The committee will have to ensure that the rating accorded to a subnational government fits in meaningfully with the whole universe of subnational governments that the rating agency has rated. The rating of a subnational government within Argentina, for example, will have to be consistent not only with those of other Argentine subnational governments but also subnational governments in other emerging economies that are in a similar state of development as Argentina. At the same time, the rating committee has to ensure that changing creditworthiness conditions over time in all the rated subnational entities are taken into account. As Bhatia (2002) noted, shifting peer comparison is often necessary, and “although the ratings are measured of absolute creditworthiness, in practice, the rating exercise is highly comparative in nature” (p. 12).

Qualitative factors and subjective judgment have a role in the rating process for issuers both in the developed and developing countries. The objective data are evaluated in light of the possibility that some other factor – a changed legal framework, a different revenue allocation, a new spending responsibility – may be introduced and put the past patterns at risk. Such other factors are more acute in emerging markets.

The policy making process is often less transparent and the likelihood of frequent policy changes much stronger in developing countries than in developed countries. There is a much higher degree of variability in policy outcome. Such variability is often driven by the changing balance of political power (both across regions and within the same subnational entity) and changing personalities at the policy-making scene. A good understanding of the policy-making environment and the personnel involved is therefore critical to the assessment of the subnational creditworthiness in developing countries. Because these factors add to uncertainty and risk, the rating agencies respond by assigning ratings that incorporate the added uncertainty.

Many developing countries started decentralization only in the 1990s, and the intergovernmental fiscal system is still going through adjustment, sorting out revenue allocation and spending responsibilities, and redefining the legal framework. In countries where the intergovernmental fiscal arrangements change unpredictably, where policy reversals are regular occurrences, and where the subnational government often has to contend with one-off changes in transfers and spending responsibilities, it would be difficult to make reliable medium-term forecasts of the subnational government’s fiscal capacity and hence credit ratings. In some countries where the intergovernmental transfers are based on some formula, on-going periodical negotiations between the governments are a rule rather than an exception. Often, the outcome of the negotiations is driven by the relative political powers of the tiers of governments.<sup>29</sup> Continuously evolving legal and regulatory frameworks create uncertainties about the binding nature of the commercial agreements and covenants of the subnational debt. Laws on subnational debt repayments are often not sufficiently clarified. In some countries, laws are changed without respect for grandfathering or protection of existing contracts signed under the previous legal framework. More generally, the irrevocability of the security pledge may be called into question when the local government faces fiscal crisis.<sup>30</sup>

> 29 This part draws heavily from S&P (2004). 30

> For a review of cross-country experiences in subnational insolvency mechanisms, see Liu and Waibel (2008b).

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