Will an African credit rating agency be a game changer?

Momentum for an African credit rating agency has been building for a while. How will creating a localised agency change the appetites and biases of users of rating information, especially investors?

The motivation for an African credit rating agency stems from a growing consensus in African scholarly circles that international ratings agencies are biased against Africa, their assessments are unduly subjective and at variance with the true level of risk. These biases and inaccuracies are costing the African continent billions of dollars in lost investment, high debt servicing costs and distorted fiscal decisions.

Said consensus has strengthened despite a flurry of empirical findings showing no statistical support for the perception of bias in African sovereign ratings. Indeed, open-source sovereign rating models, that eschew any proprietary methodologies, use transparent data and are set up without any corporate agenda, still accord African countries higher risk premia.

Concerns about bias, arbitrariness, opacity and excessive power on the part of the Big Three credit rating agencies are not confined to African complainants. The three biggest, best-known, agencies (the much-accused American behemoths of Fitch Ratings, Moody’s and S&P) are private corporations, headquartered in the US (though Fitch also uses London as a major base).

They are perceived to be racked with conflicts of interest, so, understandably, observers outside the US would be suspicious of their inordinate power.

Challenging the American ‘Big Three’

Disquiet about Big Three practices is, however, nearly universal. During the 2008 financial crisis, and its aftermath, their critics ranged from top American academics and regulators to the leading Eurocrats of the day. There isn’t a region in the world that doesn’t believe that the Big Three are somehow acting against their economic interest.

Widespread perceptions of bias persist despite the evidence generally showing that, while not perfect, sovereign ratings by the Big Three do tend to be predictive of likely defaults, which perhaps is the reason why investors continue to rely on them.

As in Africa, key economic actors in Europe also once attempted to create a “European Rating Agency” that would be more attuned to the economic fundamentals, policy priorities and market sensitivities of Europe. Roland Berger, a German consultancy, tried to raise €300m to set up a European counterweight to the Big Three.

The initial plan was for a non-profit institution with broad buy-in from the key European market movers and shakers. A rival effort by the Bertelsmann Foundation also focused on the need for nonprofit status and a multistakeholder governance model.

Eventually, emphasis shifted to removing conflicts of interest by ending the practice of borrowers paying for their ratings, in favour of investors doing the paying, even in the face of strong analytical caution against the viability of alternatives to the dominant model.

In the end, all these efforts to create a European alternative to the Big Three came to nought. The European Union Commission, by 2013, had dropped that agenda altogether. Also ditched around the same time were plans proposed by France for more radical changes to rating practices, such as blocking the agencies from downgrading countries experiencing financial crises (cue Moody’s recent downgrade of Kenya).

There are many reasons why the European effort failed, beyond the surface reason of lack of investor interest. Some of the reasons are relevant to the ongoing efforts to create an African Big Three.

Localised rating culture vs. Big Three arrogance

The world is not short of credit rating agencies. In 2008, there were between 130 and 150 credit rating agencies worldwide. A decade later, more than 30 of them were reported inactive, partly due to cutthroat competition. Of those active, the Big Three controlled over 95% of the market. Investors and other users of credit ratings seem to like the Big Three just fine.

Active since 1985, Japan Credit Rating Agency (JCR) and R&I (created from a merger of JBRI and NIS in 1998, which date from 1975) are two of Japan’s homegrown credit rating agencies. The country offers interesting lessons in the viability of “local” credit rating as a counterpoint to the Big Three.

Japan’s credit rating agencies have long touted significant “cultural differences” in their approach to rating versus American rivals. They are known to be slower to downgrade, keener to elevate qualitative information, and comfortable using material non-public information disclosed behind the scenes by corporations. Japanese borrowers, citing these differences in approach, have been critical of the Big Three and regularly lament their lack of appreciation of business cultural nuances in Japan.

Yet, the strengths of Japanese rating agencies like JCR have also been documented as weaknesses. Their close relationships with many of the companies they rate and their willingness to play a “policy role” when rating government bonds are seen as exacerbating conflicts of interest, not reducing them. Thus, the tendency of Japanese rating agencies to give higher credit scores to Japanese corporations compared to the Big Three has led to a practice where some investors “rescale” the ratings when evaluating the corporations.

Financial information users across the market determine by their patronage which rating agencies will eventually dominate in the market. Despite efforts to “adapt” to local market realities, Japanese and other Asian rating agencies have failed to dislodge the power and influence of the Big Three, despite having had decades to try. Not surprising, then, that more than a decade since the ASEAN+3 countries mooted the establishment of an Asian Regional Credit Ratings Agency, nothing much has come out of it.

Africa already has rating agencies

Africa too has credit rating agencies, even if the burden of financing their setup and growth often falls to investors from outside the continent. GCR comes best to mind. It was set up by Duff & Phelps, an American corporation. A few days ago, Moody’s snapped up the company.

Before the acquisition, Moody’s had shared ownership with DEG and Carlyle. In 2017, when Carlyle bought into the business, GCR was clocking more corporate ratings across the continent than the Big Three.

Two points are worth making here, GCR specialised in Africa and had offices across the region. If the concern is about knowledge of the terrain and familiarity with the fundamentals, more African sovereigns could have chosen to have their bonds rated by GCR.

If it was about ownership, more African investors could have picked up equity when Duff & Phelps signalled an interest to sell. It is much more likely that the African sovereigns choose not to use African-based rating agencies because their target investors assign more weight to Big Three reports, allegations of bias notwithstanding.

Powerful trade-offs between favour and utility

There is research that shows that the more market share credit rating agencies acquire, and by extension the more they “internationalise”, the more stringent they become and the less favourable their ratings of borrowers’ credit.

In some ways, therefore, the higher the influence and reputation of a credit rating agency, the stricter, in general, their grading system grows. Borrowers, including sovereign borrowers, might thus be more willing to trade off the likelihood of more favourable ratings from local and boutique rating agencies for the more influential, if also less favourable, ratings from global, more dominant, agencies.

In light of the above analysis, one has to ask how exactly creating an African credit rating agency per se will change the appetites and biases of users of rating information, especially investors.

Will Eurobond investors, for instance, buy more African government bonds at better prices (that is, offer lower interest rates) because they are more highly rated by a new, upstart, ratings agency?

And would they do that primarily because that entity is Africa-based or African-owned?