The impact of the pandemic: credit ratings, the pandemic and Africa

Credit rating agencies, like Moody’s and S&P Global, have the role of answering one key question that an investor will have: how likely am I to get my investment back and on time?

The answer to that question will usually set the level of interest the borrower must pay to offset the risk for the investor. That, in a nutshell, is why the multi-billion-dollar enterprises of Moody’s, S&P, and Fitch Ratings (amongst some other smaller players) exist.

When a company issues a ‘bond’ containing a binding agreement to borrow money from prospective investors at a pre-agreed rate and for a pre-agreed time, the ratings that the Credit Rating Agencies (CRAs) give to those bonds are, historically, very accurate. However, in the early 2000s, complicated and exotic financial products were created, known as ‘structured finance’, that pooled a number of financial revenues (i.e. from residential mortgages) to which investors could invest in a portion of those pooled revenues, for a price; CRAs provided ratings for those financial products too but, as we know from the extraordinary Financial Crisis of 2007/08, those ratings were nowhere as near to accurate as the corporate bond ratings the CRAs have traditionally provided.

Yet, countries need to finance their operations just like a company does and to do that they offer ‘sovereign bonds’ which investors can invest in. For those too, credit ratings are required.

The Role of the Creditor for a Country

Traditionally, a country would borrow from other countries. Those lending countries are known as ‘official’ creditors. Very rarely would private investors participate, but when they did they would be massive banks. After a number of instances where poorer countries could not pay their debts and needed to restructure or have the debts wiped away, banks and larger countries started to move away from lending to poorer countries, instead incentivising large institutional investors to lend their money instead.

At the same time, in the post-Financial Crisis world, those same massive institutional investors (like pension funds and money managers) who need to invest to keep their businesses afloat were faced with depressed interest rates for corporate bonds. Instead, they found poorer countries in need of investment who had to offer higher interest rates on their proposed loans because of their historic riskiness for investors. The dye was set, and consequently, the rise of the ‘private’ creditor on the global debt scene was complete. Now, ‘private’ creditors hold a large proportion of all outstanding developing market debt. That change in dynamics has real consequences.

The Changing World for Developing Countries

Countries, when lending to other countries, can alter their lending agreements very easily. Countries do not consider the credit ratings of other countries when they lend simply because, they do not have to. However, when a private creditor lends money, they do have to consider the credit ratings of a company or a country because, for a number of reasons, they are often bound by the ratings; regulators may insist that large investors can only invest in highly-rated entities for systemic risk purposes, or the underlying ‘principal’ in an investor (those who actually invest capital into the larger institutional investor) may seek to constrain the actions of their management and dictate that they only invest in entities rated above a certain level. This is common.

This however creates a fundamental problem. The traditional method chosen by the world’s financial and political architecture for a country who is facing a crisis and needs some financial breathing space is for that country’s debt obligations to be restructured or wiped away. This has been fine with regards to CRAs traditionally because they did not care, given that no private investors were harmed. Yet, now private investors are a large creditor in the global debt scene, it very much is a problem and the CRAs are taking notice. As a response to the crisis facing developing countries as they suffer at the hands of the COVID-19 pandemic, the G20 sought to develop a new initiative that would help developing countries suspend their servicing costs on their debts.

This, officially, is a restructuring of the original debt agreements. This, in the credit rating world, is considered to be a threat to the original question of ‘will I get my investment back in full, and on time’ and, as a result, the CRAs threatened any country that sought to do this with an immediate downgrade of their rating, likely to the final ‘default’ rating which means you have defaulted on your agreement and, as such, cannot be invested again until you come out of that rating. Unsurprisingly, no country has wanted to participate in the G20’s plans when it comes to private creditors.

Now that they make up such a large piece of the debt pie in the developing world, this has meant that the main international attempts to provide financial support have categorically failed. With the majority of countries eligible for the G20 initiatives being African, the continent is feeling the brunt of the pandemic more than anywhere else in the world.

The Credit Rating Impasse: A New Free-to-Read Book

This is what I have called the ‘credit rating impasse’: a country cannot get the help they need because the credit rating agencies forbid it. There have been no official solutions to this, and the G20 are essentially stumped. One argument is that the country’s should just renege on their debts and try to get investment again at some point in the future. My team argue that this is unsustainable for African countries and that something else needs to be done. We argue that the concept of a ‘rating default’ should be temporarily suspended or altered, as part of a Special Programme attached to the G20’s Initiatives, so that countries can have the space they need to restructure their debt agreements. The lack of a bankruptcy network for countries demands innovative solutions and this is just one potential solution.

You can read more about this subject, the credit rating impasse, and the solution of a Special Programme in the new free-to-read book by Daniel Cash ‘Sovereign Debt Sustainability: Multilateral Debt Treatment and the Credit Rating Impasse’ available here to download.

Daniel Cash is AAT Comment’s news writer.