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The threat of a sovereign debt crisis
A potential sovereign debt crisis has economists and policymakers concerned, owing to factors such as increasing sovereign debt levels, rising interest rates, growing fuel and food prices, and the Russia-Ukraine war. According to S&P Global Ratings, the sovereign debt of governments peaked in 2020 with a record of $14.871 trillion and is expected to remain relatively high throughout 2023. This is due to the ripple effect of economic stimulus removal and heavy fund borrowing carried out by governments during the height of the COVID-19 pandemic.
Total sovereign debt remains above pre-pandemic levels ($ trillions)
Surging global fuel and food prices are seen as contributors to a potential sovereign debt crisis. According to Lee Buchheit, a veteran sovereign debt restructurer and honorary professor at University of Edinburgh Law School, political pressure on governments is growing along with prices, leading to the necessity to borrow more to continue expanding their social safety net.
In addition, the conflict between Russia and Ukraine is not expected to be over in the short term and other countries are likely to increase their military budgets. Central Banks are implementing higher interest rates in response to the rising inflation.
As stated by Buchheit, governments will then be forced into the “odious position” of having to choose either to increase taxes or reduce national spending to service their record-high debt. As debt stocks grow, borrowing could stall.
A sovereign debt crisis would have significant implications on geopolitical risk. Unpaid sovereign debt can strain relationships between debtor countries and their creditors, prompt international aid, lead to domestic political instability, and potentially drive irregular migration trends. All of these factors can have wide-ranging effects on the affected countries and regions, and the global political and economic landscape.
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Accumulation of sovereign debt continues to deteriorate credit ratings
S&P Global Ratings rates the credit of 137 sovereigns globally. The accumulation of debt stocks was the consequence of governments’ attempt at providing support for the world economy during a series of critical events, including the global financial crisis in 2008, the COVID-19 pandemic, and the Russia-Ukraine war. The unprecedented monetary policies that governments adopted to accommodate these crises have slowly deteriorated sovereign credit quality.
According to the Global Sovereign Rating Trends 2023 report, the share of investment-grade sovereign ratings and overall sovereign credit ratings has dropped since the 2008 financial crisis. As of Dec. 31, 2022, 18 sovereigns had negative outlooks, and five had positive outlooks. Emerging markets are experiencing firsthand the negative consequences of fiscal consolidation delays, followed by developed markets.
Global sovereign ratings distribution
<span/>Global sovereign credit rating history
Regional credit rating outlooks
Europe
The credit ratings of Europe’s energy-intensive, consumer discretionary and leveraged corporate sectors will likely be hit hardest in 2023. Broadening input cost pressures, rising funding costs and potential contractions in demand will weigh on earnings, particularly in more competitive sectors lacking pricing power.
Vulnerabilities are expected to surface among companies rated B- and lower, either unable to refinance or extend maturities on a timely basis, or overly exposed to variable rates, leading to a moderate increase in the default rate (including distressed exchanges) to 3.25% by autumn next year under our base case. Retail, media and entertainment, capital goods, and consumer products are the sectors most exposed on this basis.
The credit rating outlook for European banks remains relatively stable. Despite a weakening macro environment, higher interest rates mean improving net interest margins, underpinning earnings. We expect asset quality to deteriorate (unevenly by region and sector), but the resulting rise in credit losses will be manageable and absorbed by earnings.
Weak growth and inflation pressures will primarily affect lending to small and midsize enterprises and consumers. Residential mortgage performance will hold up, even if property prices slip, thanks to high employment, low loan-to-value ratios and banks managing risk more proactively by offering some flexibility of terms to borrowers in difficulty. Furthermore, banks face 2023 with solid capital and liquidity. A more severe, spread-out recession in Europe, however, could lead to more negative sovereign credit rating outlooks emerging.
Emerging markets
Credit rating conditions in emerging markets will remain pressured during 2023, while we expect sovereigns and households to be particularly hit by the likely economic downturn. The corporate sector continues to present a mixed picture; some sectors will be able to protect profits by passing costs through prices in goods and services, taking advantage of high commodity prices (commodity exporters), while others will be affected by subdued demand (consumer products, chemicals or building materials).
Banks are well positioned to face the downturn, and higher interest rates could help bolster their net interest margins. Alternatively, asset-quality and credit losses will depend on the economic downturn's severity. Our downside-case scenario assumes that some banking systems could suffer as asset quality weakens and blunts the benefit of higher interest rates.
Emerging market sovereigns will be challenged as the revenue windfall from the nominal effect of high inflation and recovering economic growth dissipates and expenses climb amid higher interest rates, wage pressures, and social demands to curb energy prices. At the same time, emerging market households will continue struggling as lingering high prices erode their purchasing power and unemployment rises.
Ghana remains a global hotspot of rating actions, with its sovereign default risks elevated. Both the fiscal and the external deficits remain unsustainably large, putting severe pressure on dwindling foreign-exchange reserves.
Ghana’s current precarious financial predicament started in the middle of 2022 when it was locked out of refinancing its eurobonds in international capital markets. This placed new downward pressure on the foreign-exchange reserve position for debt refinancing, this time from the capital account. The value of Ghana’s cedi currency has fallen by nearly 50% against the US dollar over the past six months.
Ghanaian interest costs are now equal to just over one-half of government revenue. Without an approved International Monetary Fund program, the government will have to draw further on its very limited international reserves.
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North America
Already-strained sovereign credit rating conditions for borrowers in North America look set to worsen as we head into 2023, amid the prospect of a recession in the United States and sharply rising borrowing costs. S&P Global's economists now expect US GDP to contract 0.1% in 2023, with a mild recession in the first half and below-trend growth for the remainder of the year.
And while there are signs that inflation is easing, it's still running well above the Federal Reserve’s target. Any perceived monetary-policy misstep (in either direction) could push financing costs even higher and tighten liquidity further, straining borrowers' debt-service capacity.
Meanwhile, the credit rating trends in North America have turned negative. Downgrades have outpaced upgrades since August, and the negative outlook bias increased in the third quarter. Defaults, too, look set to tick up. S&P Global Ratings now expects the US trailing-12-month speculative-grade corporate default rate to reach 3.75% by September 2023, from 1.4% a year earlier.
Slumps in the US and Canadian housing markets are adding to pressures. While housing supply remains constrained in the US, the combination of economic uncertainty and higher mortgage interest rates is halting price growth, and even causing declines, in many markets.
In Canada, too, home sales have slowed significantly, and prices have fallen for seven straight months. Any further correction of house prices could weaken the prospects of sectors such as homebuilders, residential mortgage-backed securities and local governments.
Asia-Pacific
The credit conditions in Asia-Pacific are affected by lower global growth. Tightening global monetary policies are dampening demand, increasing risks of protracted US and European recessions and a weak recovery in China. With GDP growth (Asia-Pacific excluding China) decelerating to 3.9% in 2023, declining exports and corporate revenue will slow corporates' capital investments.
We also expect most regional central banks (except in China) to hike policy rates further. Japan, having kept rates flat in 2022, could begin raising rates to limit the yen's depreciation. Rated corporates are struggling with higher input costs and rates.
The Asia-Pacific region's currency weakness has led to costlier imports, despite lower global commodity and energy prices. Corporates have not been able to pass on higher costs to consumers. High food prices are putting pressure on households.
Pakistan’s financial position has turned precarious. Experiencing several shocks, not least the devastating consequences of severe flooding, as well as higher energy import prices and financing costs, Pakistan’s foreign-exchange reserves have fallen to less than US$8 billion, equivalent to just one month of import cover.
These shocks have also hobbled the country’s GDP growth and tax revenues. Most of existing foreign-exchange reserves result from deposits in the central bank from bilateral official donors from China and Saudi Arabia and limited releases of funding tranches from the IMF. Pakistan successfully completed its recent reviews under the IMF Extended Fund Facility (EFF) programme (totaling about US$4 billion since July 2019), but it is facing difficulties in continuing to meet the performance requirements for subsequent disbursements.
Pakistan has afforded additional independence to its central bank and, in turn, has allowed the rupee to float more freely, which has pushed up external debt-servicing costs as the rupee has depreciated versus the US dollar. In the long term, the floating currency should mitigate some structural imbalances.
Rising global interest rates and Pakistan’s interest rate risk premium in international capital markets have made its access to external market financing effectively unaffordable, implying a further reliance on multilateral and bilateral creditors to keep the country afloat.
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Sovereign debt risks are rising and vulnerabilities will likely remain high well into 2024
The number of rated sovereigns in default has increased to six: Lebanon, Belarus, Suriname, Sri Lanka, Zambia and Ghana. Moreover, the foreign currency debt of Ukraine defaulted and was restructured in August 2022. Russia also defaulted in April, but S&P Global has withdrawn its Russian sovereign ratings. Furthermore, the number of rated sovereigns in the CCC+, CCC or CC categories also increased to eight, three with negative outlooks, amid more difficult financing conditions. Sovereign default risks are expected to be escalating and perpetuate throughout 2023.
GG = General government. CA = Current account. e = Estimate. f = Forecast. Source: S&P Global Ratings.
Sovereigns in the CCC rating category | |||||||
|---|---|---|---|---|---|---|---|
| Net GG debt/GDP(%) | CA Balance/CAR (%) | GG Interests GG revenues (%) | |||||
| 2022e | 2023f | 2022e | 2023f | 2022e | 2023f | ||
| CCC+
Burkina Faso | 49.6 | 52.0 | (10.0) | (6.0) | 11.1 | 12.8 | |
| Congo-Brazzaville | 88.2 | 87.5 | 41.0 | 32.0 | 8.7 | 13.3 | |
| Mozambique | 79.5 | 79.4 | (81.7) | (44.8) | 14.0 | 12.4 | |
| Pakistan | 68.1 | 69.5 | (23.8) | (17.2) | 39.6 | 46.0 | |
| Ukraine | 97.9 | 105.8 | 11.3 | (6.2) | 11.9 | 8.5 | |
| Argentina | 68.7 | 63.0 | (7.5) | (7.0) | 6.3 | 6.7 | |
| El Salvador | 74.8 | 75.5 | (14.7) | (11.1) | 17.8 | 18.5 | |
| CCC
Ethiopia | 30.4 | 30.7 | (35.7) | (34.7) | 9.3 | 10.4 | |
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