THE IMPORTANCE OF A RATING INSIGHTS AND METHODOLOGY

1
THE IMPORTANCE OF A RATING INSIGHTS AND
METHODOLOGY

• Tertius Smith
• Managing Director
• 5 April 2006

2
Credit Ratings Explained

• A credit rating is an expression of our opinion
  of the ability of an entity or securities issue
  to meet its financial commitments timeously and
  in full.
• Ratings apply to a variety of entities and issues
  across a broad range of sovereigns and entities.
• Ratings are based on independent research,
  obtained in an unbiased manner.
• They provide investors with an indication or
  measure of relative credit risk.

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Credit Ratings Explained

• Investment grade ratings indicate a relatively
  low probability of default.
• Speculative or non-investment grade ratings
  either indicate a high probability of default, or
  that default has already occurred.
• Ratings imply no specific predication of default
  probability. Rather the actual defaults provide a
  measure of proof of the relevance of the rating
  scales.

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What is an Investment Grade Rating?

• Under the Fitch rating scale, ratings from
  BBB- to AAA are Investment Grade which
  denotes low expectation of credit risk. AAA
  rating, probability is almost nil
• Investment Grade ratings encourage creditors to
  include such ratings in their credit or
  investment portfolios. The higher the rating,
  the better and easier access to financing
• Ratings from C to BB denote the probability
  of credit risk, increasing exponentially with
  each lower level that is to say, these are
  speculative ratings

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Rating Definitions(No correlation implied)
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Long Term Average Annual Global Corporate
Cumulative Default Rates ()
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National Scale Ratings

• These provide a relative measure of
  creditworthiness for rated entities only within
  the country concerned.
• In SA all these ratings have a suffix of (ZAF).
• These ratings use the same letters, ie.
  AAA(zaf) and F1(zaf).
• National rating scale is not based on default
  probabilities.
• Merely ranks the degree of perceived risk,
  relative to the best credit risk in that same
  country.

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Importance of Ratings

• Enables better access to debt capital markets
  funding
• Broadens investor base
• Enables business opportunities with credit
  sensitive counterparts
• Enables investors and counterparts to benchmark
  their credit risk within sectors, industries and
  geographies
• Enables a company to benchmark itself against
  others
• Demonstrates transparency and discipline
• Enhances visibility and profile

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General Rating Methodology

• Standard Analytical Considerations
• Issue ratings incorporate multiple factors
  seniority, structural subordination and
  collateral position, timeliness of payment and
  expectations of recovery
• Qualitative Factors
• Industry Risk
• Operating Environment
• Market Position
• Legal and Regulatory Issues
• Corporate Governance
• Management
• Accounting

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General Rating Methodology(Continued)

• Quantitative Factors
• Cash Flow Focus
• Earnings and Cash Flow
• Capital Structure
• Financial Flexibility
• Coverage Ratios
• Leverage Measures
• Profitability
• For Structured Finance, integrity of legal
  structure and quality of assets are primary
  concerns
• Type of asset
• Quality of asset
• History of asset
• Servicer and Servicing

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Subnationals - In General

• Institutional framework
• Socioeconomic profile of the area
• Public finances
• Debt position

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Subnationals- Some detail

• Economic and Financial Indicators
• GDP or income per head
• Growth of local income per head
• Overall budget deficit
• Balance of current revenue and expenditure
• Character of the local economy
• Total public debt relative to regional GDP
• Total public debt relative to revenues
• Interest cover
• Total financing requirement in current term
• Proportion of revenue raised from external sources

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Subnationals- Some detail

• Judgmental factors
• We require an expectation of continuing good
  government
• Political situation
• Permanent employees
• Evaluation of the stability and diversity of all
  revenue sources
• Marketability of the authoritys assets

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Institutional Framework
Centralised/Decen.
Transfers
Stability
Funding
PoliticalPriorities
FiscalImbalance
Pol. Inst
Equalisation
Responsibilities
PrudentialRules
Audits/Control
Framework
Control
Control
Funding
Authorisation
Reporting
Pol. Inst
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Economy
GDP Per Cap
Natural Growth
Age Structure
Growth
Income Per Cap
Wealth
Demog.
Diversity/ Concentration
Migratory Balance
Activity Rate
Structure
Socio-Economic
Labour
Wealth
Labour
Unemploy Rate
Trend
Demographics
16
Political Environment

• Composition of local assembly whether there is
  a majority, consensus or sharp disagreements
• Policies and intentions i.e. affecting spending,
  revenues or both
• Relationship with the central government and
  other tiers of government

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Budgetary Framework and Control

• Accounting policies used (cash or accruals) and
  Statement of Accounting standards.
• Consolidation of municipal companies and entities
• Distinction between capital and current revenues
  and expenditure
• Control, audits and inspection internal an
  external
• Frequency and accountability
• Budget reforms
• Balance sheet, fund flow statements, payable and
  receivables
• Recognition of cash and expenditure

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Macro-economic analysis will enable us to assess

• Relative weight of the subnational vis-à-vis
  other levels of government
• Tax base and growth potential
• Vulnerability
• Expenditure pressure

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Fiscal Performance
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Revenues

• Financial analysis begins with a review of the
  issuers financial statements and accounting
  policies. A balance sheet disclosing cash
  balances, intra-government borrowing (among
  various related entities of the subnational
  authority), and assets and liabilities would be
  an ideal starting point. Lack of financial
  information can limit the credit rating.
• While Fitch prefers financial statements audited
  by an independent and reputable accounting firm,
  it is understood that many governments cannot
  provide them. Fundamentally, budgetary
  presentations of fiscal performance are
  inadequate but often the most commonly available
  form of financial disclosure worldwide.
  Generally, the greater the quality of the
  financial disclosure, the better the results of
  the rating process.

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Current Revenue

• Trend and composition
• Flexibility through tax setting powers
• Composition
• Taxes or transfers
• Earmarked transfers or general
• Horizontal or vertical equalisation close or
  open
• Analysis of other revenues including interest
  income

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Analysis of tax revenue will cover

• Taxpayer composition for major tax sources
• Description of each tax and rate-setting powers
• Level of tax and other revenue arrears
• Proportion of revenues and expenditures
  received/paid as barter rather than cash
• Basis for allocation of transfers to the issuer
  from the central administration (formula versus
  negotiation)
• Detail on non-recurring revenue sources, revenue
  from municipal companies and dividends

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Capital Revenue

• Sources of capital revenues and predictability
• Tied or not tied (usually tied)
• Asset sale or sale of companies or shareholdings
• Valuation of assets or companies
• Ease of realisation

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Current Expenditure

• Description of main expenditure responsibilities
  and cost drivers (e.g. number of teachers/pupils
  in the case of education)
• Analysis of protected and unprotected
  expenditures
• Trends
• Structure and composition
• Staff numbers (both directly employed and
  employed by municipal companies)
• Type, nature and beneficiary of transfers
• Outsourcing of services
• Payments which are debt like in nature
  (concessions, shadow tolls, leasing)

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Capital Expenditure

• Link with political directives
• Small number of large projects or large number of
  small projects
• Accounting for work in process
• Committed expenditure
• Investment policy
• Audits and control of capital expenditure
• Major areas of capital expenditure and assessment
  of future pressures on current expenditure

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Budgetary Performance and Ratios

• Budgetary performance is analysed through a
  number of ratios. Ratio analysis is an important
  part of Fitchs assessment. It allows us not only
  to measure performance against the past but also
  to project performance in the future. Also it
  enables the entity to be compared to other rated
  entities.

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Fiscal performance ratios can tell us

• Type of responsibility of a subnational
• Control of expenditure
• Buoyancy of revenues
• Possibility of absorbing unexpected expenditure
• Ability to finance capex from own sources
• General fiscal discipline

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Revenue ratios can tell us

• Buoyancy
• Impact of performance of the local economy on
  revenues
• Accuracy in budget revenue forecasting
• Reliance on funding from central government
• Predictability

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Expenditure ratios

• Rigidity
• Accuracy in expenditure budget forecasting
• Ability to implement capital expenditure
• Overall level of decentralization
• Responsibilities
• Expenditure burden on the local population

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Debt ratios can tell us

• Debt coverage and protection
• Analysis of present debt against prudential
  limits, if any
• Debt burden
• Overall public sector risk
• Debt weight in relation to per capita and
  economic strength
• Possibility of repaying out of own
  liquidity/sources

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Finance and Liquidity
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Debt

• Trend and projection
• Currency, structure, composition
• Repayment peaks in the future and rollover risk
• Lender (multilateral, bilateral)
• Conditions and policies for repayment
• Debt management experience
• Date, amount and circumstance of default, if any
• Centralisation debt and approval process
• Trade debt and payables
• Derivatives, swaps, hedging

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Indirect Risk

• Assess reliance on municipal companies (both
  ways)
• How are these companies funded
• Debt levels of these companies
• Guarantees issues by the subnational and
  experience of execution of these guarantees
• Any risk stemming from off-balance sheet
  activities

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Ways of Measuring Indirect Risk

• The subnational has had to assume debts in the
  past from agencies or companies - an indication
  of financial and liquidity problems of non-
  consolidated entities
• There are large unexpected transfer payments
  (more than budgeted amounts) to particular
  agencies and companies, often indicating
  bail-outs
• There are large transfers from the companies
  recognised as revenue or dividends by the central
  administration, which may imply dependency
• The agencies and companies are fulfilling
  important functions usually ascribed to the local
  authorities

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• Liquidity is an eventual part of our credit
  analyst particularly for emerging credits where
  tax non-payments and offset can seriously
  negatively impact the ability of a subnational to
  fund its debt

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Ways of Assessing Liquidity

• Cash balances and treasury, both year end and
  average for the year
• Bank deposits (type, where deposited, period of
  notice)
• Where it is held and if there are any
  restrictions for accessing these
• Liquidity back-up facilities, particularly if
  there is a large debt repayment due
• Investment policies for excess liquidity