management tools currently under discussion (such as risk‐based guarantee fees, the provisioning for financial losses in the budget, and proactively dealing with elevated risks).

Initially, NTSA started converting internal risk ratings into probabilities of distress. As NTSA does not have an internal data base of historic credit events for SOCs it is exposed to, it relies on third‐party information. First, NTSA assigns an internal credit rating on a scale from one to nine (described in Chapter 2.b.). Second, the internal credit score is translated into a credit rating on rating scales used by rating agencies. An internal conversion table is used (Table 5). The proper conversion of risk ratings from an internal to an external scale is a key factor in this process and it is dependent on the experience of credit analysts and a robust rating methodology.

For example, an internal credit score of five translates to a credit rating of Ba2 on Moody’s rating scale. Third, PDs are inferred from Moody’s published default frequencies by rating and time horizon (Moody’s Investor Service, 2018).<sup>24</sup> Moody’s default frequencies are adjusted as the definition of credit event at NTSA differs from Moody’s.<sup>25</sup> Table 6 illustrates probabilities of initial distress by rating and time horizon adapted to the South African context (i.e. probabilities of Eskom being in distress in a given year for the first time, and not having experienced distress in any previous year). In addition to PDs based on the historic and expected performance of Eskom, NTSA will also use results from stressed scenarios (discussed in Chapter 2.b.) to infer stressed PDs.

**Table 5: Table matching internal credit ratings and Moody’s ratings**

|**Internal risk ratings **|**Moody's ratings**|**Rating definitions**|
|---|---|---|
|1<br>2<br>3<br>4|Aaa<br>Aa2<br>A2<br>Baa2|Highest credit quality with the smallest degree of risk<br>High credit quality and are subject to low credit risk<br>Upper-medium grade and are subject to moderate credit risk<br>Mediumgrade and are subject to moderate credit risk|
|5<br>6|Ba2<br>B2|Obligations have questionable credit quality<br>Obligations are speculative and subject to high credit risk|
|7<br>8|Caa2<br>Ca|Obligations are of poor standing and subject to very high credit risk<br>Obligations are highly speculative and are usually in default on their obligations|
|9|C|Obligations are lowest rated class and are in default|

_Source: National Treasury of South Africa_ NTSA is currently working on estimating the economic value of guarantees; at the moment, the annual expected losses are calculated for a three‐year period.

Annual expected losses are the product of exposures, PDs, and loss given default (LGD). NTSA is using annual debt service payments to represent exposure,<sup>26</sup> and annual PDs derived from PD tables (such as Table 6). LGDs depend on the ability of the government to recover payments made under a guarantee

> 24 The time horizon chosen will depend on the objective. It may be the entire maturity of the loan or bond guaranteed or a shorter period for fiscal planning.

> 25 In Moody’s default frequency tables, an entity defaulting in year one is no longer represented in the sample of entities in year two (i.e. it can only default once). However, in the context of South Africa, entities may experience a credit event in year one (and the government steps in to make a periodic debt service payment) and may or may not experience a credit event in year two (see Chapter 2.a. for a discussion of the definition of a credit event).

> 26 Consistent with its definition of a credit event.

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