Country Risk: ECR survey highlights shortcomings of ratings agencies

Jeremy Weltman
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Credit ratings agencies have endured criticism for failing to anticipate sovereign risk in the wake of the global crisis. A poor track record raises questions about their usefulness as a predictor of changing risk perceptions. Evidence suggests that subjective assessments by country experts based on a broad set of factors are more useful in quantifying risk trends.

How useful are the ratings actions of the three main credit ratings agencies Fitch, Moody’s and Standard & Poor’s (S&P), and how do they compare to Euromoney’s Country Risk survey? These questions are perhaps difficult to answer in light of the differing approaches employed to quantify risk. Nevertheless, these agencies have been variously accused of political bias, a slowness to react and occasionally reversing their decisions soon after they are made. For many observers, their inability to provide a timely consensus view on changing risk perceptions is troubling.

South Africa action predicted by ECR

S&P’s decision to downgrade South Africa from BBB+ to BBB this month, and Moody’s from A3 to Baa1, follows in the wake of a series of strikes by mine workers, including a well-publicized incident in August when 34 miners were shot dead outside the Marikana platinum mine as they approached the police with machetes. The risk implications were investigated further by ECR.

These actions, while demonstrating the potential for violent conflict between the state and its citizens in a country still riven by historical racial divisions, also highlight potential deterioration of the country’s fiscal position leading up to the next South African parliamentary and presidential elections in 2014. The government, already grappling with a lower growth outlook, will now be forced to spend more to placate social tensions.

The downgrades will have come as no surprise to regular followers of Euromoney’s Country Risk survey. Although South Africa has climbed ECR’s global rankings this year, by two places to 43 out of 186 countries – a relative adjustment – its score had been sliding in the run-up to the announcement. It fell from 58.7 points (out of 100) at the start of this year to 57.9 by the time ECR published its latest quarterly review, which coincided with Moody’s and S&P taking their ratings actions; Fitch, the more cautious agency, held fire.

During the past two years, however, South Africa’s score has fallen more substantially, by 10.3 points. It is one of 43 sovereigns in ECR’s survey to have seen a double-digit score decline during the period. This trend has provided an important early warning indicator of the increased risk in sub-Saharan Africa’s wealthiest nation, as it has for other sovereigns. A handful of sovereigns have seen their risks diminish – again, ECR score trends, in this instance improving, have provided a useful leading indicator.


Sub-factors outline pertinent risks

It might be difficult to disaggregate what portion of sovereign risk is due to external (exogenous) factors and what might be determined by domestic (endogenous) ones – the equivalent of beta risk, say, for share investments. Yet, Euromoney’s approach can help. It differs substantially from the methodology adopted by the ratings agencies, which all assign a rating to each sovereign based on their own extensive research and provide useful commentaries explaining their decisions.

However, ECR polls and publishes experts’ assessments of 15 of the most important political, economic and structural risk factors, and combines these with other data regarding access to capital, credit ratings and debt, to formulate an overall score out of 100 (where 100 is the least risky and 0 the most). The survey has been undertaken since 1993 and is updated daily on a real-time basis, with scores collated and aggregated each quarter for comparison purposes.

Not all of South Africa’s ECR risk indicators have succumbed to lower scores this year, which in itself tells a story. Two that have been downgraded, and which seem pertinent to the recent strikes, are labour market/industrial relations (forming part of a six-factor political assessment) and government finances (one of five economic sub-factors). The changes might be small – less than half a point out of 10 in each instance – but they are important. Even small changes reflect altered perceptions among country experts – many of whom are prominent economists from banks and other institutions – and are therefore worthy of consideration. In combination, these sub-factor assessments/alterations impact on the overall risk score.

The implication, in South Africa’s case, is that higher public spending by the state seems inevitable as the government tries to quell discontent among the working poor. This is despite Lonmin, the Marikana mine owners, acquiescing to a 22% pay rise to help to remedy the situation. And increased government transfers and other outlays to beef up domestic security will directly impact South Africa’s fiscal metrics, already impaired by slowing export growth.

In the International Monetary Fund’s (IMF) latest report on South Africa, concluded just before this latest spate of industrial unrest began, it was forecasting a stubbornly high national government budget deficit of 4.8% of GDP for 2012, down slightly from the 5% level of the past few years, as well as a growing national debt burden, expected to reach 40% of GDP by the end of 2012. But, with global growth slowing and public spending increasing, the forecast path is shifting and upsetting the IMF’s predicted peak in the debt burden at 42% of GDP in 2014.