17 May 2014

Ethiopia: Results Are In!


Interviewer: "Bear Stearns was rated AAA like a month before it went bankrupt?"

Jerome Fons: "No, more likely A2."

Interviewer: "A2?"

Jerome Fons: "Yeah."

Interviewer: "A2 is still not bankrupt."

Jerome Fons: "No no no. It's a high-end investment grade. Solid investment grade really."

Jerome Fons: "Lehman Brothers was A2 within days of failing, AIG AA within days of being bailed out...Fannie Mae and Freddie Mac were AAA when they were rescued, City Group, Merrill...all of them had investment grade ratings."

Interviewer: How can that be?

Jerome Fons: Well, that's a good question...(laughs)...that's a great question!"

The above conversation between Jerome Fons, former Managing Director of Moody's Rating Agency, and an interviewer is taken from Inside Job, a 2010 Academy Award winning documentary film about the late-2000s financial crisis directed by Charles H. Ferguson.

The film, which received positive reviews including a 98 percent rating by Rotten Tomatoes featured global intellectuals like, Christine Lagarde (ex-finance minister of France and current head of the IMF,) Glen Hubbard (dean of the Columbia University Graduate School of Business,) Frederic Mishkin (ex-governor of the US Federal Reserve,) Nouriel Roubini (professor at New York University's Stern School of Business,) Raghuram Rajan (ex-chief economist of the IMF) and Andrew Sheng (chairman of the Hong Kong Securities and Futures Commission (SFC)) among others to comment on the advent and gradual hike of the financial crisis.

Hot-seat interviews and in-depth analysis are what made the documentary a critically acclaimed one. The film was made in connection with the 2008 global financial meltdown, one of the most severe crises in recent memory.

No single financial institution got its goodwill sullied like Lehman Brothers, one of biggest investment banks in the US behind Goldman Sachs, Morgan Stanley, and Merrill Lynch, or perhaps American International Group (AIG,) another insurance giant in the US, with regards to the above financial crisis that led to a global economic meltdown.

The crisis triggered in the US mortgage market and its derivative financial products like the Collateralized Debt Obligations (CDO) spread like wildfire and engulfed major economies in Europe and Asia. However, experts and politicians of the time believed that there was a lot more to the story of the financial crisis than a market driven failure in the system.

Many scholars until this day contend that the crisis was the makings of companies that are dominate Wall Street and the financial system. It was vividly depicted by the aforementioned documentary, where financial deregulation was undertaken since the administration of Ronald Regan is seen to pave the way for the crisis.

If not like the investment banks, which declared bankruptcy on the verge of the crisis, the three renowned credit rating agencies in the US - Standard & Poor's, Moody's Investors Service and Fitch Ratings - also had their goodwill and reputation on the line by the crisis.

The film argued these rating agencies should take their fair share of the blame. A direct outcome of the financial deregulation process, which continued through the Clinton and Bush administrations, led to the innovation of diversified financial instruments called derivatives and a market for them.

One such instrument were the CDOs, where highly risky housing loans dubbed sub-prime mortgages were combined together to form another financial instrument that is sold for secondary investors. The film shows how lenders started to pay less attention to the quality of mortgage loans they were giving out to home buyers since they would ultimately sell these debts [mortgages] to investment banks who would in turn sell them to other investors.

"This is where the rating agencies come into play," the film's narrator, renowned Hollywood actor and Academy Award winner, Matt Damon declares. In addition to these banks and financial institutions, which received top investment ratings, complex derivative financial instruments like CDOs also received high investment grades, an equivalent of a stamp of approval for investors who want to invest in them at stock markets but have no clue as to how risky the mortgages are.

The stamp of approval gave a green light to pension funds and retirement schemes to invest in the CDOs, according to the film. And the investments they made had disastrous consequences. When the housing bubble hit the sector everything including the secondary investors crumbled overnight.

The agencies were not the same after the crisis, in many countries a regulatory framework for credit rating agencies was initiated and many pushed for more transparent credit evaluation criteria and methodologies. Well, their influence in the global capital markets and national financial systems never waned through time.

To true form, this week the three announced their rating of a never before assessed and rated country - Ethiopia - and published their accompanying outlook on the future conditions of the country. Moody's is one agency that showed more optimism about Ethiopia's credit worthiness with an assigned rating of "B1" an equivalent of a "B+" rating as per the symbolization of S&P and Fitch. The last two were not so bullish and rated Ethiopia "B"; a notch lower from Moody's rating. What it is about?

Of course, it is not the same corporate debt investment rating that they do in Wall Street; however, sovereign investment rating is about understanding the probabilities of default of sovereign debtor entities. It addresses concerns of creditors as to how fit the country is to pay back loans it has contracted in full, and in time.

In a way, it is a sovereign counterpart to the corporate debt rating that the three rating giants have specialized in. From the top of one's head, it is clear that no amount of information about any particular debtor is enough to predict with absolute certainty whether the borrower can repay its debt obligations in time; there is always a risk. But, informed predictions are possible. Based on the available information, agencies can project if a borrower is worthy of taking credit, or can rank countries and corporate entities on the basis of their credit worthiness.

Credit rating started to gain much importance in connection to the evolution of stock markets, where corporations go shopping for capital and investors for good investment opportunities. Investment decisions heavily rely on assessment of various potential investment opportunities in the market and the three rating agencies built their practice around this information gap and financial need of corporations.

Similarly, countries and sovereign entities turn to international capital markets to finance their deficit; through issuance of sovereign bonds. Hence, among other things, the rating agencies specialize in selling their informed opinions and credibility looks to be everything in this business.

As far as investment rating is concerned, the three giants seem to have higher ratings themselves. After the crisis however, the agencies look to be more transparent in their exercise of rating debt instruments and entities. As a result, these days the rating agencies are more open with the methodology they employ when grading sovereign and corporate credit worthiness.

When it comes to sovereign rating, the agencies employ a mix of economic, social and political criteria to assess conditions in the country. In general, for economic criteria, level of per-capita income, GDP growth, fiscal and external balances, debt burden and the ability of monetary policy to support economic growth in the future are important factors to look into.

The growth side of the story informs the prospect of the nation's economy and ability to create the wealth that would sustain the debt it will take on. Of course, the nature of both external and local debt burdens are also important factors considered by ratings. The external balance of payment and market position the country commands in the international market is another important factor.

Effective execution of monetary policy in controlling macroeconomic problems like inflation is also another thing to look at. Almost equally important is the political side of the story. The rating agency also heavily focuses on potentials for political risk and destabilization while rating sovereign entities since performance from economic perspective can easily be risked by politics. Nevertheless, methodologies that most rating agencies follow show that bad history of credit default can be quite detrimental for the countries under review.

On the scale:

The controversy apart, the investment rating that these agencies assign carries a lot of weight. Lenders and financiers around the world consider lending as a simple business proposition as do banks and other financial institutions. The decision to purchase bonds or papers issued by a country depends first and foremost on the yield (interest) it offers up on settlement debt.

While on the other hand, the risk it entails expressed in probability of default is very important. In fact, according to experts, the yield offered by issues that becomes acceptable by investors (creditors) depends highly on the level of risk the bond has. Riskier bonds would obviously have to offer better yields to access capital.

And nothing is more revealing about default risk than an investment grade from one of the three rating agencies; although now rating agencies like the Canadian DRBS, originally known as Dominion Bond Rating Service, upcoming Chinese rating agency Dagong, and the Japan Credit Rating Agency (JCR) also command considerable market credibility.

Except for the symbolization, the three agencies most of the time agree on the ratings they assign. Generally, the rating assigned to a country or corporation ranges from grading that shows lower risk, which makes it highly favorable for investment, to those classified as junk.

Investment grading in itself differs greatly in that it ranges from a solid AAA, dubbed prime investment grade, to a high investment grade which incorporates (AA+,) (AA,) (AA-.) Meanwhile, upper medium and lower medium investment grades also include (A+,) (A,) (A-) and (BBB+,) (BBB,) (BBB-,) respectively.

Below that is the non-investment grades, which incorporate speculative, highly speculative, substantial risk bearing and extremely speculative and finally the lowest grading of CCC- and CC, C and sometimes D. Ethiopia's rating of all three falls firmly within the highly speculative investment grading, apparently an investment grading shared by most African nations except South Africa, Botswana, Morocco, Mauritius and Tunisia.

In his most recent interview with the media, Minister of Finance Sufian Ahmed went on record to say that the investment grading Ethiopia received is something to be happy about. Although the context he explained it in could mean that the country is new to the rating system and that the rating in itself is encouraging, rating agencies do not seem to be so positive about a highly speculative rating, both in the context of a country and a corporate debt instrument.

Why now?

Not surprisingly, a number of African nations share the same level of rating as Ethiopia. Another striking fact is that the country is among the latest to be rated by the three agencies, each securing 40,000 dollars for the work. According to the Minister it about time the country took the step since FDI flow at times require such credible opinion on the prospect of the Ethiopian economy to make up their mind. According to Sufian, the agencies' assessment was quite comprehensive.

He told members of the press that apart from the data furnished by the government, the agencies obtained alternative opinions from the private sector, embassies and international organizations like the IMF. All in all, the finance minister looked optimistic to opportunities that the rating would bring to Ethiopia. But, he remained defiant as to the prospect of accessing the international capital market. "We are not in immediate need to issue bonds, but that is something we will consider doing when the time comes," he boldly stated.

Still, one of the recent developments in sub-Saharan Africa is a rush to tap into the international capital market. Although Ghana was the first to issue sovereign bonds in 2007 from the region, now a lot of countries including Nigeria, Zambia and mote recently Rwanda are accessing capital from the capital market. To some extent, neighboring Kenya and Tanzania are also expected to be the next to join the group of countries issuing the bonds.

Thus far, Ethiopia sources its finance largely from bilateral and multilateral sources, while commercial loans are also becoming important in recent years. According to the recent Rwandan experience, the international market would require countries with B level investment grade to offer above 7 percent interest rate on the bonds they issue, an interest rate higher than what Ethiopia pays for its loans on average.

Indeed, government bonds from African countries surprisingly generated a great interest in international capital markets since it is a refreshing change from the usual developed countries' issues. Who knows, Ethiopia's paper might also be one that attracts a number of subscribers.

Ed.'s Note: Bruh Yihunbelay of The Reporter has contributed to this report.

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