By Arend Kulenkampff, Innovative Finance Lead at NatureFinance
As climate and commodity shocks escalate, reliance on opaque governance indicators threatens to worsen distortion in sovereign debt markets.
It’s easy to forget that not too long ago the world seemed poised for a sovereign debt crisis in low- and middle-income countries (LMICs). The issue has receded as geoeconomic tensions have dominated global risk concerns, pushing debt crises to 17th place in the World Economic Forum’s latest survey of global risks.
The funding environment has turned out to be more benign for public borrowers from LMICs. Several have re-entered sovereign debt markets (e.g., Ivory Coast, Benin) as global interest rates have come down and global capital flows have picked up. The sovereign credit rating agencies (CRAs)—gatekeepers of international capital markets—have validated this shift in sentiment with upgrades and positive outlooks. The credit cycle appears to have bottomed out.
The liquidity reprieve may prove short lived, however. The war in the Gulf comes against the backdrop of precarious fiscal financing conditions.Debt levels remain at historic highs; debt servicing burdens continue to eat up large shares of public budgets, and several LMICs are still working through protracted restructuring processes. According to the World Bank’s International Debt Statistics, more than half were classified as facing high debt risk or in debt distress in 2024 (the latest year for which complete data are available), up from less than a quarter in 2013. The LMIC sovereign debt crisis simmers on.
And there are ominous signs that the prodigious sovereign debt burdens of advanced economies are reaching tipping points. Extraordinary budget deficits, gyrations in Japanese yield curves and UK gilt markets, leverage in US treasury repo markets, and hidden systemic risks in dark corners of the financial system suggest that stress is building up under the bedrock of the international financial system. As pressure to boost spending on defense, energy, and industrialization intensifies, and as the fiscal costs of climate shocks and nature loss crystallize, handwringing about public debt sustainability and sovereign creditworthiness may soon spread beyond emerging markets to major creditor countries. If these pressures boil over, the assumptions and judgements encoded in sovereign risk models will matter as much for Paris and Washington as for Accra or Nairobi.
When it does, sovereign credit rating agencies will again be thrust into the spotlight—much as they were during the 2008 Global Financial Crisis and the 2010 Eurozone sovereign debt crisis. The “Big Three” CRAs—Fitch Ratings, Moody’s, S&P Global—rely heavily on subjective expert judgement for assessments of governments’ “willingness and ability to pay,” inviting accusations of error and bias and contributing to punishing risk premia on certain Eurozone government bonds.
Sovereign ratings are still mostly judgement calls
Intense scrutiny over how ratings are determined led CRAs to document and disclose detailed rating criteria and methodologies. These combine quantitative metrics like debt ratios and economic growth rates with qualitative factors such as “governance” and political risk scores. The latter assess the “institutional quality” of government bureaucracies as a measure of their “willingness” to prioritize debt service and ensure debt sustainability. Because such assessments are by their nature ambiguous, Fitch and Moody’s turned to the World Bank’s Worldwide Governance Indicators (WGIs) for objective benchmarks.
WGIs are perception-based indicators that score countries on themes such as political stability and regulatory quality by drawing on 30+ expert assessments and public opinions.
Yet appealing to “objective” third-party assessments obscure the fact that the WGIs are themselves based on subjective and opaque inputs, plus they include variables that have little bearing on sovereign creditworthiness. Recent analysis by NatureFinance examining this qualitative layer of sovereign credit ratings shows how such perception-based indicators can materially influence final rating outcomes.
To illustrate the point, consider one of their sources – the Bertelsmann Transformation Index – which assigns Brazil a score of 1 out of 10 for “conflict management” — below countries such as Haiti (3), Libya (2), and Somalia (2). This feeds directly through to the country’s foreign currency sovereign credit ratings (under Fitch’s model), which in turn influences the interest rates for the economy as a whole. And like credit ratings themselves, the WGIs have become encoded in a wide variety of other country risk scores and measurements, including the pricing of export credit insurance. Hence, errors and omissions on qualitative scoring can have far-reaching consequences. This asymmetry between the formulaic portrayal of rating criteria and the reality that rating decisions are largely a judgement call by a handful of analysts has not been lost on LMIC issuers. Complaints that the Big Three credit ratings agencies are distorting the risk perceptions of sovereign debt investors and driving up borrowing costs for Sub-Saharan Africa have been widespread and growing louder. It was a reason Afreximbank cited in their decision to cancel their Fitch rating in January.
Critics of these complaints argue that lower LMIC ratings are due more to structural reasons like the size of the economy than the bias of individual analysts. Others point the finger at gaps in fiscal transparency and data quality. Those things matter, and work is certainly needed to plug gaps in the quality of macro-fiscal statistics. Yet qualitative considerations far outweigh the quantitative numbers crunching in sovereign credit assessments, so fixing the former is likely to generate far more “uplift” for under-rated sovereigns. In practice, qualitative judgements dominate final rating outcomes—making their calibration the single largest lever for correcting mispricing.
There are a handful of concrete and highly actionable reforms that can help fix these flawed metrics and stop distorting sovereign debt markets to the tune of billions of dollars each year:
1. Getting institutional assessment right
Institutions matter a lot for sovereign risk analysis. Hard data and quantitative analysis alone cannot capture the complexity of the decision-making machinery that impels some governments to default. Qualitative analysis will remain central to sovereign risk analysis, and making sure it is accurate, timely, consistent, and transparent is critical to meaningfully address concerns about biased and arbitrary credit ratings.
2. Qualitative factors should measure what actually drives credit risk.
Assessments should focus on institutional capacities that affect solvency and repayment—fiscal credibility, macro-fiscal planning, public financial management, resilience capabilities, and the operational quality of national and subnational institutions, including state-owned enterprises and development banks. Proxies for political style should not masquerade as predictors of default.
3. Countries should not be trapped by stale narratives.
High-frequency, granular indicators should replace multi-year lags that penalize reformers. New metrics should distinguish structural weaknesses from short-term political noise, preventing the accumulation of “institutional debt” that clings to reform-era leaders long after conditions improve. Without this, reforming governments face weak incentives to invest political capital in institutional upgrades.
4. Nature and climate resilience must count.
Today, sovereigns are punished for climate exposure and nature risk but seldom rewarded for resilience investments—strong disaster planning, watershed protection, building codes—because these assets are harder to quantify. A modern system should value them explicitly, in the same way that nature and climate vulnerabilities are currently counted as liabilities.
5. Performance—not perception—should drive qualitative scores.
Opaque expert opinion should give way to observable progress against clear, credit-relevant targets. Think of it as a governance analogue to sustainability-linked bonds: scores tied to delivery, not promises and rhetoric.
6. Decision-making should no longer be a black box.
Rating committees should disclose scoring rationales, data inputs, and model structures. External challenge panels should audit assumptions. Such transparency would cut against a business model built on informational asymmetry, highlighting that ratings agencies often have incentives to protect their proprietary opacity even when greater openness would serve countries and the public far better.
7. A new governance indicator—purpose-built for sovereign risk.
Independently governed, globally representative, open-source, and free from ideological tilt, this indicator should integrate natural-capital stewardship, resilience capacity, subnational dynamics, and the operational realities of development banks and state-owned enterprises. Such an indicator would benefit issuers and investors alike by restoring signal integrity.
A necessary evolution
This is not a utopian wish list; it is a prerequisite for credible sovereign risk analysis in a rapidly changing world. In a context where climate and nature shocks increasingly translate into fiscal shocks, and where misinformation distorts risk perceptions, the global financial system can no longer rely on governance metrics rooted in unvetted perception, ideology, and inertia.
Today’s qualitative scores and governance indicators do more than mismeasure. They misallocate capital. By embedding opaque judgements into sovereign credit assessments, they push LMICs to pay a premium for methodological complacency dressed up as objectivity and “robustness.”
If sovereign debt distress spreads to advanced economies, these concerns will no longer be confined to peripheral issuers in the $70+ trillion sovereign debt market. They will reach the core of the treasury markets that underpin international finance, where persistent mispricing can have destabilizing consequences for global financial stability. Investors will need clearer, more credible signals to navigate sovereign risk. At that point, credit rating agencies will be back in the limelight, and calls for transparency and accountability will grow louder. The time to fix institutional assessment is now—before the next crisis makes reform impossible.
