Dr Hippolyte Fofack
The economic downturn created by the COVID-19 pandemic, which begot Africa’s first recession in 25 years, also triggered an avalanche of sovereign credit rating downgrades across the region.
In one of the most dramatic moves on record, 18 of the 32 African countries rated by at least one of the “big three” agencies (Fitch, Moody’s, and S&P) endured downgrades at the peak of the pandemic downturn in 2020, heightening uncertainty and potentially exacerbating the crisis.
Several studies have shown that sovereigns that suffer such demotions are likely to experience a deterioration of their macroeconomic fundamentals and an increase in foreign currency borrowing costs.
This landslide of procyclical downgrades affected more than 56 percent of rated African countries, significantly above the global average of 31.8 percent as well as averages in other parts of the world (45.4 percent in the Americas, 28 percent in Asia, and 9.2 percent in Europe).
The share of affected African nations is even higher (62.5 percent) if we extend the period covered to include the two countries downgraded in the first half of 2021.
Further curtailing investor confidence, the glut of downgrades has been accompanied by a torrent of negative reviews of African countries’ ratings outlooks. Cumulatively, rating agencies revised downward the outlook of 17 nations, in four cases from positive to stable and in the remaining 13 from stable to negative.
The significance of these large-scale procyclical moves goes far beyond the total number of downgrades. They have created cliff effects, with two of the very few African countries – Morocco and South Africa – that have enjoyed a relatively low sovereign risk premium losing their investment grade and becoming, in the vernacular of rating agencies, “fallen angels”.
For years, four nations in the region – Botswana, Mauritius, Morocco and South Africa – have enjoyed investment grade status. By downgrading the latter two to high-yield and junk status, the financial fallout of the COVID-19 downturn has been cataclysmic for Africa’s sovereign risk profile. The region will emerge from the pandemic with over 93 percent of its sovereigns rated as sub-investment grade borrowers.
These downgrades are underpinned by several factors, but two are especially relevant to Africa. The first is the institutional instinct of rating agencies to preserve their reputational capital.
The second concerns perception premiums – the overinflated risk with which African sovereign and corporate entities have been perennially overburdened, irrespective of their improving economic fundamentals.
While the synchronised nature of the pandemic downturn offers an opportunity to scrutinise the extent to which perception premiums are shaping the distribution of sovereign risk across countries and regions, the disproportionately larger number of African countries affected by procyclical downgrades further supports the Africa premium hypothesis.
Impact on growth
Irrespective of the underlying causes, the bevy of downgrades will have significant implications for the region. By raising countries’ risk premiums and ringing investors’ risk-aversion bells, they could undermine access to the development financing that would support growth and the structural transformation of African economies.
Higher premiums will raise the costs of borrowing on international capital markets, and getting the cold shoulder from investors will diminish demand for African public assets. Prevailing regulations either prohibit investors from holding sub-investment grade securities, or generally deter such investments by requiring that extra capital be held against those securities.
The spillover effects of the procyclical downgrades were strongly felt across Africa when the sharp tightening of financial conditions early in the COVID-19 crisis set the stage for sudden stops and reversals in capital flows in a “flight to quality”.
Capital outflows from the region reached new highs, with South Africa particularly affected. It recorded net non-resident portfolio outflows (bonds and equities) exceeding US$10.6 billion (3.6 percent of GDP), and its 10-year bond yield rose by more than 100 basis points (from 8.24 percent to 9.27 percent) between January and September 2020.
Across Africa, the impact of the downgrades on countries’ ability to access financing were just as significant. A comparison based on a large sample of Eurobonds shows that the spreads of African sovereign issuers increased dramatically in the wake of the demotions. They rose sharply relative to the full JP Morgan EMBI averages, setting a record in June after escalating by over 1,000 basis points above US treasuries and more than 400 basis points above the all-grade EMBI composite index spread.
Throughout the region, the short-term implications of the downgrades for borrowing costs on international capital markets are magnified by the predominantly junk status of African sovereign issuers.
Most regional sovereigns were already sub-investment grade borrowers, paying higher coupons to attract investors. The downgrades will raise these costs, as yields are not only inversely proportional to credit rating scores, but are also more sensitive to rating changes within the sub-investment grade bracket.
Moody’s own research has shown that yields that are relatively insensitive to downgrading when the rating is above investment grade become very responsive even to small downgrades when the rating plunges below investment grade.
Perhaps this helps to explain the large spreads logged across Africa last year, and validates policymakers’ concerns about the cliff effects associated with the demotions of Morocco and South Africa.
Besides their short-term implications for economic recovery, the negative spillovers of procyclical downgrades can persist long after crises have passed. These downgrades are not automatically reversed after recession and recovery from the trough of business cycles.
As the pandemic unfolded, Fitch, in a dramatic “multi-notch move”, downgraded Gabon’s sovereign rating to CCC from B, largely on the grounds that falling oil prices would widen the country’s twin deficits and undermine the government’s capacity to honour commitments to external creditors.
Oil prices have since recovered, rising above pre-crisis levels and as the world braces for a post-pandemic commodity super-cycle. But an upgrade of Gabon’s sovereign credit rating seems far from imminent, with empirical evidence showing that it takes an average of seven years for a downgraded developing country to regain its previous rating.
Reflecting these challenges, early in the COVID-19 crisis the European Securities and Market Authority cautioned rating agencies against deepening the pandemic downturn through ‘quick-fire’ downgrades. The European Systemic Risk Board echoed these concerns, stressing the need for greater transparency and incorporating changes in economic fundamentals in credit rating models in a timely manner.
With a view to reducing volatility, these groups also argued for a through-the-cycle approach to credit risk assessment, recognising that credit ratings are not expected to change frequently during business cycles.
Whether or not through-the-cycle approaches are fully integrated in existing credit rating models, the concerns raised by these regulators highlight the potential risks of procyclical downgrades to growth and financial stability.
Across Africa, where private sources (bondholders and commercial banks) have become major providers of long-term development financing, the dangers of large-scale downgrades are even more acute.
Beyond exacerbating the crisis and compounding macroeconomic management challenges in the short term, procyclical downgrades have long-term consequences for economic development.
They can undermine the process of structural transformation necessary to reduce the unhealthy correlation between commodity price cycles and growth, especially in a region where most countries remain heavily commodity-dependent.
Access to affordable long-term development financing will boost returns on investment and accelerate the diversification of sources of growth and trade. This, in turn, will broaden African countries’ fiscal space and set them on the path towards long-term fiscal and debt sustainability, both of which are credit-rating positive.
These factors, in addition to the unlikelihood of a rapid reversal (even in the face of better economic fundamentals) of rating demotions, should militate against hasty large-scale procyclical downgrades, even though rating agencies may rationalise such moves on the basis of self-preservation.
Striking a balance
Finding the right balance, though perhaps less expedient, should be their objective. Ultimately, this will lead to a win-win engagement that accounts for increases in credit risk without undermining economic recovery or long-term development goals.
It is possible for rating agencies to preserve their reputational capital without jeopardising the growth prospects of sovereigns aspiring to global standards of macroeconomic and corporate governance. Across Africa, striking that balance will enable countries to escape the destructive twins – the high costs of development financing and commodity-dependency traps – and ease the process of global income convergence. – African Business
Dr Hippolyte Fofack is Chief Economist & Director of Research and International Co-operation at the African Export-Import Bank