President Goodluck Jonathan
A country with more transparent budget processes is likely to be assigned a better sovereign credit rating and lower risk premiums for a number of reasons, writes Eromosele Abiodun.
The spat between the Nigerian parliament and executive arm of government over the transparency and implementation of this year’s budget is yet to die down. While the house claimed that the budget has performed below 35 per cent, the executive argued that the budget has achieved over 50 per cent performance. Despite their disagreements however, Nigeria recently got a favourable rating from several rating agencies based on the country’s economic outlook and its debt position. This position may change soon. Reasons being that there is a link between budget transparency and sovereign rating as well as sovereign debts. In particular, more transparent countries, after controlling for various economic variables, have higher credit ratings and lower debts. Further, for countries with similar credit ratings, higher transparency is associated with lower spreads.
It is important to note that investors are interested in determining the default risk associated with various sovereign borrowers which is largely dependent on a country’s long term fiscal position. Often it is difficult for investors to determine the true nature of a country’s fiscal position because governments for various reasons engage in fiscal misreporting or off-budget activity. Budget transparency can improve the ability of investors to assess a government’s fiscal position thus its ability and willingness to service its debt obligations. It is also a fact that a country with more transparent budget processes is likely to be assigned a better sovereign credit rating and lower risk premiums for a number of reasons.
Transparency and Financial Markets
Financial markets have played an increasingly important role in the ability of the advanced as well as developing economies to finance their budget deficits. The emerging markets in particular have been able to tap the international sovereign bond markets to support their expenditures. Before investing in a country’s bonds, the lenders need to assess the creditworthiness of the particular borrowers. Two broadly used indicators of a sovereign borrower’s risk level are the credit rating and the sovereign spread. The credit rating refers to the a rating assigned by a credit rating agency (e.g. Standard & Poor’s, Fitch and Moody’s) and generally ranges from AAA (triple A) to D for default. Higher rated sovereign can borrow at lower cost since they are deemed to be less risky. The other major indicator of risk level is the sovereign bond spread, i.e., the difference between the yield of a risk free (or nearly risk free) bond, such as the U.S. Treasury bill and the yield of the sovereign bond in question. In other words, it is the expected return required to compensate the investors for holding riskier bonds. Yields (based on the price of the bond and its coupon) are available at a high frequency and respond immediately to market conditions.
The higher the spread the higher is the market assessment of the country risk and higher will be the borrowing cost. For instance, for a $1 billion sovereign bond issue, a spread of 3.5 per cent would mean that the borrower will pay an additional $35 million on an annual basis to service the bond compared to a borrower with minimal risk. Transparency may also shield a country from the effects of sudden changes in market sentiments and mitigate contagion. Meanwhile, lack of transparency has often been cited as a partial contributor to financial crises. For example, the International Monetary Fund (IMF) in a 2001 report noted that, “A lack of transparency was a feature of the build-up to the Mexican crisis of 1994-95 and of the emerging market crises of 1997-98 and that inadequate economic data, hidden weaknesses in financial systems, and a lack of clarity about government policies and policy formulation contributed to a loss of confidence that ultimately threatened to undermine global stability.”
In its annual survey to examine the relationship between budget transparency, sovereign rating and investors, the International Budget Partnership (IBP), noted that the most direct channel through which budget transparency impacts the financial markets is through provision of more fiscal information and reduced uncertainty around that information.
The International Budget Partnership collaborates with civil society around the world to use budget analysis and advocacy as a tool to improve effective governance and reduce poverty.
Specifically, the IBP noted that reduced uncertainty is likely to result in lower risk premiums thus lower cost of borrowing.
“But this is assuming that more information is necessarily favourable information, which may not always be true. For example, in an attempt to become more transparent, a country may do a stock taking of all of its debt and if the result of the analysis reveals that the consolidated debt of the government is much higher than previously reported, the higher transparency could very well increase the risk premium and thus the cost of borrowing. It is plausible that the governments are aware of this trade-off and are likely to make rational decisions regarding their level of transparency.
“Essentially, this suggests a non-linear relationship of transparency and gains from transparency i.e. for those countries which have a reason to remain non-transparent as well those countries which are already highly transparent the gains from additional transparency may be limited (at least in the short-run). On the other hand, countries in the middle may have the most of gain from increased transparency, “IBP said.
The IBP also stressed that another way to look at the impact of transparency on financial markets is to consider two countries with similar economic fundamentals but different budget transparency levels.
They added: “We argue that investors are likely to rate the more transparent country higher than the one with low transparency. This is not because markets attach an intrinsic value to transparency but because given that governments are rational, engaging in non-transparent practices implies that government perceives a gain from those practices. This in turn suggests that the information provided by the government needs to be discounted and the economic fundamentals are likely to be worse than reported.
“That being said, it is also possible that government may have a preference for opaqueness (particularly in non-democratic regimes) in which case the government may be reporting actual numbers without providing any assurances of accuracy. Similarly, financial market impact of the low or high level of transparency may be mitigated by other factors such as the appeal of the market size, contagion from neighbouring countries, global economic conditions etc.”
IBP however, stated that it was often difficult for the markets to determine the true nature of a county’s fiscal position because the government for various reasons may engage in fiscal misreporting or creative accounting.
“For example, during an election year, government may try to increase spending but while trying to hide the deficit if voters dislike deficit. In other cases, the government may engage in off-budget activity to circumvent numerical rules such as deficit or debt limits. This suggests that the level of fiscal gimmickry may influence the impact of fiscal variables on ratings and spreads,” IBP said.