We think Standard & Poor’s sovereign credit rating model breaks down when applied to Egypt — and that’s preventing an improvement in the rating agency’s outlook on Egypt and a possible upgrade in the credit rating. Why does this matter? Lower credit ratings translate into higher borrowing costs for the state and are a barrier to some investors. At the heart of it: S&P says, qualitatively, that it welcomes the float of the EGP, which it says will do good things for the economy going forward. But quantitatively, their model for assessing our credit rating punishes us for the magnitude of the very same devaluation they say they welcome, making it impossible for them to upgrade our credit rating or outlook. Contrast that with the exceptional performance of Egypt’s eurobonds in the market, which is arguably a real-world, fact-based argument in favour of an upgrade. Here’s the backstory, and how we think S&Ps model is holding Egypt back:

THE BACKGROUND: We spoke by phone with the S&P analyst responsible for Egypt’s credit rating on Monday to dig deeper into the drivers of the agency’s most recent report on the country, in which they affirmed Egypt’s credit rating at B- / Stable on 12 May. “Overall, the situation [in Egypt] is improving,” the credit analyst said. The stable outlook and affirmation of the rating are balanced out by risks arising from fiscal and external deficits and the gradual implementation of reforms. S&P sees GDP growth slowing down to 3.8% from 4.3% in the current fiscal year. That’s because devaluation of the EGP and the subsequent wave of high inflation are seen as weighing heavily on domestic demand, the main driver of economic growth over last years. Instead, foreign and domestic investment are likely to drive growth in the coming period, alongside net exports.

The ratings agency sees the Ismail government’s reforms starting to bear fruit in late2018 and early 2019. Economic growth in 2017 will take a hit as we adjust to the new foreign exchange regime and as inflation continues to be high. And presidential elections in 2018 are likely to cause investors to take a “wait and see” stance. These factors should dissipate by 2019 and, coupled with a rebound in tourism and the start of production from Zohr, should see GDP growth accelerate. S&P thinks the fiscal deficit will narrow to 7% by 2020, pulling general government debt to a declining path that should see it drop to 82% of GDP by 2020.

Before the 12 May report, S&P last looked at Egypt on 11 November 2016. Heading into our call on Monday, our primary question for S&P was how they view the reform measures taken since November, given the stable rating and outlook in their most recent assessment. We were also concerned with how the international bond market was pricing Egyptian debt, as it was cheaper than the higher-rated Nigeria and Ethiopia, for example, and very close to Jordan’s, which carries a significantly higher rating of BB-. (See our take on Ahmed Namatalla’s piece for Bloomberg, Egypt’s performance on the bond market merits a credit upgrade.)

THE METHODOLOGY: This is where we need to get down into the weeds, so bear with us. The sovereign credit analyst explained that S&P’s sovereign credit ratings are driven by five factors that determine credit worthiness: institutional, economic, external, fiscal, and monetary. Together, they provide a sovereign indicative rating level that could then be subject to supplemental adjustment factors and “one notch of uplift / downlift, if applicable.” Each factor is given a score of 1 (strongest) to 6 (weakest). The institutional and economic assessments are averaged to give “the institutional and economic profile,” while the other three factors are averaged to give “the flexibility and performance profile.” The two profiles are used to determine an indicative rating level (specified in a table by S&P) with other factors that allow for the “one notch higher or lower” movement.

S&P says Egypt’s rating was “constrained by wide fiscal deficits, high public debt,low income levels, and institutional and social fragility,” according to the report. The fiscal deficit, as noted, is on a downward trajectory, bringing down public debt with it, S&P says. The S&P analyst also said “our institutional assessment did not change from the last one in November 2016.”

THE PROBLEM: Look at the rating criteria and you’ll see that the factor that weighed most heavily on S&P’s assessment was our poor performance on GDP per capita, which is measured in USD terms. According to S&P’s figures, USD-denominated GDP per capita dropped to USD 2.9k in FY 2016-17 from a peak of USD 3.7k in FY 2015-16.

Looking at the data provided with the S&P report as well as the S&P Sovereign Rating Methodology, we take issue with the rating agency’s criteria and the model they use. On the economic assessment criteria, S&P says: “The determination of the economic assessment uses the current-year estimate for the GDP per capita from national statistics, converted to [USD].” S&P then considers the real GDP per capita growth trend for the decision to bump the economic assessment score “one category worse or better than the initial assessment.”

S&P uses the same criteria (quite transparently) across all of the sovereigns it rates. The problem is that the methodology is not necessarily reflective of reality in Egypt. According to S&P data, real GDP per capita growth in Egypt grew by 2.9% in FY 2015-16 and by 1.5% in FY 2016-17. At the same time, using the same data, we can see that GDP per capita in USD terms has decreased by nearly 22% between FY 2015-16 and FY 2016-17 and is expected to drop further still by almost 21% to USD 2.3k in FY 2017-18. Since S&P says real GDP per capita growth in Egypt is positive, the expected decreases are then driven entirely by the exchange rate adjustment. GDP, in USD terms, is bound to be significantly lower in FY 2016-17 than in previous years as the currency lost nearly half its value, a drop that is by no means equates to an equal erosion of wealth.

And since the model’s starting point is the USD-denominated GDP figure, it seems clear to us that the ratings framework used by S&P is not responsive to large exchange rate adjustments such as the one we’re living through today in Egypt. S&P described the float of the EGP as “a vital step toward alleviating Egypt’s acute foreign currency shortage, eliminating the differential between the official and unofficial exchange rates and improving the country’s export competitiveness.” But quantitatively, the rating model punishes us for the float in calculating the economic assessment criteria.

Fundamentally, this suggests there are two problems with the model S&P is using for its sovereign credit ratings: First, forcing the USD denomination. Second, aggregating across measures — using averages based on so few criteria can lead to having one outlier causing big shifts, even when it should not.

Our take:

• S&P’s sovereign credit ratings model is broken in the case of Egypt and susceptible to bias.
• The credit rating report issued on 12 May does not necessarily reflect the reality of the economic situation in Egypt, nor the nation’s creditworthiness.
• Future rating decisions will continue to be inadequate as long as the model’s shortcomings are not addressed.