Nigel Clarke | Credit ratings matter because cost of credit matters
Standard and Poor’s (S&P), the international credit rating agency, recently upgraded Jamaica sovereign debt from B+ to BB-. This is the best credit rating that Jamaica has received from S&P since they started rating Jamaica’s sovereign debt in 1999.
Many Jamaicans intrinsically understand the significance of this development. Others wonder, however, why does this matter? Credit ratings matter because the cost of credit matters. And credit rating upgrades matter because they support improvements in the relative cost of credit.
INFLUENCE RELATIVE COST OF CREDIT
Governments rely on loan financing to plug seasonal cash-flow gaps and to fund projects and programmes. Bond investors provide loan financing to governments and price these loans primarily through the interest rate (i.e. the yield) they require the borrowing government to pay.
For bonds issued in international capital markets, the yield can be thought of as consisting of two components. The first is the prevailing yield on similar securities issued by the United States (US) government (i.e. US Treasury Bonds and US Treasury Bills, collectively referred to hereinafter as US Treasuries). These are traditionally regarded as the safest investments one can make. The second component is the spread above comparable US Treasuries that represents the perceived riskiness of lending to the borrowing country. The riskier the economy, the higher the spread over US Treasuries that investors will demand.
However, international government bond investors do not all have the capacity, nor the inclination, to keep track of the riskiness of all the countries they lend to. As such, international credit rating agencies, who have tremendous scale in research and analysis, perform the service of closely tracking countries and ascribing periodic credit ratings that represent their view of the country’s creditworthiness. These ratings play an influential role in determining the spread over US Treasury yields that investors demand for lending to the particular country.
Figure 1 shows the evolution of the average spread over US Treasuries that prevailed over the period 2010-2023, across all outstanding emerging market bonds, for S&P rated ‘B’, ‘BB’ and ‘BBB’ rated bonds. Over this 13-year period investors demanded an average spread of 600 basis points (i.e. 6 percentage points) over US Treasuries for bonds rated ‘B’.
However, over the same time horizon, “BB” rated bonds required an average “spread” of 295 basis points (i.e. 2.95 percentage points) over US Treasuries across all ‘BB’ rated emerging market countries.
So, for illustrative purposes, if US Treasuries yielded an average of 2.5 per cent over this period, the ‘B’ rated bonds, of similar maturity profile, would have yielded an average of 8.5 per cent over the same period while ‘BB’ rated bonds would have yielded 5.45 per cent. These yields reflect the prices that countries with a ‘B’ rating, and others with a ‘BB’ rating, would have had to pay, on average, on new bonds issued over that period.
Over time, this 305-basis point (3.05 percentage points) differential between what the ‘B’ rated country pays on its debt and what the ‘BB’ rated country pays, adds up to substantial amounts that the ‘BB’ rated country can deploy to other activities that are better aligned with development, such as education, health and infrastructure spending.
BETTER THAN REGIONAL PEERS
We can bring the point closer home by examining the trajectory of the spread over US Treasuries that investors required to hold Jamaica’s bond maturing in 2025, (Jamaica’s 2025 bond), which was issued in 2005. In early 2013, when Jamaica had a credit rating of CCC from S&P, investors required a spread of approximately 700 basis points (seven percentage points!) over US Treasuries to hold Jamaica’s 2025 bond.
By early 2016, Jamaica’s credit rating was single B, two notches above CCC, and bond investors reduced this spread to 500 basis points (five percentage points) over comparable US Treasuries. Today, Jamaica’s credit rating is BB-, two notches above single B, and the spread on the Jamaica 2025 bond, hovers at just over 100 basis points (one percentage point) over similar US Treasuries. The dramatic reduction in this spread, from seven percentage points to 1 percentage point, vividly portrays the improvement in Jamaica’s risk profile and Jamaica’s relative cost of financing over the period.
Today, investors require an even lower yield on Jamaican bonds than our credit rating would suggest. Figure 2 shows the spread over US Treasuries that bonds, of similar tenor, yield across a range of emerging market countries as at September 21, 2022 when this snapshot was taken. On this date investors were requiring compensation of:
• 1,992 basis points (19.92 percentage points) above US Treasuries to hold Sri Lanka government bonds,
• 705 basis points (7.05 percentage points) above US Treasuries to hold Bahamas government bonds, and
• 370 basis points (3.7 percentage points) above US Treasuries to hold Barbados government bonds,
• But only 119 basis points (1.19 percentage points) above US Treasuries to hold Jamaican government bonds of similar tenor.
Also, from Figure 2, the spread over US Treasuries that investors require to hold Jamaican bonds is even less today than investors require to hold bonds issued by governments of Mexico, Panama, and Hungary even though these countries are designated “investment grade”, by rating agencies, which represents a credit rating three notches above Jamaica’s.
At the same time the yield on the 10-year US Treasury bond has increased from 1.7 per cent at the beginning of 2022 to about 4.5 per cent today, which means yields on all government bonds, globally, have increased over this timeframe. However, Jamaica’s relative cost of financing has never been cheaper. These market data above suggest that, today, Jamaica is able to raise financing on international capital markets more cheaply than the vast majority of our regional peers.
IMPROVE COST OF DOING BUSINESS TOO
This improvement in the GOJ’s credit profile also has a positive impact on the cost of credit for Jamaican businesses. A higher credit rating improves the terms of trade that Jamaica has with the rest of the world. This matters as we imported approximately US$7.7 billion of goods in 2022 which represented approximately 40 per cent of GDP. Commercial importers need to negotiate credit terms with suppliers who assess the risk of being repaid and the credit risk of the GOJ features prominently in such assessments. Depending on the industry, commercial importers may have to post bonds, or secure credit insurance to satisfy suppliers. These become more affordable the higher the credit rating of the GOJ. The more competitive the industry, the more these savings flow to consumers.
In addition, project financings and public private partnerships (PPP’s) become more financeable and hence more feasible the higher a country’s credit rating. Similarly, the signals transmitted from a higher credit rating make Jamaica more attractive for foreign investment in general.
In upgrading Jamaica’s credit rating, S&P would have taken into consideration the following, among other factors:
(a) Jamaica’s improved and more robust institutional framework – an independent central bank, a new fiscal commissioner and the independent fiscal commission;
(b) Jamaica’s monetary policy framework of inflation targeting within the context of a market determined exchange rate;
(c) Jamaica’s improved disaster risk financing framework which improves fiscal resilience – an independently sponsored catastrophe bond, a capitalised contingency fund for natural disasters and a credit contingency claim;
(d) Jamaica’s commitment to debt reduction and our dramatically improved Debt/GDP which is projected to be lowered to 74 per cent by March 2023 down from 110 per cent at the height of the pandemic;
(e) The existence of a credible fiscal path for Jamaica to attain Debt/GDP of 60 per cent within the timeline specified in Jamaica’s fiscal rules;
(f) Jamaica’s improved net international reserves (NIR) of US$4.4 billion, significantly more than the US$3 billion when Jamaica was last upgraded to B+ in 2019, and double the US$2 billion in NIR in early 2016.
These policy reforms and achievements contributed to the historic S&P credit upgrade and it is vitally important that we continue to build on these, to lower Jamaica’s cost of credit and create even more fiscal space for development.