Africa is becoming increasingly integrated into the global financial and economic system. The African Development Bank (AfDB) estimates that portfolio flows to Africa nearly quadrupled between 2005 and 2014, rising from USD 6.3 billion to USD 23.9 billion in 2014 (AfDB, 2014). In addition, remittance flows to the continent recorded remarkable growth, increasing over twenty years from USD 2.5 billion to USD 31 billion in 2012.
In this context, understanding the role of credit ratings in the development of African financial markets is crucial.
Credit ratings: what impact do they have on the development of African financial markets?
To better understand the importance of credit ratings in the development of African financial markets, it is necessary to look at their function.
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.
The ratings assigned to a borrower represent opinions on the relative probability of default on debt obligations. In other words, they assess the risk that debt obligations (principal and interest) may not be repaid in full at maturity.
Ratings play an important role for rated entities. As highlighted by the International Monetary Fund (IMF), they “allow borrowers to access global and domestic markets and attract investment funds, thereby adding liquidity to markets that would otherwise remain illiquid” (IMF, 2010). Ratings enable companies and governments to raise funds directly on the capital markets by issuing debt, rather than borrowing from a bank or development partner.
Three major functions help illustrate the important role of credit ratings in the development of African financial markets.
1. Ratings facilitate debt issuance by rated entities
Ratings can be particularly important for Africa, where in many countries the banking sector remains underdeveloped and access to banking services is still limited.
Across the continent, banks are often reluctant or unable to lend. This situation can be explained in particular by difficulties related to contract enforcement due to weak judicial systems, the lack of credit bureaux for sharing information on the solvency of potential borrowers, and the absence of economically viable business plans presented by borrowers.
Given this context of constrained bank lending combined with a low banking penetration rate, ratings can help large private borrowers and sovereign borrowers attract a greater number of lenders by facilitating the issuance and purchase of bonds through the availability of independent information on their creditworthiness.
The United Nations Development Programme (UNDP) has also recognised the importance of credit ratings for African governments in diversifying their financing sources so as to increase investment in sectors that support growth and help reduce poverty. In 2003, the UNDP supported several African governments in obtaining their first credit ratings.
2. Ratings provide a benchmark for assessing the risk profile of economies
Another useful function of sovereign ratings lies in their ability to serve as a benchmark for non-sovereign issuers in their debt issuance activities and for investors in their investment decisions.
Sovereign ratings first and foremost help inform rated States about the strengths and weaknesses of their credit profile. Knowledge of the factors required for a strong credit rating is important for governments. These factors include the existence of strong institutions and effective governance, high levels of wealth, income and economic growth, strong and resilient external positions, modest fiscal balances, moderate levels of public debt, and effective and credible monetary policy.
Once rated, States can use the assessments of rating agencies to form their own view of progress made in these important areas.
A sovereign rating can also serve as a benchmark for the broader economy. Corporate ratings rarely exceed the sovereign rating of the State in which the companies are established. A country’s sovereign rating can therefore constitute the ceiling for the ratings assigned to companies based in that country.
Investors may in turn base their country-risk assessments on the consideration of the factors underpinning a sovereign rating when making investment decisions in specific sectors or companies.
3. Ratings help reduce information asymmetry between investors and debt issuers
By providing information and accounting-based creditworthiness analysis, credit ratings facilitate issuers’ access to the financial market. This function can be of major importance in Africa, where information and research on many countries and entities remain relatively limited.
In many cases, recent data on national economic accounts, the public debt position or the latest policy statements issued by ministries are not readily accessible on the websites of African public administrations or third parties. Access to annual reports or investment plans of African companies can also be difficult.
Through the data collection required for any credit rating process, rating agencies can facilitate the dissemination of information that would otherwise be difficult to access.
In addition to ratings, rating agencies publish detailed reports that contain both quantitative and qualitative data and analysis. Making these analyses and this information available to the public demonstrates the willingness of rated issuers to act transparently by allowing an independent external assessment of their creditworthiness.
Providing the market with credible and independent opinions on the risks associated with sovereign bonds helps reassure investors. Identifying and assessing credit risk enables investors to make informed investment decisions and to demand an appropriate level of return on their capital for risky investments, rather than avoiding such investments altogether for lack of information.
With the increase in financial and trade flows between Africa and the rest of the world, the continent has become an increasingly important player in the global economic and financial system, and credit ratings have contributed to that progress.
Despite this progress, many challenges remain. Several indicators show that the financial systems of most African countries remain underdeveloped. Moreover, not all African States — and the majority of African companies — are yet rated, and therefore do not have access to global and domestic financial markets.
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