Guidelines on Local Government Borrowing and Recent Developments in South East Europe
5. Improving Financial Management Performance

5.2. Credit Rating

Local governments could improve their financial management performance by applying for an external credit rating. A credit rating is an opinion assigned by Credit Rating Agency on the ability and willingness of an issuer to make timely payments on a debt instrument over the life of that instrument. By obtaining the credit rating, the local government will better understand what the main determinants of its creditworthiness are and can decide what changes are needed to improve its credit risk profile and thereby reduce its borrowing costs.

Three major firms now provide this service for regional and local governments in South East Europe: Moody's Investors Service, Standard and Poor's and Fitch. Long-term bonds of the highest quality are rated "Aaa" by Moody's and "AAA" by Standard and Poor's and Fitch. Issues rated below "Baa" by Moody's and below "BBB" by Standard and Poor's are considered below investment grade. A separate set of ratings are used for short-term notes.

Table 11: Moody's Long-term Debt Ratings (maturities of one year or greater)

Investment Grade Aaa – "gilt edged"
Aa1, Aa2, Aa3 – high-grade
Baa1, Baa2, Baa3 – medium grade
Speculative Grade Ba1, Ba2, Ba3 – speculative elements
B1, B2, B3 – lack of characteristics of a desirable investments
Caa1, Caa2, Caa3 – bonds of poor standing
Ca – highly speculative
C – lowest rating, extremely poor prospects of attaining any real investment standing

Moody's Short-term Debt Ratings (maturities of less than one year)
Prime-1 (highest quality)
Not Prime (can be thought of as speculative grade)

The rating process:

Local governments approach Credit Rating Agency

Application with specific financial information related to the local governments' activity is sent out to the Credit Rating Agency.

Credit Rating Agency analyses the local governments' application along with the local and national economic conditions and assigns a credit rating to the local government. As a rule, the credit rating of a local government cannot exceed the country's sovereign rating.

After the initial rating, the Credit Rating Agency reviews periodically the rating to take into account the latest financial and economic information related to the local governments' position.

Important definitions pertaining to the rating process16:

Rating outlooks: These are opinions regarding the likely direction of an issuer's rating over the medium term, generally 18 months. Outlooks fall into 4 categories: positive, negative, stable, developing;

Rating review: A credit is placed on the watch list when it is on review for pos- 16 Moody's Investor Service – Rating Methodology 57 sible upgrade, or on review for possible downgrade, or (more rarely) on review with direction uncertain. A formal review is normally concluded within 90 days;

Confirmation of a rating: If after a formal review a rating committee decides not to change a rating, the rating is said to be confirmed.

Benefits of a credit rating for a local government:

Access to a broad number of potential investors, thereby reducing the local government's borrowing costs as competition will increase;

Independent opinion on the future ability and legal obligation of an issuer to make timely payments on its financial commitments;

Independent estimation of the current municipal credit condition and future revenue and expenditure scenarios based on budget trends and budget projections;

Diagnosis of the basic risk factors that contribute to the creditworthiness condition and identification of the critical risk areas that may threaten the ability of the local government to make timely principal and interest payments on their debt obligations;

Objective assessment of important municipal financial operations of critical concern to mayors, municipal councils and citizens;

Increased transparency and accountability of municipal operations.