The economic downturn created by the Covid-19 pandemic, which spawned Africa’s first recession in 25 years, has also triggered an avalanche of sovereign credit rating downgrades across the region.
In one of the most dramatic moves on record, 18 of 32 African countries rated by at least one of the ‘big three’ agencies (Fitch, Moody’s and S&P) suffered downgrades at the height of the pandemic recession in 2020 , which has increased uncertainty and potentially aggravated the crisis.
Several studies have shown that sovereigns that experience such downgrades are likely to experience deteriorating macroeconomic fundamentals and increased foreign currency borrowing costs.
This landslide of pro-cyclical downgrades affected more than 56% of rated African countries, significantly above the global average of 31.8% as well as averages in other parts of the world (45.4% in the Americas , 28% in Asia and 9.2% in Europe). ).
The share of affected African nations is even higher (62.5%) if one extends the period covered to include the two countries downgraded in the first half of 2021.
Further hampering investor confidence, the glut of downgrades has been accompanied by a torrent of negative criticism of the rating outlook for African countries. Cumulatively, rating agencies have downgraded the outlook for 17 nations, in four cases from positive to stable and in the other 13 from stable to negative.
The significance of these large-scale pro-cyclical moves goes far beyond the total number of downgrades. They created cliff-edge effects, with two of the few African countries – Morocco and South Africa – having benefited from a relatively low sovereign risk premium losing their investment quality and becoming, in the parlance of the rating agencies notation, “fallen angels”.
For years, four countries 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 from the Covid-19 downturn has been cataclysmic for Africa’s sovereign risk profile. The region will emerge from the pandemic with over 93% of its sovereign borrowers rated as below investment grade.
These downward revisions are underpinned by several factors, but two are particularly relevant for Africa. The first is the institutional instinct of rating agencies to preserve their reputational capital.
The second relates to perception premiums – the exaggerated risk with which African sovereigns and corporations have been consistently burdened, regardless of improving economic fundamentals.
Does Covid-19 offer a new way of understanding African risk?
While the synchronized nature of the pandemic slowdown provides an opportunity to examine the extent to which perception premia shape the distribution of sovereign risk across countries and regions, the disproportionately higher number of African countries affected by pro-cyclical downgrades further supports the African premium hypothesis.
Impact on growth
Regardless of the underlying causes, the multitude of downgrades will have significant implications for the region. By raising countries’ risk premia and ringing the bell of investor risk aversion, they could jeopardize access to development finance that would support the growth and structural transformation of African economies.
Higher premiums will increase borrowing costs in international capital markets, and a cold reception from investors will decrease demand for African public assets. Applicable regulations prohibit investors from holding securities below investment grade or generally discourage such investments by requiring that additional capital be held in such securities.
The ripple effects of pro-cyclical downgrades were felt strongly across Africa as the sharp tightening of financial conditions at the onset of 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 have reached new heights, with South Africa particularly hard hit. It recorded net nonresident portfolio outflows (bonds and equities) exceeding $10.6 billion (3.6% of GDP), and its 10-year bond yield rose by more than 100 basis points ( from 8.24% to 9.27%) between January and September 2020.
Across Africa, the impact of the downgrades on countries’ ability to access finance has been equally significant. A comparison based on a large sample of Eurobonds shows that African sovereign issuer spreads have increased dramatically in the wake of the downgrades. They rose sharply against the full averages of JP Morgan’s EMBI, setting a record in June after rising more than 1,000 basis points above US Treasuries and more than 400 basis points above US Treasuries. above the spread of the EMBI composite index all categories.
Across the region, the short-term implications of downward revisions to borrowing costs in international capital markets are amplified by the largely undesirable status of African sovereign issuers.
Most regional sovereigns were already sub-investment grade borrowers, paying higher coupons to attract investors. Downgrades will increase these costs, as yields are not only inversely proportional to credit ratings, but are also more sensitive to rating changes within the sub-investment grade bracket.
Moody’s own research has shown that returns that are relatively insensitive to downgrade when the rating is above investment grade become highly responsive to even small downgrades when the rating dips below investment grade.
This perhaps helps explain the wide gaps across Africa last year and validates policymakers’ concerns about cliff-edge effects associated with Morocco and South Africa’s downgrades.
Lasting effects of downgrades
In addition to their short-term implications for economic recovery, the negative spillovers from pro-cyclical downgrades can persist long after the crises end. These downward revisions are not automatically reversed after the recession and the recovery from the bottom of economic 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 oil would widen the country’s twin deficits and undermine the government’s ability to honor commitments to external creditors.
Oil prices have since recovered, surpassing pre-crisis levels and as the world braces for a post-pandemic commodity super cycle. But an upgrade in 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, at the onset of the Covid-19 crisis, the European Securities and Markets Authority warned rating agencies against worsening the pandemic downturn through “swift” downgrades. The European Systemic Risk Board has echoed these concerns, stressing the need for greater transparency and timely incorporation of changes in economic fundamentals into credit rating models.
To reduce volatility, these groups also advocated a full-cycle approach to credit risk assessment, recognizing that credit ratings should not change frequently during economic cycles.
Whether or not full-cycle approaches are fully integrated into existing credit rating models, the concerns raised by these regulators highlight the potential risks of pro-cyclical downgrades to growth and financial stability.
Across Africa, where private sources (bondholders and commercial banks) have become the main providers of long-term development finance, the dangers of large-scale downgrades are even more acute.
In addition to exacerbating the crisis and aggravating short-term macroeconomic management problems, pro-cyclical downgrades have long-term consequences for economic development.
They can undermine the process of structural transformation needed to reduce the unhealthy correlation between commodity price cycles and growth, especially in a region where most countries remain heavily dependent on commodities.
Access to affordable long-term development finance will boost returns on investment and accelerate the diversification of sources of growth and trade. This, in turn, will expand fiscal space for African countries and put them on the path to long-term fiscal and debt sustainability, both of which have a positive credit rating.
These factors, in addition to the unlikelihood of a rapid reversal (even in the face of better economic fundamentals) of rating downgrades, should militate against precipitous pro-cyclical downgrades on a large scale, even if rating agencies can rationalize such moves on the basis of self-assessments. preservation.
Find the right balance
Finding the right balance, although perhaps less expedient, should be their goal. Ultimately, this will lead to a win-win engagement that accommodates increases in credit risk without compromising economic recovery or long-term development goals.
It is possible for rating agencies to preserve their reputational capital without jeopardizing the growth prospects of sovereigns aspiring to global standards of macroeconomic and corporate governance. Across Africa, finding this balance will allow countries to escape the destructive twins – the high costs of development finance and the pitfalls of commodity dependence – and will facilitate the process of global income convergence.
Hippolyte Fofack is Chief Economist and Director of Research and International Cooperation at the African Export-Import Bank.