GCR GLOBAL CREDIT RATING CO.
                                                                         Local Expertise   Global Presence


Chapter 1. An overview of the role of a rating agency, key success factors, the benefits
                      of ratings, and regulatory considerations

The role of a rating agency is to independently differentiate credit quality across all industry
sectors and investment instruments, with the purpose of providing investors with the information
on which to base appropriate investment and pricing decisions. Accordingly, a formal rating
provides an independent and internationally recognised measurement of an organisation’s
financial strength and quantifies the relative risk of default on any particular debt instrument
(expressed in the form of the accordance of a Rating Symbol). The long term rating scale will
range from AAA (being the highest credit quality), through AA, A and BBB (all being investment
grade quality), down to BB,B and CCC.

The key to the success of the local rating initiative revolves around:

   the maintenance of absolute independence
   the adherence to internationally accepted rating standards
   the maintenance of strictest confidentiality
   demonstrated quality and consistency of analysis

It is generally accepted that the existence of a credible ratings industry is an essential pre-
requisite for the development of efficient capital markets. In this regard the general benefits are
as follows:

   For investors, ratings provide the mechanism to more effectively price for risk (consistent
   across all investment instruments, industries and companies) and to monitor credit risk
   exposures over time.
   For issuers, a favourable rating can immediately result in an increased pool of investors,
   improved direct access to capital markets and ultimately a reduction in funding costs.
   For regulators and the marketplace as a whole, they benefit from the direct manner in which
   ratings facilitate the development of deeper, more transparent and more liquid capital
   markets, and particularly from the manor in which ratings serve to protect the interests of the
   “man in the street”. In many countries Pension Funds and Unit Trusts are required, by law,
   to invest in paper with a certain minimum rating (as accorded by an accredited rating

In essence, independent rating agencies developed in line with the growth in international
capital markets. Investors required an independent opinion on the creditworthiness of the issuer
so that the securities could be differentiated from each-other. The end result was that investors
began using ratings as a means of accurately pricing for risk. and the graph hereunder provides
an indication of the remarkable historical accuracy of ratings in the “investment grade” category,
by measuring the level of default for each rating class over an 8 year period. The direct
correlation between the ratings to the yields demanded is also clearly apparent.
                           Cumulative default rate & yield correlations
             %                                                                         BP
         7                                                                                  160






         0                                                                                  40
                  AAA                         AA-          A-                   BBB-
                        Default probability          Average new issue spread

Source: FT Credit Ratings International. Issue 1 2003.

The issue of the regulation of rating agencies

In developed markets it is the norm for rating agencies to be “accredited” by the relevant market
authority (normally the Securities Exchange Commission or its equivalent). Such accreditation is
granted once the rating agency has demonstrated its technical competence and market
acceptance, and after adhering to all the Authority’s laid down guidelines in order to qualify for
accreditation. The basic concept is that wherever there is a regulatory requirement for any form
of debt instruments to be rated, this should be accompanied by a clearly specified accreditation
process for rating agencies operating in the market. In Africa, there has been a major recent
trend by the leading regulatory authorities to incorporate independent ratings as a key
measurement of what constitutes “acceptable investments” by organisations investing public
funds (in line with the long established practice in developed countries). Accordingly, over the
past couple of years many authorities have made it a regulatory requirement for rating agencies
to be officially accredited.

         Chapter 2. Assessment of the need to establish a rating system in Africa

With the efforts underway to establish debt capital markets and promote the growth of the long
term contractual savings industry, the establishment of an internationally accepted ratings
system is clearly a key requirement. In fact, the absence of such a system would clearly
significantly undermine the attempts to develop the local markets. By the same token, there is a
desperate need to attract more international investment into Africa. Noteworthy is the fact there
seem to be a number of different rating initiatives underway, including a UNIDO/EBID initiative
(pertaining to a need to establish a local rating system in the ECOWAS region), as well as 2
independent initiatives to fund sovereign ratings in Africa (i.e. by the US State Department in
collaboration with Fitch, and by the UNDP in collaboration with S&P). There is also a private
sector initiative by Global Credit Ratings (“GCR”), which specialises in emerging markets, to
expand local rating initiatives across the continent. Finally, the issue of independent ratings
appears to be a central theme of certain NEPAD objectives. A core challenge is thus to
ascertain if and how all such initiatives can be integrated.
At this juncture, it is crucial to reflect on the most appropriate system which should be
implemented in the region. More specifically, should the focus be on implementing local or
foreign currency rating scales, or a hybrid?

International foreign currency ratings effectively benchmark credit quality off US Government
risk, and measure the ability of an organisation to service foreign currency obligations. In this
regard, typically no organisation or debt issue in a country can be rated higher than the
country’s “sovereign risk rating” on the basis that, regardless of a company’s stand-alone
strength, the government can “block” any organisation within its jurisdiction from
obtaining/disbursing foreign currency. Exceptions can arise in the case of structured finance
transactions (if there is an opportunity to pierce the sovereign cap, e.g. by trapping foreign
currency offshore).

Chapter 3. What are the potential problems associated with foreign currency (otherwise
known as “International Scale”) ratings?:

The fact that Africa is overwhelmingly non-investment grade on the foreign currency
rating scale makes it particularly vulnerable to the following practical problems:

1. The fact is that there is a very substantial difference between the main US-based rating
agencies in terms of non-investment grade default data, as evidenced below:

                                      8 year default data
               %                                                                    48.3
          45                                                 39.7
          40                                                              34.3   34.2
          25                                              20.6
          20                 14.3        13.8
          15              8.5         9.8
          10   5.9 5.4

               BBB-        BB+            BB     BB-         B+       B            B-

                                    S&P            Moody's

Source: FT Credit Ratings International. Issue 1 2003.

Immediately apparent is that:
     - unlike the statistical track record pertaining to the investment grade band, there is a
         massive differential in default probabilities in the non investment grade band. For as
         long as this continues, how can investors utilise these ratings as a basis to accurately
         price for risk?
     - While in the 10 investment grade categories (AAA to BBB-) the differential in default
         probability is very finely measured (i.e. it equates to around a 5% differential across
         all 10 categories), default probabilities “fall off the cliff” in the non-investment grade
         band (i.e. in the B category alone the differential is around 14%). Once again, this
         seriously impedes the ability of investors to accurately price for risk
2. It is an indisputable fact that the international rating agency track record in emerging markets
has been poor compared to their track record in “first world” markets. The reality is that
emerging markets are fundamentally different to the developed markets in the US and Western
Europe (as many agencies discovered to their cost during the emerging markets crises of the
past), which calls for a fundamental appreciation of the unique characteristics of these markets.
We would argue that it is an essential pre-requisite for any rating agency to have established an
“on the ground presence” before rating in a particular country (as this is the only way one can
develop the necessary understanding of the unique characteristics pertaining to each market),
yet in Sub Saharan Africa US-based agencies have only established a presence in 1 country
(South Africa).

Is there sufficient differentiation of risk in Africa?

Most of the sovereign foreign currency ratings accorded in Africa to date are in the very low

speculative grade band. For example, of the last 10 foreign currency ratings accorded in Africa

by a leading US agency, 9 are in the single B band, as evidenced below:

Benin                                                B+
Burkina Faso                                         B
Cape Verde                                           B+
Cameroon                                             B
Mali                                                 B
Madagascar                                           B
Mozambique                                           B
Ghana                                                B+
Senegal                                              B+

As evidenced, the sovereign ratings are almost all the same and, being so low (and thus capping
the foreign currency ratings which can be accorded to underlying companies in the region), the
rating scale hardly allows for ANY differentiation of underlying credit risk within the majority of the

It can further be argued that most companies who actually operate businesses in the above
countries would seriously question, intuitively, whether there was only a 1 notch difference in risk
between say Ghana and Mozambique. If, however, one understands that, according to the S&P
default data, a B+ has a 21% probability of default over an 8 year period, while a B has a 29%
probability of default, than this makes more sense. However, it is surely apparent that there is
insufficient calibration of risk below BBB-, which begs the next question:

Was the rating scale designed for first world markets?

The previous sections clearly specify the problems associated with applying the scale in
emerging markets (i.e. clearly insufficient calibration of risk in the non investment grade band,
with a lack of consistency between rating scales and default probabilities amongst different
agencies). The answer has to be to scientifically expand the calibration of risk below the non-
investment grade band, in order to provide more meaningful statistical data pertaining to Africa.
Is the international rating scale relevant in respect of local currency denominated bond

International foreign currency ratings are pertinent in respect of any sovereign or organisation
contemplating a US$ denominated bond issue, but are not relevant in the case of local currency
denominated bond issues. These should be rated on the local currency national rating scale.

Local currency ratings effectively benchmark credit quality off an assumed “best possible” rating
of AAA (i.e. they exclude the risk of currency conversion). The argument is that such ratings
should be able to be accorded to a Central Government (as they effectively have the power to
“print” their own currency), although in GCR’s experience, the theory does not necessarily apply
in Africa, and there are clear cases where an underlying corporate evidences a lower probability
of default even on local currency obligations than the Central Government. The rating
methodologies and rating scales utilised in the accordance of both types of ratings are identical,
but the key difference is that one scale measures the probability of default on FOREIGN
CURRENCY obligations, while the other measures the probability of default on LOCAL
CURRENCY obligations. It stands to reason that, particularly in markets such as Africa, there is
a far higher probability of default with regards to the former. It is in this regard, that any attempt
to stringently “tie” a local currency rating to a foreign currency rating (which the US agencies
have historically followed as a matter of policy, in respect of their “international local currency
ratings”) could result in patently incorrect outcomes when rating in “lower foreign currency rated
countries”. This policy has already resulted in certain absurd distortions in Africa, both within a
specific country as well as across countries, which bear no relativity to actual probability of
default data/studies.

Chapter 4. What are the advantages associated with local currency National Scale

   -   Such ratings are pertinent in respect of local currency denominated bond issues, and are
       thus more pertinent to facilitating the development of local capital markets
   -   The national rating scale enables the differentiation of underlying credit risks within each
       country (as it is not “capped” by the sovereign risk ceiling)
   -   GCR’s experience in Africa over the past 8 years is that there is statistically a greater
       correlation (between the different rating bands and default probabilities) on the local
       currency scale than on the foreign currency rating scale.

The downside is that national scale ratings are not comparable across different countries in the
same way that foreign currency ratings are (i.e. while a Ghanaian organisation which is
accorded an A rating in respect of its ability to honour Cedi obligations should reflect a similar
probability of default on local currency obligations as a Nigerian organisation which is accorded
an A rating in respect of its Naira obligations, it does NOT mean that they have equal ability to
honour their foreign currency obligations). In this regard, GCR is of the view that there is a need
to further develop the national scale ratings to incorporate an “African national scale rating”
(whereby all issuers in Africa would be benchmarked of “the strongest country in Africa’s,
assumed rating of AAA”). This would enable incorporation of all sovereign risks within the
continent, but still enable appropriate differentiation of underlying risks within the continent.
Chapter 5. Conclusion

In order for the African Continent to achieve the desired benefits from credit ratings, we would
argue that the following are pre-requisites:

   1. The foreign currency international scale ratings (relevant to the attraction of foreign
      investment) must be developed hand-in-hand with the local currency national scale
      ratings (relevant to the development of local capital markets).
   2. Serious attention should be given to exploring how the large number of different
      initiatives currently underway on the continent can be integrated, preferably to be
      endorsed by all relevant role players (such as NEPAD and the Multilateral agencies).
   3. The questions which have been raised, pertaining to the potential problems associated
      with the international rating scale in Africa, need to be debated and satisfactorily
   4. A mechanism must be found whereby credit risks below investment grade can be further
      calibrated on the international scale. In effect, relative default probabilities in the sub-
      investment grade band should be as well calibrated as they have always been in the
      investment grade band.
   5. In attending to the above GCR would argue that it is extremely important to get “buy-in”
      from both Africans and the international community. The objective must be to come up
      with the solution that most effectively and accurately quantifies relative risks across the
      continent (i.e. not to develop an “African solution” per se, but one that better meets the
      demanding requirements of the international community at large)

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