Rating agency treatment of EM risk at odds with the people who take it
Credit rating agencies are attracting harsh criticism over their treatment of emerging market sovereigns. Some in the bond markets believe it threatens to undermine their authority when it comes to assessing creditworthiness.
Credit rating agencies have become fundamental to the smooth functioning of capital markets, doing an awful lot of number crunching and risk assessment so that investors, borrowers and middlemen don't have to — meaning more capital can be raised more quickly. In fact, it is hard to think of an area of investment work that has been so comprehensively outsourced and with such trust.
But the coronavirus pandemic has shed light on what some see as the rating agencies' blind spots, which critics believe have become increasingly prominent over the last year.
The controversy lies in the downgrades made to some emerging market sovereigns and the speed with which these were done. Senior emerging market bankers in Europe say that the rating agencies are "disconnected" from the reality of markets.
As of November last year, Moody’s had taken 108 rating actions against sovereigns, with 60% being negative. Of the 33 sovereigns downgraded by Fitch in 2020, 27 were in emerging markets. Of the sovereigns that were downgraded more than once, all were in emerging markets.
But these cuts came too fast, argue the critics. Very few EM countries have the ability to adjust their balance of payments within six months, which raises the question of why so many sovereigns faced so much downgrading so quickly.
The critics go further, arguing that rating agencies treat EM and developed market credits differently, with the latter group supported as much by reputation as by cold, hard numbers.
The rating agencies say any difference is down to debt affordability metrics worsening for emerging market credits relative to those in developed markets over the last decade, despite the average debt-to-GDP metrics of emerging markets being far lower than those of the developed world.
ING forecast developed economies fiscal deficits at 14.2% of GDP in 2020, with general sovereign gross debt rising by 20 percentage points to 124% of GDP. Emerging market countries, on the other hand, were forecast to run an average fiscal deficit at 10.4% of GDP in 2020 with debt-to-GDP rising by 9 percentage points to 61%.
A case in point was Fitch’s downgrade of Morocco to junk status, which drew a strong reaction from market participants.
Morocco was pushed from BBB- to BB+. Fitch attributed that to the material rise in its debt burden, the impact of lower tourism and the worsening of its current account deficit.
But less than two weeks later, Morocco entered international debt markets to sell a triple-tranche $3bn bond, which market sources at the time heaped praise upon. Indeed, Morocco is in their eyes one of the most reliable and popular issuers in North Africa.
Matter of judgement
Defenders of the rating agencies point to the positive technical picture in the bond market at the time — as central banks, governments and multilateral institutions stepped in to bolster asset prices and the economy — to ward off criticism that the downgrade had little impact on investors. It is also worth remembering that Morocco does not benefit from the same asset purchase programmes and central bank liquidity that other sovereigns that were issuing at the same time do.
But demand for the bonds suggests that the rating agencies appear to be out of step and investors are said to be relying ever more on in-house credit risk assessments than those of the rating agencies.
The downgrades to junk ratings over the last year threaten the ability of downgraded sovereigns to make a full and timely economic recovery, a task that is already inherently more difficult for emerging markets, which are anticipated to face challenges with vaccine distribution.
The rating agencies say it is not their remit to consider how a downgrade may affect a sovereign's chance at economic recovery.
"We do not allow ourselves to be influenced by considerations of whether a downgrade may hamper economic recovery," said Tony Stringer, managing director, sovereign ratings at Fitch Group. "That would push us into an area of moral hazard and we wouldn’t be fulfilling our duty to give investors timely and objective credit opinions. Rating actions are taken in line with our criteria."
Nonetheless, the downgrades have done little to alleviate EM bond watchers’ fears that African credits are victims of inherently negative-leaning perceptions of credit risk.
“Some attitudes towards Africa, whether it be western politics or ratings agencies, often look misinformed and possibly even burdened by historical perceptions,” said Simon Quijano-Evans, head of research at Gemcorp Capital. “A case in point is the amazing way the continent has dealt with Covid-19, compared to Europe, for example. The overall view of sub-Saharan Africa is too negative — it does not make sense for a country like Ghana to be eight or nine notches below some eurozone periphery countries, when they have tackled the pandemic so well and show they can deal with election challenges.”
According to the World Health Organization, there are just over 2m confirmed cases of Covid-19 across the entire continent, compared to Europe's 29m cases.
Africa, with the much larger population — 1.3bn people versus about 750m in Europe, according to the UN — and less advanced healthcare systems, has worked against the expectations of many to keep infection rates low.
The continent has had just one sovereign default victim out of the five EM borrowers to have run aground. And experts say there is no risk of Zambia's default triggering a default domino across the region.
But, still, the region has found itself at the centre of downgrades.
The good news for the bond market is that primary market liquidity is so strong that even infrequent credits like Benin have managed to tap investors in the first two weeks of the year. More are expected to follow, including South Africa, which Fitch downgraded from BB to BB- in October.
But long-term, continued downgrades risk having a deleterious effect on emerging market credits, which can take decades to repair, according to some bankers.
Rating agencies must of course be blind to the consequences of their opinions if they are to give them impartially and fairly. But there is a growing divide between what the rating agencies believe and what those putting their money at risk think — and what they believe they can see in the data. The credit scorers could do worse than to take stock of the growing divide to ask if they are still making the right calls.