Cutting through the noise on the impact of ratings
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Cutting through the noise on the impact of ratings

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Corporate and development banks want their capital to reach the smallest and most impactful of SMEs in frontier markets. Traditional credit ratings and risk assessments can get in the way.

Are debt ratings a hurdle to sustainable small and medium-sized enterprise (SME) lending?

The question can be dismissed for being overly simplistic: whether their business is green or not, lending to small corporates is always more challenging and credit ratings are nothing more than an assessment of a debt issuer’s ability to repay. A measurement used to quantify a risk can hardly be held responsible for that risk.

With sustainable finance however, nothing is ever that simple.

In many emerging African markets, so-called high-impact SMEs are struggling to gain access to private capital. Their banking partners think sovereign debt ratings may have something to do with it.

They see poor sovereign debt ratings as one of many roadblocks to granting loans to these businesses, either because of methodological practices like the country ceiling – which prevents private-sector entities from having a better rating than their sovereigns – or restrictions as a consequence of debt being rated non-investment grade.

According to the IMF, only about 60% of emerging markets and 8% of developing economies have an investment-grade rating. And as one development banker pointed out to Euromoney at COP28:Half the countries in Africa don’t even have a credit rating”.

This issue is becoming increasingly political. In September last year, the African Union announced its plans to launch a new credit rating agency, a response to concerns about how Moody’s, S&P Global Ratings and Fitch assess lending risks in continent's markets.


It is not the first time the big three credit rating agencies find themselves in the line of fire as the market struggles to fit impact finance into the rules of traditional lending.

But to understand why some actors think credit ratings are an issue, it is worth remembering that high-impact SMEs are genuinely hard to fund.

In fact, these companies stand at the intersection of a nasty trifecta: SME, developing-market and sustainability-funding gaps.

Micro, small and medium-sized enterprises (MSMEs) account for roughly 90% of all businesses and 50% of employment globally, and up to 40% of GDP in some countries, yet many are locked out of traditional forms of lending.

This gap has increased with the decline of capital flows towards the global South. According to World Bank data, private capital flows to developing countries (excluding China) fell 32% between 2012 and 2022. The IFC estimates that 40% of formal MSMEs in developing countries have unmet financing needs equivalent to 1.4 times the current level of global MSME lending.

In sub-Saharan Africa specifically, the estimated MSME financing gap stands at $331 billion.

Add to that the enormous sustainable development goal funding gap, which stands between $2.5 trillion and $3 trillion a year for developing countries, and we can start to understand why both public and private-sector banks are anxious to address this.

Risk perception

These ever-growing funding gaps are, in part, a result of how investors measure the risks associated with lending to high-impact SMEs in emerging markets.

“Funding small assets in risky countries doubles the risk perception from a traditional lending perspective, even though no data is available to confirm this perception,” says Marie-Aimee Boury, head of impact-based finance at Societe Generale.

The AfDB’s solution to financing adaptation

Financing small and medium-sized enterprises is hard, but when those SMEs are tackling climate adaptation it is much worse.

Everybody wants capital flows towards the global South to increase, but a lot of the projects that aim to increase community resilience to climate shocks and extreme weather don’t make money.

“The fundamental problem for SMEs to access capital is the lack of secure cash flows for projects, particularly adaptation projects,” says Gareth Phillips, chief climate change and green officer at the African Development Bank. "We want to create certified benefits for sale to donors and corporates in the business world to contribute towards the cost of adaptation projects."

Importantly, adaptation benefits mechanisms are not credits. They are not tradable.

“They are an asset which you can sell, but the only thing you can do with it is retire it and claim the benefit that you have paid for by reporting it through the [UN's] enhanced transparency framework,” explains Phillips.

The benefits are denominated into context-specific and technology-specific units, such as kilometres of mangrove protecting coastline or hectares of land for resilient agriculture.

“We are trying to create a mechanism whereby there is a sort of revenue for adaptation projects,” he adds. "If you can crack that problem, then all the financial instruments that we have could be applied to the adaptation space."

Like other development banks, the AfDB advocates reorganizing the international finance architecture to balance adaptation and mitigation.

Currently, 95% of climate finance investment goes to mitigation projects because there are few, if any, mechanisms that encourage private-sector players to look at adaptation.

There is also a lack of focus on adaptation by policymakers.

“For every ton of CO2, there is an adaptation cost,” says Phillips. "But governments are not currently allocating a budget for this, and there are no credible financial instruments that the private sector can use."

What’s the catch?

The project cycle of the AfDB’s adaptation benefits mechanisms is based on the [UN's] Clean Development Mechanism (CDM) and outsources verification to external auditors.

The CDM was the first carbon finance instrument agreed in the Kyoto Protocol in 1997 to advance the reduction of global greenhouse gas emissions. The scheme collapsed in 2012 but its spirit lives on in the global shift towards carbon credits as a tool to reach net zero.

“One of the drawbacks of the CDM is that the results that were created were fungible commodities, then subject to accumulation and speculation,” Phillips says.

The problem with a commoditized approach is that it can drive developers to find the cheapest projects to maximise profits.

“But with adaptation, since they are not tradeable, there is no speculation,” Phillips claims. "That radically alters the way the private sector would engage with it."

She argues that this is exactly why credit rating agencies ought to be brought into the conversation.

“Their traditional portfolio risk assessment methodology capped by the country ceiling does not give a fair representation of the true risk embedded in these deals,” Boury points out.

This is common across African markets, where the credit score of active entities is generally capped to the corresponding sovereign debt rating. The Republic of Ghana for example, is Africa’s 10th-largest economy by GDP in 2023; its SMEs contribute 60% of GDP. The country saw its debt rating fall by several notches before defaulting on its debt in December 2022.

In early 2023, therefore, Moody’s lowered Ghana’s local-currency and foreign-currency country ceilings to respectively Caa1 and Caa2 to mirror the sovereign ratings downgrade.

Meanwhile, Fitch Ratings gave Ghana a country ceiling of B- saying “that the private sector has not been prevented or significantly impeded from converting local currency into foreign currency and transferring the proceeds to non-resident creditors to service debt payments” in its July 2023 comment after the country’s credit score downgrade from C to RD.

Commercial banks are also wrestling with tougher macroeconomic conditions and regulatory reforms on minimum regulatory capital requirements in many geographies. This lowers the incentive to go for young, fragile companies with thin track records and fewer, if not zero, offtake agreements.

“The EU central institutions are sending us contradictory signals of telling us to go full steam ahead on green lending and financial innovation but also take less risk,” says Boury, pointing to a whole subset of MSMEs with financing needs that even the development finance institutions don’t currently address.

“In agriculture for example, the transformation of local value chains through the use of regenerative practices is perceived as too risky even for them,” she adds.

For development banks, this is also an issue because it limits the reach that some of their investment funds can have.

“There is a higher perceived risk in Africa that scares investors away,” says Gareth Phillips, chief climate change and green officer at the African Development Bank, adding that this is the case for SME and larger entities alike; even infrastructure projects have better return on investment rates than the ones in some Latin American countries.

With its Climate Fund in partnership with the government of Canada for example, which includes a C$123 million ($91 million) investment facility, AfDB limits the credit rating of recipients for sovereign-guaranteed loans to B or higher, and a 40/60 split between B- and B or higher for non-sovereign guaranteed loans.

Adverse effects

Unsurprisingly, the credit ratings agencies defend their position and suggest that stakeholders are scapegoating credit scores as a way to avoid commitments.

“To say that the state of the SME ecosystem in African markets is worse because of their sovereign ratings is a way of avoiding the real, underlying, challenging issues facing SMEs regarding securing financing in frontier markets,” says Aurelien Mali, vice-president, senior credit officer for Africa at Moody’s.

We want to stay close to these fast-growing companies so that we can get involved once they reach a maturity where we can offer more traditional types of lending and advisory
Marie-Aimee Boury, Societe Generale

The fact is that SME lending becomes more difficult when sovereign debts ratings are low. That isn’t just because of the rating itself, but because of adverse effects on local banks’ ability to lend.

Losses on holdings of low-ranked government debt weaken banks’ balance sheets and make funding more costly and difficult to obtain.

“There is always a rationale explaining our opinion detailing why we think that the government ability or willingness to pay has declined to some extent,” says Mali. "When that happens, the resulting premium increase sometimes requested by investors is usually passed through to SMEs by local banks since their cost of funding from foreign banks, for example, has likely gone up too."

For him, the country ceiling is also often either misinterpreted or overestimated.

“The gap between the country’s ceiling for all entities' credit ratings and the sovereign rating is influenced by the capacity and track record of government’s interference in the economy,” he points out.

The problem might not be with the debt ratings themselves but rather how they are used to make investment decisions by risk-averse lenders.

“We apply our methodologies robustly, that is our role in the market,” points out another source close to the ratings agencies. "What you are describing is a market participant using the ratings in their decision-making.

“The truth is that it’s hard for a private sector to develop in a country that struggles to pay back its debt.”

Bad debt

If traditional lending doesn’t work for this emerging segment of high-impact businesses, then adapting banking products to fit the needs of these clients is probably a better solution than redefining what a credit rating is or does.

As the London Stock Exchange’s Africa Advisory Group pointed out in its last Africa SME financing report, bank loan financing leaves a small company prioritising loan repayments or risking default.

“Debt is thus fundamentally ill-suited to enabling SMEs to fund the innovation and long-term projects that ultimately drive economic growth and create new jobs,” the report states.

The DFIs … are focused on risk-sharing via pari passu guarantees, which is not sufficient for private lenders in terms of a de-risking mechanism
Sandrine Enguehard, Societe Generale

Where banks can have true impact is by working with equity funds to identify and select the right companies.

“This is why we like this idea of ecosystem building,” says Boury. "We want to stay close to these fast-growing companies so that we can get involved once they reach a maturity where we can offer more traditional types of lending and advisory."

Under its 'Grow with Africa' initiative, SocGen aims to double its exposure to SMEs in Africa. Its investment in the Afrigreen Debt Impact Fund for example, provides loans for smaller decentralized solar projects that displace high-polluting electricity generators.

Like many others, the French bank has been working with development banks and philanthropic funds to address the country-risk element. The idea is to have first-loss risk taken by these actors via catalytic capital in blended finance structures where banks and other private investors can fund the senior tranche.

The DFIs are trying to do this, but right now they are focused on risk-sharing via pari passu guarantees, which is not sufficient for private lenders in terms of a de-risking mechanism,” says Sandrine Enguehard, global head of positive impact solutions at SocGen.

But development banks are dealing with their own capacity constraints. The World Bank estimates that there are about 44 million MSMEs in sub–Saharan Africa alone. DFIs simply cannot cope with that level of need.

“Getting small amounts of money to communities through SMEs is the real challenge,” says Phillips at the AfDB. “The only way to do that is through small lines of credits through commercial banks – or potentially green banks.”

Green banks are public or non-profit entities created to generate private investment in domestic low-carbon, climate-resilient infrastructure. AfDB launched its green bank initiative at COP27 in 2022 in Egypt and is set to roll out four further schemes in Côte d’Ivoire, Benin, Morocco and Egypt.

The needs of impact finance are not going to precipitate a change in rating-agency methodology. But lenders should think about how debt ratings feed into investment decisions in a way that is complementary to the global sustainability agenda.

This would hopefully go some way towards preventing lenders being discouraged from looking at these small but high-impact SMEs and help them to see the transition through.

Should sustainability be priced in?

“We have to incorporate long-term sustainability metrics into economic growth and credit rating frameworks, so that the investment community can understand that short GDP boost that comes at the expense of capital resources has a cost”.

Jang Ping Thia, AIIB

Speaking to Euromoney at COP28 at the launch of the Asian Infrastructure Investment Bank’s report on nature as infrastructure, the AIIB’s lead economist Jang Ping Thia points to a fundamental problem in global markets: developing economies get better pricing on their debt if they can demonstrate GDP growth, even though that might mean they have weaker environmental, social and governance scores.

The only way to shift that is to better price in the influence of ESG criteria.

“Credit rating agencies have a role to play in terms of highlighting if the practices are unsustainable, but the domestic policymakers are also critical: if natural capital stock depletion is measured well, then investors can know the true cost of the GDP growth,” Thia says.

But how far can credit agencies really go to integrate ESG scores in their credit analyses? Most of them already provide ESG ratings, which are complementary to credit ratings, and integrate some ESG factors into credit ratings when it is relevant to do so.

“ESG considerations are embedded in our credit ratings, but they are different assessments,” says Aurelien Mali, vice-president, senior credit officer for Africa at Moody’s. "We have made the correlation more visible by assigning ESG scores alongside our credit ratings.

“For example, the assessment of governance and institutional strength has always been part of our sovereign credit rating methodology because having stronger institutions leads to a stronger ability for an economy to absorb shocks and is generally more conducive for repayments.”

Different process

Social factors also filter into key economic metrics such as poverty rates, GDP per capita and political stability, while environmental factors are reflected in issues such as access to water, exposure to climate shocks, the cost of rebuilding, etc.

“We determine an issuer’s exposure to ESG risks and then we determine a credit impact score [CIS] that reflects the impact of ESG risks on the credit rating,” adds Mali. If the CIS were lower, the credit rating would be higher.

The question is not if sustainability should feed into credit rating methodologies, but rather how material the different topics within sustainability are to the probability of debt repayment.

“There’s a push from NGOs to turn credit ratings into something that they are not, when there are other ways to channel finance and capture the sustainability element,” a source close to the rating agencies tells Euromoney.

When an issuer inches close to default, there is also a question of priorities. The materiality of sustainability metrics to credit ratings will depend on who the issuer is and what kind of debt it has.

If an issuer is in the triple-C category, the horizon of its credit rating is very short, and it is likely to default before the environmental and/or social risks materialise. It is the double- or triple-A rated entities that have the luxury to look at the long-term impact of ESG criteria on their debt.

“We get people asking us: ‘The world is ending; why don’t you incorporate that into your credit ratings?’ But we do scenario planning; it’s just a different process,” the source adds.

For example, when wind-energy project developers were expanding in the 2010s, their credit ratings were going down, and that wasn’t a judgment by the ratings agencies on whether investors should fund wind projects, but simply that leverage goes up while their assets aren't generating cash.

Among other tools, credit ratings are there to determine the quality of the debt; it is then up to investors to decide what they base their decisions on.


Gros, Marianne.jpg
Sustainability and ESG senior reporter
Marianne Gros is sustainability and ESG senior reporter. She joined Euromoney in 2022, having previously covered asset allocation news in the European institutional investment space.
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