The need for an African credit rating agency has been the collective call of heads of African countries and players in the financial market, and this was reiterated by the African Union chairman and the president of Senegal, President Macky Sall, during the 54th Conference of African Ministers of Finance, Planning and Economic Development (CoM2022) and at the 35th African Union Summit.
The establishment of the African credit rating agency is deemed an important step towards providing opportunities for the continent to access capital and to serve as a means of integrating the continent’s financial markets with global financial markets, which rely greatly on credit ratings. Will this quest yield the expected results?
Why credit rating agencies?
External funding is essential to many developing countries because of the quantum of their budget deficits. International funding is a “necessary-evil” as it provides significant support in economic development particularly in financing infrastructure development. International funding sources evaluate associated risks with funding developing countries, thereby making the Credit Rating Agencies (CRAs), which provide external assessment of credit risks, published as ratings for investors, key actors in the framework.
The ratings by CRAs are perceived to be accurate, thereby influencing borrowing costs of countries, i.e., a low rated economy is perceived as high risk of default and hence will be expected to have high borrowing cost. Investors and regulators rely on credit risks assessments, empowering CRAs as key players in financial markets. This reliance stems from the belief that the work of CRAs addresses information asymmetry between debt issuers and investors.
Interestingly, the IMF global financial stability report 2010 identified over seventy (70) rating agencies globally, but the industry is oligopolistic in nature, because it is dominated by “the big three” rating agencies, namely Standard and Poor’s, Moody’s, and Fitch, whose ratings dwarf that of the others and have been operating since 1860, 1909 and 1913, respectively. These “big three” CRAs hold approximately 95percent of market share (i.e., S&P and Moody’s hold 40percent each, and Fitch holds 15percent). The mechanism of growth in their market share is driven largely by merging and acquiring other rating agencies.
In Africa for example, Moody’s acquired a leading African rating agency in 2022 named Global Credit Rating Company (GCR) which was based in Mauritius with offices in South Africa, Nigeria, Kenya, and Senegal. In addition to this, it acquired a significant stake in the Egypt-based Middle East Rating and Investors Service (MERIS), etc.
The big three
This big three’s dominance has not been without criticisms and allegations; creating a rather bad image for them. Their ratings, either for structured finance transactions or credit ratings for countries, often referred to as sovereign ratings, raise eyebrows and allegations of bias especially in the case of African countries, as ratings covering Africa usually fall in the lower part of the global rating scale.
Their downgrades are said to unjustifiably blow up the existing problem of these countries, drive up market rates and unfortunately prohibit some of these countries’ access to international financial markets, thereby undermining the rescue operations of many countries.
Evidently, the bringer of bad news will not be accepted with open arms, hence, financial market players and countries alike bemoan how rating agencies, by raising or lowering of the thumb, affect an economy’s participation in the global financial market. No wonder a United States Congress Inquiry Commission emphasised that rating agencies played a major role, through their ratings, in causing the 2007/08 global financial crisis and the associated spill overs leading to the European sovereign debt crisis.
The big three rating agencies are therefore regarded as powerful because they have control over the world’s perception of a country’s governance. However, the rating methodology of these rating agencies are being questioned mainly because of the alleged opaqueness or lack of transparency, their issuer-pay business model which raises concerns of conflict of interest, and the absence of an appreciable understanding of domestic issues especially on the African continent.
CRAs have also proven infallible as misjudgements have occurred, like in the case of the collapse of Enron, where rating was still within investment grade until four days before their collapse even when Enron’s share prices had been dropping way before that time. These misjudgements and concerns intensify allegations of bias.
The test for sovereign bias
The big three credit rating agencies have similar alphabetic approaches to assessing sovereign credit risks ranging from an investment grade; (AAA, AA, A, and BBB) to a non-investment grade; (BB, B, CCC, CC, C, and D) for Standard & Poor’s and Fitch, and investment grade (Aaa, Aa, A and Baa) to non-investment grade; (Ba, B, Caa, Ca and C) for Moody’s. Modifiers are attached to further differentiate ratings within each classification.
For instance, Fitch and S&P use pluses and minuses e.g. AA+, AA-, and Moddy’s uses numbers e.g. Aa1, Aa3, etc. The methodologies adopted incorporate publicly available data and others from country authorities on economic and fiscal outcomes and prospects, with other significant qualitative concepts such as governance, risk, and institutional frameworks.
The ratings seek to measure a country’s ‘ability’ and ‘willingness’ to repay debt. The concept of willingness to pay is important because a sovereign may have the capacity to pay but may not be willing to pay after judging its level of social and political costs.
A closer look at Moody’s approach shows its ratings considers qualitative and quantitative factors in determining not only the likelihood of default but also the losses investors may suffer in the event of default.
Moody’s ratings are based on a Scorecard-indicated outcome, which is expressed as a range, and calculated by summing the sovereign economic strength, and institutions and governance strength factors to generate what Moody’s refers to as Economic Resiliency score. The Economic Resiliency score is added to the fiscal strength factor score to arrive at the Government Financial Strength score, which is further added to the sovereign’s susceptibility to event risk.
The quantitative metrices used in Moody’s ratings, such as nominal GDP values, GDP growth volatility, GDP per capita, Debt to GDP ratio or interest payment to GDP/ Revenue, are based on publicly available data, thereby making their influence on ratings relatively easy to understand and follow. For instance, a higher debt to GDP ratio, holding other things equal, is associated with greater credit risk.
But the qualitative factors applied in rating, similar to analyst judgements, give considerable discretion in assigning a final rating even after a scorecard-indicated outcome. The nature of these qualitative factors on scores, makes it difficult to identify how much of any qualitative judgement reflects ‘true’ conditions or a conscious or unconscious bias.
In November 2022, Moody’s published an updated methodology for rating sovereigns, replacing the version published on November 25, 2019. This confirms the fact that rating agencies are constantly fine-tuning their methodologies and suggests that there may still be relevant scope yet to be captured in the methodologies adopted.
In the updated methodology, Moody’s retained the same key rating factors but made specific changes including replacing the use of standard deviation in assessing real GDP growth volatility with the Median Absolute Deviation (MAD), with additional data in assessing institutions and governance strength, adjustment to debt trends, integration of Environmental, Social and Governance (ESG) considerations, etc.
The African argument
The claim by African countries is that in the absence of any bias, the continent should enjoy higher ratings, lower borrowing costs and hence brighter economic prospects given that there is a positive corelation between economic development and credit ratings.
The very subjective aspect of the system of assessment – alleged to comprise 20% of the criteria in the case of African countries, include factors like cultural or linguistic for example, which bear no relation to the parameters used for measuring economic stability. Therefore, the perception of investment risk in Africa is always much bigger than the real risk of default, making credit more expensive.
This in some instances, have prompted countries to appeal against and contest ratings. For example, the Zambian government rejected Moody’s downgrade in 2015, Namibia appealed the junk status downgrade in 2017, Nigeria strongly contested downgrades in 2016 and 2017, Tanzania appealed against inaccurate rating in 2018, and Ghana appealed against ratings by Fitch and Moody’s in 2022 as not reflective of the country’s risk factors. Unfortunately, there has not been any successful appeal since the rating agencies play the dual role of player and referee in Africa, unlike other territories where there are appeal authorities who conduct fair hearings and pronounce a decision.
Sovereign Africa Rating (SAR)
The 4th African Union – Specialised Technical Committee (STC), granted the mandate for the financial, structural and legal feasibility of establishing an African rating agency and in September 2022, a group of entrepreneurs launched the Sovereign Africa Ratings (SAR), publishing its first report on South Africa, rating it “BBB” whiles that of Standard & Poor’s, Fitch and Moddy’s rated; ‘BB-’, ‘BB-’ and ‘Ba2’, respectively.
Sovereign Africa Ratings (SAR) blends both quantitative and qualitative analysis to arrive at the final rating ranging from AAA to D, in a 1,000 to 0 scale. The rating framework consists of twenty attributes, ninety-two variables, and eight main pillars, which translate into risk determinants, including fiscal, economic, environment, governance, climate change and natural resource endowments to make judgements on a sovereign’s creditworthiness adjusted by qualitative judgements. Data for the various indicators is obtained from central banks, treasury departments, domestic private and public research institutes, African Development Bank, IMF, and the World Bank.
The SAR agency prides itself in considering projections, historical performance of indicators, prospects of government expenditure, and gives a significant emphasis to mineral wealth as a performance indicator, especially because Africa is well-endowed with mineral resources. These, for the SAR, are the differentiating factors.
The solution – Is SAR and other African credit rating agencies a suitable replacement?
Undoubtedly, CRAs play a critical role in capital markets and therefore their role of assessing risk ought to be without fear or favour. The only real currency of CRAs is credibility and a commitment to quality control procedures, well-researched methodologies, and ethical business practices.
If the African continent seeks to reduce its reliance on existing foreign CRAs, will an African CRA be a suitable replacement and will the rating of such an agency be regarded as credible by foreign investors? And will such an agency, having the advantage of a permanent presence closer to sources of information, local experts, and deeper local understanding of economic aspects, be prudent, thorough, and objective in research and analysis without conflict of interest?
Or should Africa’s solution rather be to have a continental regulatory body equivalent to the European Securities and Market Authority or the United States’ Securities and Exchange Commission, to encourage accurate approaches as well as serve as a platform of appeal for countries to seek remedy for what they deem as unfair practices by any rating agency?
>>>Bridgewater Advisors Limited is a boutique investment banking firm providing corporate finance solutions in capital raising, mergers & acquisitions, restructuring and deal advisory to both public and private, and governments across Africa. The firm has over the years delivered world-class capabilities and high-quality service to clients, delivering the insights needed to address their most complex capital issues. The firm’s expertise cuts across transaction services in deal execution and transaction support for buy and sell side mandates, large cap syndications and cross boarder deal making. The firm can be reached via [email protected] and or +233 (0) 302 906860 | (0) 307 011336
