making use of outside database. The evaluation process at thisstage consists of the long-term credit risk evaluation program and theforeign currency liquidity risk evaluation program. JCR evaluates thetwo risks separately (the liquidity risk evaluation is made only todeveloping countries).
• 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 the first stage stand as they arerecognized. And then a synthetic analysis is made necessary to proceedwith the next stages. Accordingly, it can be said that this stage is themost important process of the whole evaluation system. We omit
detailed explanation on its contents here for want of space and outsideof 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 and5economic position of a country),
Gross domestic product in terms of both supply and expendituresides(including history of industrial development),
Public finances,
Monetary and fiscal policies,
Financial system,
Balance of payments,- External debt,• The third stage: the process of qualitative evaluation
At this stage, the qualitative evaluation is made, based on a perceptionof the country under review built at the previous stage. The qualitativeevaluation also consists of the credit risk evaluation in longerperspective and the liquidity risk evaluation. The separate evaluation
programs are applied to each of them.
• The fourth stage: the process of overall evaluation
The overall evaluation is made based on certain procedures, following
a quantitative and a qualitative evaluation made at the first and thirdstages respectively. Here again, the overall evaluation of credit risk inlonger perspective and that of liquidity risk are separately made. Andthen, both are crosschecked based on the corresponding relation
between the two separate evaluation set by us. JCR’s evaluation system
has the mechanism that activates a warning signal to the credit risk
evaluation, if the liquidity risk heightens to a certain degree.
• The fifth stage: the process of predictive evaluation
At the final stage, a one-year predictive evaluation is made as to thesame items for quantitative evaluation as applied at the first stage,
based on the analyses made at the preceding steps. At the same time, aone- year prediction on qualitative evaluation is similarly conducted aswell. Strictly speaking, the evaluation process from the first to fourthstages, particularly that of quality contains prospective variations in thenear future. Accordingly, there may be duplication in the system.
Knowing that, however, we dare to make the one-year prediction to6

obtain the overall evaluation based on the previous analyses. Thisoverall evaluation obtained under the system is used as the important
tool for assessing the outlook for a credit rating. The evaluation
process at the fifth stage makes it possible to conduct a scenario
analysis. Developments of big events such as the chaebol reform andthe financial system reform in Korea can have great influences on theoutlook 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 of credit ratings to establish a systematic rating methodology.
Changes in the world economic circumstances seem to gather paceincreasingly. This implies that credit rating agencies are required to makeincessant efforts to respond appropriately to such changes. JCR admits that its
rating evaluation system as described above cannot be perfect. To respondbetter to the changing economic circumstance, JCR will continue to makeefforts to improve the system.

7The Multi-Stage
Sovereign Risk Evaluation System

Quantitative Evaluation Process
First Stage

Second Stage

Third Stage

Long-Term Credit Risk
Evaluation

Synthetical Analysis Process

Qualitative Evaluation Process
Long-Term Credit Risk
Evaluation

Fourth Stage

Liquidity Risk
Evaluation

Overall Evaluation Process
Long-Term Credit Risk
Evaluation

Fifth Stage

Liquidity Risk
Evaluation

Liquidity Risk
EvaluationPredictive Evaluation Process8