subnational debt market constitutes a key component of the capital markets.<sup>8</sup> It is important therefore for potential lenders and investors such as multilateral agencies, commercial banks and private sector participants in the international capital market to understand how the rating agencies conduct their subnational creditworthiness analysis. At the policy level, such understanding helps contribute to policymakers’ broader fiscal reform programs.

This paper attempts to provide an understanding of the methodologies used by the three major international rating agencies (S&P, Moody’s and Fitch) in assessing the creditworthiness of subnational governments.<sup>9</sup> All three rating agencies share the general approach of deriving the final score for rating from a matrix of quantitative and qualitative factors covering economic, fiscal, financial and institutional factors. Understanding how these variables are used and how they may differ among the agencies allows us to better appreciate what constitutes a sound subnational credit standing. It also contributes to the development of a comparative database for fiscal monitoring. This paper will also discuss other major issues and challenges related to subnational credit ratings, such as the importance of sovereign factor as a determinant of subnational credit ratings, changes in the methodologies as a result of risks from indirect debt and off-balance-sheet financing, and the required governance and institutional reforms for a robust rating system and fiscal monitoring.

The paper is organized as follows. In section 2 we review and compare the rating process for subnational governments, the key variables considered when assigning a subnational rating, and the similarities and differences among the rating approaches used by the three major rating agencies. Section 3 analyzes the benefits and limitations of subnational credit ratings. Section 4 looks at the interaction between sovereign and sub-sovereign ratings and the binding impact of the sovereign rating on the ratings of sub-sovereign credits. Section 5 discusses important changes in subnational rating methodology that took place in the last decade and the reinforced focus on debt profile and contingent liabilities following the financial crisis. Section 6 discusses challenges of subnational credit ratings in developing countries. Section 7 concludes the paper.

# **2. The Rating Process and Criteria**

The credit rating of a subnational government represents a formal opinion of the subnational government’s capacity and willingness to repay commercial debt obligations in full and on time. Each rating agency follows a certain procedure in deriving the final rating for the subnational government being rated.<sup>10</sup> The key forum for decision making is the rating committee, which is made up of a group of experienced analysts who are familiar with the creditworthiness conditions in the rated entity. The rating is decided by votes after the deliberation of the committee.

At the core of the rating analysis is a matrix of political, economic, budgetary, financial and institutional variables deemed relevant to the subnational government’s creditworthiness. All

> 8 For example, in the United State, sub-sovereign bond accounts for 26 percent of public sector debt and 10 percent of total public and corporate debt (Liu and Waibel 2008a).

> 9 The World Bank (1999) provided some information on, but not a comparative review of, the subnational credit ratings. Since 1999, rating methodologies have gone through significant changes.

> 10  See Bhatia (2002), Hilderman (1999), S&P (2009), Moody’s (2008a), Fitch (2008b).

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