State Bank of Pakistan has been endeavoring to promote self-discipline in the financial markets of Pakistan through transparency and sufficient disclosure by the market participants. In order to augment our ongoing efforts to maximize disclosure for the benefit of stakeholders and market participants, all banks/DFIs were required to get themselves credit rated with effect from June 30, 2001. The objective was to provide another yardstick to the market participants and stakeholders for informed decision making, promote healthy competition and induce financial institutions to improve their state of financial affairs. This decision was taken after consultations with the representatives of banks/DFIs.

Accordingly, banks/DFIs continuously get themselves credit rated from credit rating agencies on the panel of SBP i.e. banks’/DFIs’ rating is updated from year to year, within six months from the date of close of each financial year. Most of the banks/DFIs have already made their credit rating public through print media and we have also compiled their ratings for the benefit of all stakeholders.

Credit rating is an independent opinion expressed by the professional bodies i.e. credit rating agencies that states about capacity of an entity to meet its obligations and is based on various quantitative and qualitative factors. These ratings therefore, represent the opinions of respective rating agencies and do not reflect the views of the State Bank of Pakistan. Besides they also do not represent investment advice or should be construed as such.

 

Rating & Grading of Public Sector Entities (PSE) in Pakistan: A General Framework

Public Sector Organizations are enterprises potentially affected by extraordinary government intervention in an economic or financial stress scenario. In most cases, the intervention is in the form of support, and the PSE rating is enhanced by the government relationship. Conversely, government intervention could redirect PSE resources to the government and weaken PSE credit quality. Most PSEs are in the public sector and controlled by a government (or governments) through majority ownership. However, some PSEs have little or no government ownership and are PSEs because of their monopoly positions or their roles as systemically important financial institutions, as providers of other crucial goods and services, or as critical employers.

In Pakistan government's actions affect all entities domiciled in its jurisdiction, in some cases directly by methods such as regulation and licensing and in other cases more broadly through the impact of fiscal, monetary, and other economic policies. Sovereign and country risks also play a role in most ratings because of the power of government to shape the operational and financial environments in which corporations, financial institutions, and other entities operate. In addition, supranationals are affected by government policies, but in a fundamentally different manner that involves several or many sovereigns. The subject of this criteria piece is the narrower set of institutions that are either in the public sector (of one country) or in the private sector but could be affected by special government influence in a stress scenario, usually because of their economic importance.

In order to rate PSEs in Pakistan following point shall be considered:

 

1. Classification of PSEs into two distinct categories i.e.: public-policy-based institutions and commercial (or potentially commercial) institutions.
2. Specific consideration of systemically important private-sector financial institutions
3. Rating PSEs above the government and above the sovereign.
4. Foreign currency considerations shall be explicitly addressed.

Criteria and Overview

Pakistani Government relies on market mechanisms more often now than they did in the past. In numerous countries, privatization is on the agenda, but even where it is not, many policymakers are showing a growing tendency to expose government-owned institutions to market discipline. At the same time, in some instances, important private-sector institutions that face operational and financial difficulties continue to benefit from various forms of extraordinary government support.

Despite aligning rating on public-sector entities with the ratings on Government, it is mandatory to focus on the stand-alone credit quality of the PSE and determining the durability of the entity's links with the government. The advantage of this approach is that it is analytically rigorous, forcing consideration not only of the operational and financial aspects of the entity but also the evolution of the relationship with the government. If government support for an entity wanes, signs of government ambiguity emerge, or the government's ability to support diminishes, the rating may be adjusted to rest more heavily on the institution's own debt-servicing capabilities. If the government adopts a privatization program or a more active competition policy, a similar adjustment will occur, taking into account the specifics of the affected institutions. Therefore, abrupt changes in ratings are minimized.

Analysis of the likelihood of extraordinary government influence begins by classifying the PSE on the basis of its public-policy role and integration into the government's operations and finances. All PSEs are rated on the basis of a combination of stand-alone credit quality, which includes all ongoing government support, and the likelihood of extraordinary support. For institutions most closely tied to the government, the significant probability that the government will extend timely extraordinary support in a stress scenario tends to be the crucial factor, and the rating on the entity is linked to that on the government. A rating on a closely tied institution generally differs from that on the government by no more than two rating categories.

Conversely, all private-sector PSEs as well as public-sector PSEs that benefit from supportive government policies and possibly direct assistance but are capable of functioning in a commercial environment, have ratings more closely aligned with their stand-alone credit quality. As with more closely tied institutions, the stand-alone rating includes ongoing government support. The potential for extraordinary assistance in a stress scenario might enhance the rating on such an institution, usually by no more than one or two rating categories. Among the private-sector PSEs in this category are systemically important financial institutions in country where the likelihood of the government providing direct support to a failing institution or facilitating a merger with a stronger institution boosts credit quality. In the case of healthy private-sector banks with no special role in the national economy, the rating enhancement usually does not exceed one notch.

Stand-Alone Ratings Incorporate Ongoing Government Influence

The first analytical step is the determination of the PSE's stand-alone credit quality. A stand-alone rating reflects the PSE's strategies, performance, and prospects, including whatever government support or intervention the PSE typically receives in the normal course of business. However, it excludes credit for any extraordinary government assistance or influence that might be expected in the event of a crisis.

Because the stand-alone rating includes any long-standing government involvement in the PSE's operations or finances as well as consideration of how government influence is evolving, the term "stand-alone" has, at times, caused some confusion. The stand-alone rating focuses on the status-quo environment, including material government influence. Crucially, it is forward-looking in including potential changes in that environment.

Ongoing government influence included in a stand-alone credit rating embraces, in addition to subsidies and capital injections, access to preferential funding, a monopoly position, favorable contracts, and sympathetic regulatory regimes. These are difficult-to-measure forms of support that enhance both operational and financial performance. On the negative side, price ceilings, risky investment-project mandates, and directives to provide loss-generating goods and services constitute forms of government intervention that adversely affect operational and financial performance.

The stand-alone rating provides the clearest view of the contingent liability the PSE poses for the government, aside from economic efficiency considerations. The stand-alone rating identifies the downside, or credit cliff, for the PSE if the potential for extraordinary government support were to dissipate. A key assumption made in determining the stand-alone rating is that the government will not specifically intervene to maintain the solvency or liquidity of the PSE; in other words, the government will not bail out the enterprise in a crisis. Particularly where privatization or reduced government involvement is on the agenda, we make assumptions as to what changes in the entity's capital structure and business focus are likely to occur. This results in a stand-alone rating that is forward-looking and necessarily subjective but that is nonetheless useful in managing the issuer's rating transition to a possible eventual privatization. The analytical process also includes comparisons with similar institutions, both locally and globally.

Extraordinary Government Influence Could Enhance or Impair A Rating on A PSE

The stand-alone rating on the PSE and the rating on the government form the inclusive bounds between which the rating on the PSE lies. Following the determination of the stand-alone rating, consideration is given to extraordinary government influence. Although in most cases, the likelihood of government support enhances the PSE rating, in some cases, government intervention is a negative, potentially draining resources and keeping financial flexibility below what it would be on a stand-alone basis.

In assessing the credit implications of government ownership or the government relationship, we classify PSEs in one of two broad categories:

1. Public-policy-based institutions, which play a central role in meeting political and economic objectives and have credit standings more closely associated with those of their governments.
2. Commercial (or potentially commercial) enterprises, which play a lesser or no public policy role and have credit standings more closely connected to the stand-alone ratings on the PSEs.

The purpose of this categorization is to clarify our thinking about the relationship between the government and the entity concerned. It recognizes a range of relationships that imply varying degrees of government intervention, with different degrees of certainty. Our task is to evaluate the potential government influence and factor it into the rating on the PSE in a coherent and consistent manner.

The strongest form of government influence usually implies alignment of the ratings on the PSE and the government. In most cases, this will mean that the rating on the entity exceeds the stand-alone rating, but for some well-capitalized and well-run institutions, the rating could be below the stand-alone rating. In the latter case, the PSE rating could be seen as being constrained by the government, but of course the relatively strong operational and financial characteristics are themselves the result of government decisions, at least if the PSE is in the public sector.

For policy-based institutions, depending on conclusions about the government's willingness and ability to provide timely support (or take resources), the rating tends to be within two rating categories of the government rating. For more commercial PSEs benefiting from a supportive government, the issuer rating would generally be within one or two rating categories of the stand-alone rating on the entity. In the case of healthy private-sector bank PSEs with no special role in the national economy, the enhancement over the stand-alone rating usually does not exceed one notch. However, in a situation where the stand-alone rating on the PSE and the rating on the government are far apart or where one of these ratings or the relationship between the PSE and the government is changing, the PSE rating could vary by more than these guidelines.

Distinguishing Between Public-Policy-Based and Commercial PSEs

Distinguishing between public-policy-based and more commercially oriented entities can be quite difficult. Most PSEs benefit from supportive government policies and potentially benefit from extraordinary assistance, so they in fact lie on a continuum between these two categorizations. Given the growing tendency of governments to privatize and pursue market-oriented policies, we tend to put entities on the policy/commercial dividing line in the commercial category. For public-policy-based institutions, government influence tends to be a matter of both policy and law, with the latter expressed, in part, through timely or ultimate guarantees (see section below for discussion of guarantees). Commercially oriented entities generally do not benefit from any guarantee and may be in the private sector. Extraordinary government support is possible but less likely than for policy-based institutions. However, government interest and influence might affect the business risks faced by commercial PSEs.

Public-policy-based PSEs

Even when government control is assessed as very strong, support is often less than totally certain, and a rating differential between the government and the PSE might be appropriate. Extraordinary government support is not simply a matter of a positive attitude and supportive disposition. We must be convinced that the government could and would intervene to avoid default by the enterprise. The degree of likely support could be constrained by the number of PSEs and the government's limited capacity to provide support.

Rating distinctions of up to two categories are most common. A rating distinction within a single category of that on the government is generally appropriate when the enterprise benefits from an ultimate (non-timely) guarantee, the government is rated in the 'AA' or 'AAA' categories, the government's relationship with the entity is regarded as stable, the PSE has moderately strong stand-alone creditworthiness, or the number of PSEs is relatively small. A larger rating distinction addresses situations where there is no statutory guarantee, there are many government-related entities with ambiguous or diminishing public policy roles (which, in aggregate, pose a significant contingent financial risk to the government), or the risk of privatization of the rated entity is deemed to be rising.

We consider in assessing the degree of notching for potential extraordinary government influence (within the bounds set by the stand-alone rating on the PSE and the rating on the government) are the following:

1. The government's track record of extraordinary support for PSEs. If untested, what are the government's policies on support, does it have the means, and what mechanisms are in place for diagnosing and responding to financial distress in a timely fashion?
2. The government's track record of burdening PSEs with higher taxes and dividends or other means to boost government resources during a period of increasing political or economic stress.
3. The specific PSE's economic and political importance as well as its ranking in terms of order of importance to the government versus other PSEs and its public policy role compared with similar entities in other jurisdictions.
4. The essentiality of the service the specific PSE provides and the likelihood of other (particularly private sector) entities providing the same products or services.
5. The likelihood of access to the debt markets by the government or related entities being compromised in the event of a particular PSE defaulting as well as the importance of continued, unimpeded access to debt markets for the government.
6. The government's policy and track record regarding privatization, including the government's history of assuming liabilities or re-capitalizing companies upon privatization.

These issues are not always clear-cut and will be weighed within the context of the direction of government policy and the underlying credit strength of the enterprise itself in reaching a final rating conclusion. For some emerging-market governments, support could be more questionable when the legal system and governance is weak and when there are a number of entities relying on such support. In these instances, the PSE rating might be driven more by the inherent credit attributes of the PSE itself. When the government plays a large role in the economy, its support could be diluted, and the ratings on PSEs can rest largely on their stand-alone credit quality, whereby the same PSE in a leaner public sector might benefit from more support.

Notwithstanding the current government policy, the ultimate rating decision takes into consideration the time horizon of privatization risk, the likelihood of a reversal in current policy, and the stand-alone rating.

When is a PSE rating aligned with that on the government?

The rating on a PSE is generally aligned with that on the government when the entity is a government ministry or when the entity either is the source of substantial budgetary revenue, has a constitutionally or legally mandated place in the machinery of government that is difficult to change, and engages in activities that cannot readily be undertaken on a commercial basis. Alignment does not result solely from the entity's policy role or importance but rather from its place in the processes of government. Among the entities in this category are deposit insurance agencies, strategic petroleum reserves, and a number of development banks and export credit institutions. In some cases, the potential for government intervention limits the rating. A government-owned oil company, for example, might have higher stand-alone credit quality than the final rating indicates because the final rating includes the government's tendency to increase taxes and dividends, to require the PSE to provide subsidies, or to restrict the PSE's flexibility in some other way in a period of fiscal or external stress.

Commercial PSEs

Commercial PSEs include an array of government-owned enterprises with lesser or no defined public policy mission as well as private-sector institutions that could be affected by extraordinary government influence. Among private-sector PSEs are systemically important financial institutions in countries with interventionist or supportive governments. Commercial PSEs are generally rated within one or two categories of their stand-alone ratings. In the case of healthy private-sector bank PSEs with no special role in the national economy, the enhancement over the stand-alone rating usually does not exceed one notch. Rating enhancement based on the potential for extraordinary government support reflects situations where government support is possible but is less certain than for a policy-based institution. It also applies to situations where the government could act in an increasingly supportive manner during a crisis and, as such, reduce the business risks faced by the PSE.

In some cases, government officials assert support and pledge to assure avoidance of default, but we may constrain the notching because of doubts about institutional stability, administrative processes, or the ability to diagnose and promptly respond to financial distress. There is also the situation of considerable ambiguity, where the government has a track record of avoiding default by its enterprises, but its official or stated position is one of nonsupport. Ambiguities of this kind generally lead to an analytical approach that puts less weight on the government relationship and more on the enterprise's own credit attributes.

Potential extraordinary government support could rise as the stand-alone assessment falls

Our application of criteria guidelines is dynamic, so a given institution could transition between the policy and commercial classifications and in or out of the PSE category altogether. Evidence leading to greater or lesser confidence in extraordinary government support could vary over time. In particular, the evidence for government support might increase as the financial condition of a corporate or a financial institution (or of an entire financial system) deteriorates. Ratings may accordingly incorporate additional support as the stand-alone assessment deteriorates, braking a slide in ratings that would otherwise occur. Where this happens, the PSE rating may deviate from the normal notching guidelines.

Government Guarantees

Some PSEs have outstanding obligations benefiting from timely, unconditional government guarantees. These guaranteed obligations are most often rated the same as the government. However, the issuer credit rating will not necessarily be the same, despite the level of support indicated by the guarantee. To determine an issuer credit rating (and thus the rating assigned to nonguaranteed financial obligations), the entity is classified as policy-based or commercial, and the appropriate approach indicated above is employed.

Ultimate guarantees generally require the guarantor to meet obligations in full, but only after the resources of the guaranteed entity are exhausted. Issuer ratings for PSEs enjoying an ultimate, rather than a timely, guarantee are also rated in accordance with the methodology outlined above. As already suggested, these entities are generally placed in the policy-based category of PSEs.

When a government guarantee carries conditions, or when the guarantee obligation is timely and ranks equally with the government's own obligations, but administrative and other problems hamper timely service, the guaranteed issuer or issue is rated in accordance with the PSE criteria rather than receiving the government rating. A private-sector entity generally cannot discriminate between obligations with the same ranking, but in the public sector, lags in payments on guarantees do occur, and they rarely result in creditors accelerating other obligations or seeking legal redress.

Rating A PSE above The Rating On Its Government

A PSE may be rated above its government if the stand-alone rating on the PSE exceeds the rating on the government and the government is not expected in a stress scenario to take actions that impair the PSE's credit standing. Rating a PSE above the government under which it operates is not common. The key considerations are:

1. The PSE should be a commercial enterprise operating in a competitive environment. Government linkages, including contracts and liquidity held in government securities, should be minimal.
2. Government control/ownership, which should be materially less than 100% and unlikely to increase, is viewed in a parent/subsidiary context. If the parent (government) is under severe stress, it could demand increasing amounts of cash from the subsidiary (partly government owned-entity). As a result, the PSE should demonstrate significant ability to mitigate this type of government-owner interference through methods such as nongovernment shareholder support, solid governance standards, financial resilience to interference, and a track record of a hands-off approach by the government.
3. The proposed PSE rating should incorporate standard country risk analysis, which includes a review of the business and financial impact of country risk and subjects the PSE to significant stress tests, particularly for rating above the sovereign foreign currency rating. The entity must have the ability to mitigate relevant country risks. Generally, regulated utilities are judged least likely to have such characteristics, and exporters or entities with off-shore operations are most likely.

Rating above the sovereign

Expanding on the last bullet point above, aside from a PSE that is essentially an arm of the government, it is highly unlikely that the potential for extraordinary sovereign support can bring a the local currency rating on the PSE above the foreign currency rating on the sovereign. For sovereign support to provide such enhancement, We must feel comfortable that the sovereign will provide support even as it fails to meet its own foreign currency obligations. More commonly, the rating on the PSE exceeds the sovereign foreign currency rating only if the stress-tested, stand-alone PSE rating exceeds the sovereign foreign currency rating. Stress tests normally involve sharp currency depreciation, higher inflation, economic contraction, and rising real and nominal interest rates as well as reductions in government support, higher required reserves and other taxes, increases in regulatory risk, and nonpayment of government obligations.

When we rate an issuer or specific obligation above a sovereign, it is expressing its view that willingness and ability to service debt is superior to that of the sovereign and, ultimately, that if there is a sovereign default, there is a measurable probability that the issuer or issue will not default. Sovereign stress/default often creates very difficult situations, and rating entities above the sovereign requires consideration of stress scenarios. Among PSEs, commercial entities with strong operating and financial characteristics, geographically diversified business, and modest holdings of government debt are the best candidates, particularly where the sovereign itself tends not to be very interventionist.

Financial institutions are usually not rated above the sovereign foreign currency rating
Financial institutions usually have neither local nor foreign currency ratings above the foreign currency rating on the sovereign because of:

1. The bank's overall credit exposure to the general economy, the performance of which is likely correlated with sovereign creditworthiness.
2. The threats of negative intervention, such as a deposit freeze in a sovereign stress scenario.
3. However, a sovereign stress scenario could be considerably less grim for a monetary union member in that depreciation is likely to be less harsh and inflation less severe, suggesting greater scope for rating above the sovereign. Government-owned banks are least likely to be rated above the sovereign. Banks are typically among the most harshly affected by a sovereign default or distress scenario, and government-owned banks frequently are affected more than private-sector ones

Foreign Currency Considerations

The criteria outlined so far focus on the methodology for assigning local currency issuer credit ratings. Foreign currency considerations introduce several dichotomies:

1. If the related government is not a sovereign, the foreign currency rating on the PSE is the lower of its local currency rating and the transfer and convertibility (T&C) assessment for the country of domicile. The T&C assessment is the rating associated with the probability of the sovereign restricting non sovereign access to foreign exchange needed for debt service.
2. If the related government is the sovereign and the PSE is a policy-based institution, the foreign currency rating on the PSE is either the local currency rating on the PSE or the sovereign foreign currency rating, whichever is lower. The latter constraint is not the T&C assessment because a sovereign can interfere with policy-based entities it owns or supports in a variety of ways without resorting to T&C restrictions. T&C restrictions are normally designed for non sovereigns. A local currency PSE rating that is based on the potential for extraordinary sovereign support and exceeds the foreign currency rating on the sovereign (but never the local currency rating on the sovereign) addresses just the PSE's capacity for meeting local currency debt-servicing requirements. The reason that the sovereign local currency definition applies here is because policy-based institutions are in large part agents of the government.
3. If the related government is the sovereign and the PSE is a cinstitution, the foreign currency rating on the PSE normally is the local currency rating or the T&C assessment for the country of domicile, whichever is lower. The PSE local currency rating can exceed the sovereign foreign rating only if the PSE's stand-alone assessment exceeds the sovereign foreign currency rating and the potential for negative intervention is viewed as low. The best candidates among PSEs are sound oil companies playing no policy role and strong private-sector institutions, where the sovereign is not expected to act in ways that specifically diminish these PSEs' flexibility in a time of sovereign stress.

Sovereign local currency ratings are higher than foreign currency ratings (in many instances) because of the unique power of sovereigns to create local currency and thus meet all local currency obligations. A variety of considerations sometimes prevent sovereigns from doing so, though sovereign local currency defaults are infrequent and rather nuanced. In each of the last 25 years, sovereign foreign currency defaults have exceeded local currency defaults by more than 5%. This is compelling evidence supporting higher sovereign local currency ratings and, by extension, higher local currency ratings for PSEs that are essentially arms of the government. Such marked differentials do not exist for non sovereigns because of their inability in many circumstances to distinguish among equally ranking obligations, aside from the situation where the sovereign restricts access to foreign currency.

Summary Conclusion

Broadly categorizing PSEs in accordance with the nature and stability of the relationship with the government enhances the predictive power of PSE credit ratings. This approach addresses the variations in the nature of the relationships between governments and PSEs while recognizing the ongoing evolution of these relationships. Relationships between PSEs and governments are often unclear or seemingly contradictory. Some governments have a clear track record of supporting certain entities, even though the stated policy is one of nonsupport. Some governments treat their enterprises badly, refusing price increases or imposing unprofitable tasks. This sometimes implies acute credit risks, while at other times it reflects and deepens the government's moral obligation to the entity. Governments often deal with PSEs arbitrarily, precisely because they are likely recipients of extraordinary government assistance and do not necessarily need strong financial profiles to continue to trade and access financial markets. Our task is to evaluate the relationship, while recognizing that extraordinary government support/intervention is not a black-and-white issue.

Mr. Imran Aziz, CEO RAD Federation Contributed to this article with other team members and experts.

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