What is a credit rating?

Also known as a rating, a credit rating is a technique used to assess the solvency of a borrower and the borrower’s willingness to meet short- and/or long-term financial obligations. It is generally issued by a rating agency approved by a regulator, although any creditor may carry out its own assessment.

A credit rating represents an opinion on the assessment of the rated entity’s credit risk, excluding all other risks. This risk assessment is based on the independent analysis of a range of quantitative and qualitative data, including:

🔵 the economic and financial situation of the rated entity;

🔵 the quality of governance and the growth prospects of its activity.

For a given State, this analysis is based on:

🔵 the strength and stability of institutions;

🔵 the effectiveness of governance;

🔵 income levels and economic growth;

🔵 the strength and resilience of external positions;

🔵 fiscal balance levels;

🔵 debt stock levels, as well as the effectiveness and credibility of monetary policy.

These qualitative and quantitative data are then aggregated to arrive at a final rating that reflects the credit quality of the rated entity. Credit quality is then interpreted through a rating scale, which links the rating to a given level of credit risk.

A rating generally applies to a borrower, but it may also apply to a security. It is most often issued by rating agencies that use rating scales on which the scores assigned to different entities are ranked. These ratings are expressed through a combination of letters, numbers and symbols linked to a given level of credit risk, summarising the rating agencies’ analysis. The leading global rating agencies are Moody’s, Standard & Poor’s (S&P) and Fitch Ratings.

A rating is generally issued at the request of the borrower (solicited rating). However, it may also be initiated by the rating agency itself (unsolicited rating).

There are two main types of rating depending on the period over which credit risk is assessed:

🔵 Long-term ratings, for the assessment of credit risk over a period of 12 months or more;

🔵 Short-term ratings, for the assessment of the issuer’s ability and willingness to meet financial commitments over a period of less than 12 months.

There are also two types of rating depending on the currency in which credit risk is assessed:

🔵 Local-currency ratings, for assessing the issuer’s ability to meet payment obligations in its own currency — the CFA franc in the case of issuers in the WAEMU region;

🔵 Foreign-currency ratings, for assessing the issuer’s ability to meet payment obligations in a currency other than its own currency — such as the US dollar, the euro, etc., in the case of issuers in the WAEMU region.

A published rating is accompanied by an outlook, which indicates its possible direction during its period of validity. This outlook may be:

🔵 Positive: possible upgrade of the rating;

🔵 Stable: no expected change in the rating;

🔵 Negative: possible downgrade of the rating.

Local-currency credit ratings are of major importance for issuers in the WAEMU region. Participants in financial markets need information on which to base their investment decisions. Credit ratings therefore serve as an investment decision-support tool. For borrowers, they determine the risk premium in capital markets. For regional issuers, local-currency ratings make it possible to assess their credit quality in CFA francs, which is the currency in which they issue on the regional financial market.

Credit ratings: what value do they bring to WAEMU States?

Ratings play an important role for rated entities. According to the International Monetary Fund (IMF), the ratings obtained by rated entities “allow borrowers to access global and domestic markets and attract investment funds, thereby adding liquidity to markets that would otherwise remain illiquid” (IMF, 2010).

Four key benefits may be attributed to the local-currency credit ratings of WAEMU States.

First, they help reduce information asymmetry in the regional financial market. Ratings provide market participants with information and solvency analysis on a comparable and independent basis, thereby contributing to greater market transparency.

Secondly, credit ratings serve as benchmarks for issuers in the regional financial market. Sovereign ratings assigned to WAEMU sovereign issuers — that is, States — can serve as a reference point for the wider economy and for all borrowings by the rated entity, especially for issuers other than States and public or local authorities. A sovereign rating is generally regarded, within a State, as the ceiling for ratings that may be assigned to resident issuers in that State.

In addition, ratings contribute to broadening the base of potential investors in the regional market. The availability of reliable information through credit ratings can help Union States attract new investment to the regional financial market.

Finally, ratings support the development of the regional financial market. Credit ratings facilitate debt issuance by strengthening transparency and should therefore contribute to the development of the regional market. In turn, the development of the financial market can also contribute to improving credit ratings, insofar as a more developed financial market would enable WAEMU States to mobilise resources at lower cost and therefore reduce debt service, all else being equal. This would enhance the creditworthiness of those States.

Credit ratings: the role of agencies and rating methodologies

The role of rating agencies

The current African economic environment is attracting growing interest from international investors, who increasingly view the government securities market as a safe-haven asset in the face of slower growth in more advanced economies. However, the limited availability of information on markets in the region prevents market participants from reliably assessing the trade-off between expected returns and counterparty risk. This remains an obstacle to the attractiveness of these markets.

In response to the relative opacity of financial markets in the region, regional rating agencies provide independent opinions and analysis not only on the credit quality of borrowers but also on the political and socio-economic environment that may affect the market.

The ratings assigned and reviewed annually highlight an entity’s strengths and weaknesses, thereby encouraging long-term commitment to sound governance. Depending on the ratings and outlooks, the rated entity can improve its borrowing conditions and strengthen its visibility among investors. Simply being transparent about its risk profile opens up opportunities.

The methodology of credit ratings

Although rating agency methodologies are broadly similar, each agency has its own rating scale.

Overall, rating methodologies are based on the use of econometric models (or rating models) that combine qualitative and quantitative indicators in order ultimately to evaluate credit risk.

A score is assigned to each variable according to its contribution to the assessment of credit risk. The weighted sum of these scores then produces an overall score corresponding to a given level of credit risk. The methodology applied depends on the nature of the rated entity.

The rating process is divided into eight key stages:

1 – Contracting

The issuer requests to be rated and signs a letter of engagement.

2 – Preliminary assessment

The rating agency sets up a team of analysts to review the relevant information available.

3 – Meetings with the issuer’s management (Management Meetings)

The team of analysts meets the issuer’s management to discuss the information.

4 – Analysis

The analysts assess the information and propose a rating to the Rating Committee.

5 – Rating Committee meeting

The Rating Committee rules on the rating proposal submitted by the analyst team and decides the rating to be assigned to the issuer following a vote.

6 – Notification

The rating agency submits a draft rating report to the issuer for comments (to verify the completeness and accuracy of the information).

7 – Publication and dissemination of the rating

The rating agency issues a press release to make the issuer’s rating public and publishes the rating report on its website.

8 – Surveillance

The objective of surveillance is to keep the rating up to date by identifying the factors that could lead to an upgrade or downgrade.

International and regional rating agencies: what is the difference?

Rating agencies can broadly be divided into two categories:

• international rating agencies, which operate globally;
• rating agencies whose scope of activity is limited to a local or regional level.

In general, international rating agencies assess the ability of the rated entity to meet its domestic and external obligations, in the short, medium and long term, in both foreign currency and local currency, based on international standards. Regional rating agencies, by contrast, focus on that ability in local currency and on a local scale.

International rating agencies position all countries on a single rating scale when assigning or updating an issuer’s rating. Such a rating is established on a global scale. By contrast, a regional rating agency typically evaluates credit characteristics relative to other countries in the region and within a local context. The rating is therefore established on a local scale, allowing for more refined assessment and better differentiation among the ratings assigned to the various market participants.

The objective of equipping WAEMU Member States with a rating on a regional scale stems from the desire to highlight the specific features of each issuer within the region, and in particular the advantages arising from the monetary union.

Unlike international rating agencies, all of which are based outside the continent, regional rating agencies, which are established within the Union, are more familiar with the realities of the States and are therefore better placed to highlight, on a local scale, the heterogeneity of economies. Their presence on the ground gives them the advantage of being able to take better account of qualitative factors linked to the socio-political, economic and cultural environment of States.

Credit ratings on a regional scale, in the WAEMU framework, necessarily take into account the implications of belonging to an economic and monetary union, particularly in terms of strengths, solidarity mechanisms and the constraints linked to the existence of a common Central Bank and the relinquishment by States of individual monetary policy management.

To continue reading and learn more about local-currency credit ratings, download our free e-book here.