1 Chapter I Introduction I.1 Background I.1.1 Credit Risk and Sovereign Risk In fulfilling the financing gap for the country’s development, including general government operation, which mainly occurs in developing countries, sovereign debt is issued to generate alternatives source of funding. Most countries issue a combination of bonds, bills, and notes, and their debt structure is based on market conditions and government policy. In the immense majority of the world’s current debt capital markets, national governments are the largest borrowers, and their credit standing provides a benchmark for other debt issuers. It makes sovereign bonds and ratings increasingly crucial as countries tap the international bond markets, including Indonesia as a developing country. As one of the most desirable types of international investment, which a government issues, sovereign bonds have specific risks associated with that is sovereign risk. Canuto et al. (2012) defines sovereign risk as the credit risk related to operations involving the credit of sovereign states and explain that the risk agencies’ ratings are severe, public domain indicators that contribute to reducing investor uncertainty related to the risks that involve government securities. Figure I.1 The need for managing country’s sovereign credit rating 2 I.1.2 Credit Rating and Policy Implications Financial transactions basically call for information asymmetries to exist between investors and borrowers. Borrowers need to be more well-informed about their willingness to pay and payment capacity than the resource providers. Asymmetry will affect the premia from the credit risks which as part of any credit and securities operation from the creditor’s point of view. Financial transactions come to realisation only when the means are in place to lessen the information asymmetries negative weight: gathering and processing information before the operations, formulating contracts, and supervising execution of these to monitor the use where the funds are put after they are transmitted; introducing guarantees to reduce losses in cases of debtor default or failure, thereby increasing a debtor’s preparedness to pay, etc. While costs are attached to such mechanism, the relevant mechanisms are not always adhered to strictly enough to avoid hindrances. In cases where there are no legal and judicial or institutional instruments to underpin compliance with contracts and exercise of guarantees, information asymmetry and the premia charged as compensation for the credit risks increase and, in the worst case, render financial transactions unviable. As for the private and public credit risk rating agencies and institutions are in a position to assemble and process information in advance of operations. Whether as information-generating facilities for exclusive use within a particular economic group or as providers of services for clients, agencies develop specific skills and benefit from economies of scope and scale in the business of analysis and credit risk rating. This approach endows them with their motivation and makes them a viable proposition from an economic standpoint. In short, agencies specialized in providing ratings as a commercial product have become a necessary factor for ensuring that the supply of financial resources in any economy is not confined to banks - institutions that possess special expertise in assembling and processing information regarding the status of their clients, with whom they maintain close relationships as an intrinsic part of their commercial operations. Given the remote and impersonal nature of the relationship between investors and borrowers - which differentiates banks from capital markets 3 (shares and credit instruments negotiable in secondary markets) - the development of the latter calls for the services of risk-rating firms. Within this context, a particular risk is “sovereign risk” - credit risk associated with operations involving credit for sovereign states. Moreover, the determinants for payment capacity and willingness to repay debt are different, reflecting macroeconomic variables such as the available stock of foreign currency reserves and balance of payments flows, economic growth prospects and capacity to generate tax receipts, a variety of political factors, etc.