Ethiopia downgraded on default concerns

Ethiopia’s long- and short-term foreign currency sovereign credit ratings have been lowered from B to CCC by Fitch Ratings, on default concerns.

The country has not been given an outlook, as Fitch does not assign outlooks for countries with a rating of CCC or below.

Ethiopia’s downgrade follows the government’s announcement that it is looking to make use of the G20 Common Framework for Debt Treatments beyond the Debt Service Suspension Initiative (DSSI) (G20 CF). This although still an untested mechanism, explicitly raises the risk of a default event, according to Fitch.

The G20 CF, agreed in November 2020 by the G20 and Paris Club, goes beyond the DSSI that took effect in May 2020. It requires countries to seek debt treatment by private creditors and that this should be comparable with the debt treatment provided by official bilateral creditors.

This could mean that Ethiopia’s outstanding Eurobond and other commercial debt would need to be restructured, potentially representing a distressed debt exchange under Fitch’s sovereign rating criteria.

There remains uncertainty over how the G20 CF will be implemented in practice, including the requirement for private sector participation and comparable treatment. Fitch’s sovereign ratings apply to borrowing from the private sector, so official bilateral debt relief does not constitute a default, although it can point to increasing credit stress.

The focus of Ethiopia’s engagement with the G20 CF will be on official bilateral debt, as re-profiling of this will have the biggest impact on overall debt sustainability.

Nonetheless, the terms of the framework clearly create risk that private sector creditors will also be negatively affected.

The G20 statement on the G20 CF indicates that debt treatments will not typically involve debt write-offs or cancellation unless deemed necessary. The focus will instead be on some combination of lowering coupons and lengthening grace periods and maturities.

The extent of debt treatment required will be based upon the outcome of the International Monetary Fund’s (IMF) debt sustainability Analysis for Ethiopia, which is currently being updated.

However, any material change of terms for private creditors, including the lowering of coupons or the extension of maturities, would be consistent with the definition of default in Fitch’s criteria.

The bulk of Ethiopia’s public external debt is official multilateral and bilateral debt. Government and government-guaranteed external debt stood at $25 billion in the 2020 fiscal year (FY), which ended in June 2020.

Of this, $3.3 billion was owed to private creditors, including Ethiopia’s outstanding $1 billion Eurobond due in December 2024, with minimal annual debt service of $66 million until maturity. This also includes $2.3 billion government-guaranteed debt owed to foreign commercial banks and suppliers.

Other state-owned enterprises (SOE) debt to private creditors which relates to telecommunications services provider, Ethio Telecom and transportation company, Ethiopian Airlines is a further $3.3 billion. While this is not guaranteed by the government, it represents a potential contingent liability.

Ethiopia’s external finances are a rating weakness and this is the main factor behind the intention of using the G20 CF. Persistent current account deficits (CAD), low foreign exchange (FX) reserves and rising external debt repayments present risks to external debt sustainability.

The country’s external financing requirements, at more than $5 billion on average in the 2021 and 2022 FY including federal government and SOE amortisation are high relative to FX reserves. Fitch expects these to remain at around $3 billion. Reserves cover only around two months of current external payments.

Ethiopia’s CAD narrowed to 4.1% of gross domestic product (GDP) in the 2020 FY as imports declined, maintaining the trend since 2015 when the CAD was 12.5% of GDP. The rating agency expects the CAD to hover around 4% of GDP, although this does not incorporate potential import costs associated with vaccines to combat the coronavirus pandemic.

Smaller CADs have not eased pressure on FX reserves because net foreign direct investment (FDI) has been lacklustre, averaging 2.7% of GDP in the 2019 ad 2020 FY. The net external borrowing has moderated with negative net borrowing by SOEs.

The central bank has allowed sharper exchange rate depreciation, but the currency nonetheless remains overvalued, with a weaker rate in the parallel market.

Proposed sales of mobile licenses and a stake in Ethio Telecom, are an upside risk to FDI inflows and reserves in the 2021 and 2022 FY.

On the upside, strong economic growth potential and an improving policy framework support Ethiopia’s rating. However, double-digit inflation, low development and governance indicators and elevated political risks weigh on the rating.

The coronavirus disease 2019 (COVID-19) crisis continues to present significant risks to Ethiopia, but the negative economic impacts since the onset have been somewhat contained so far.

Given that the FY ends in June, Fitch expects more of a hit to growth in the 2021 FY than the 2020 FY. The rating agency forecasts a return to growth rates in the 6% to 7% range over the medium term.

Ethiopia’s government has maintained considerable budgetary discipline. The country has seen moderate increases in the general government budget deficit, to 2.8% of GDP and government debt-to-GDP at 31.5%, while total SOE debt-to-GDP at 25.6% has fallen.

However, the crisis presents risks of upward pressure on spending. Government financing has continued its transition towards market-based treasury bill auctions and away from the long-standing system of direct advances from the National Bank of Ethiopia (NBE). This is a core part of the IMF programme, which seeks to promote monetary policy reforms to help gradually tackle inflation that has remained extremely high at close to 20%.

Fitch would consider upgrading the rating if there is clarity that the G20 CF will not lead to a default event.

Stronger external finances with acceleration in exports, for example, leading to smaller CADs and higher foreign-currency reserves, would also lead to an upgrade in the rating, according to Fitch.

Fitch would consider downgrading Ethiopia if there is stronger evidence that engagement in the G20 CF will lead to comparable treatment for private sector creditors consistent with a default event.

Increased external vulnerability that heightens the risk of default irrespective of the G20 CF, would also lead to a downgrade, according to the rating agency.

This comes after S&P Global Ratings affirmed Ethiopia’s long and short-term foreign and local currency sovereign credit ratings at B/B, on its strong medium term economic growth potential, in 2020.

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