transparency, there are two direct benefits for subnational governments to utilize independent credit ratings – a good track record of creditworthiness allows subnational governments to raise funds in the capital market and to reduce the cost of capital. However, there are also limitations on the effective interpretation and use of credit ratings. Below we summarize both the benefits and the limitations.

# **3.1  Accessing Capital Markets**

The main reason for subnational governments wanting to seek a formal rating is the ability to raise funds directly in capital markets. If the experience of sovereign ratings is anything to go by, the ability to establish a good track record in creditworthiness could indeed affect the pattern of capital flows to and the dynamics of economic growth in developing countries. In many emerging East Asian countries, for example, the fast pace of economic development before the 1997 financial crisis was in no small measure attributed to the vast inflows of foreign capital inflows. The credit ratings that many of these economies obtained, with a number of them being rated investment-grade and above (e.g., Malaysia, South Korea, Thailand and Indonesia), were a key contributor to such capital flows.

Securing a formal investment-grade rating could help attract capital inflows and substantially lower borrowing costs as the ratings have a major impact on yield spreads. Having a sound rating expands the range of institutional investors available to the subnational borrower. With the financial crisis, investors are likely to prefer to invest in instruments with substantially lower risks.

While credit ratings are required to access the international capital market, the reasons for getting a credit rating vary based on the rules of each domestic market. In Colombia, ratings are necessary for regulatory purposes. In Argentina, ratings are voluntary and are used as a disclosure gesture to inform investors.<sup>15</sup> In Mexico, although subnational participation in the credit ratings is voluntary, the requirements of the capital-risk weighting of bank loans introduced in 2000 and of loss provisions introduced in 2004 aim at imposing subnational fiscal discipline through the market. China is piloting S&P’s credit ratings of municipal investment companies owned by Chongqing municipality (population 31 million), to establish a benchmark for market-based monitoring of municipal companies.

Major investment banks in the world makes regular assessment of a country’s sovereign risks but it does not translate such risk assessment into a rating that can be used for cross-country comparison. Neither does it provide similar risk assessments for subnational governments. Moreover, to meet market demands, most of them focus on short-term analysis, with relatively little attention being given to medium- and long-term risk assessment. A major problem with these risk assessments is their perceived bias, i.e., they are not seen to be independent of the commercial interests of the banks.

The outcome of the rating agencies’ assessment of a country’s sovereign risks, on the other hand, is translated to a specific rating which allows investors to make comparisons across countries and over time. Such comparisons are essential in pricing the debt. The ratings are updated regularly

> 15 World Bank (1999), chapter 6.

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