Prevailing political and institutional frameworks shape policies, and policies in turn shape economic outcomes and therefore sovereign ratings. We believe that political and institutional uncertainties are on the rise in so-called emerging and advanced economies alike. Changes in governance quality impact sovereign ratings: Among the 20 largest emerging market sovereigns we rate, the 10 that we have downgraded since January 2012 saw our assessment of their institutional effectiveness worsen by one notch (on a six-rung scale). In contrast, those not downgraded saw their institutional assessment improve by almost half a notch. Among the five main factors that determine our rating criteria, institutional assessment has been the most important negative driver distinguishing emerging market sovereigns that were downgraded from those that were not.
At the same time, it may no longer be possible to separate advanced economies from emerging markets by describing their political systems as displaying superior levels of stability, effectiveness, and predictability of policymaking and political institutions. For example, the lowering of our ratings on the U.S. in 2011 and the U.K. in 2016 stemmed from our negative reassessment of institutional quality and governance effectiveness. The downgrade of more than half of the eurozone sovereigns in early 2012 was driven by similar considerations.
- Political and institutional risks appear to be rising in both emerging and advanced economies.
- Growing protectionist and nationalistic policies, and a focus on domestic agendas to the detriment of economic issues, are the main risk trends we see for sovereigns worldwide.
- We see several key political challenges for sovereigns as we enter 2017.
Ratings have also converged. A decade ago, there was little overlap between sovereign ratings on advanced economies (typically in the 'A' category and above) and ratings on emerging market sovereigns--mostly in the 'BBB' category or in speculative grade ('BB+' and lower). Today this differentiation is much less pronounced. In fact, the biggest sovereign default of all time was by an OECD member normally classified as an advanced economy (Greece).
As the ratings have converged, so have the political and institutional risks. Predictability of policies and democratic choices have diminished in the Western world, as reflected in the surprise votes for Brexit in the U.K. and the election of a non-political outsider to the presidency of the U.S. Voters' rejection of constitutional reform in the Italian referendum last weekend can be seen in a similar context.
The first trend reflects a backlash in the advanced economies of what is perceived as an increasingly unequal distribution of the benefits of economic growth and globalization. This is reflected in the growing dispersion of incomes and wealth in many advanced economies (see "How Increasing Income Inequality Is Dampening U.S. Economic Growth, And Possible Ways To Change The Tide," Aug. 5, 2014, and "QE And Economic Inequality: The U.K. Experience," Feb. 10, 2016). It may also partly reflect aging societies and related anxieties surrounding a quickly evolving economic environment.
The rapid structural changes in advanced economies are perceived as threatening their relative economic positions in society. This sense of falling behind feeds the support of political projects that appear to offer the prospect of returning to what many perceive, rightly or wrongly, to have been a golden era, where jobs were secure and the future less uncertain. When analyzing the socio-demographic voting patterns in the election of Donald Trump, or the referendum decision by the U.K. to leave the EU, we see these motives at play. The same current is observable when analyzing the recently buoyant support for populist parties in Europe. All of these movements have furthermore been able to bring previously apathetic strata of society back to the polling booth to cast their protest vote.
We believe that the success of these political movements will lead to a halt, or maybe even a reversal of globalization, including the risk of protectionist tendencies. This would risk reducing economic efficiency and growth, without self-evident gains in improving social justice. Most of the economic fallout of less open economies will be in the countries turning protectionist themselves. But there can also be non-negligible knock-on effects to third countries, which have important economic ties with the potentially inward-turning countries. The possible effect on emerging markets of a potential U.S. pivot toward itself is a clear reminder of the web of relations that connects the global economy in the 21st century.
The second trend toward rising political and institutional risk could be considered a reflection of complacency. Years of quasi-effortless growth thanks to generous terms of trade, global demand, and cheap financing have led some emerging market policymakers to succumb to complacency. Attempts to further enhance resilience and underlying growth potential appear to have become a second-order priority in many places. Why push for further opening up of markets and antagonize important stakeholders at home, when things appear to be running rather smoothly anyway?
Instead, politically more rewarding issues have attracted policymakers' attention. Some have thereby failed to establish robust regulation that would have prevented excessive leverage from creeping into the economy. Central banks may have been put under pressure to accommodate political priorities. Others were tempted to accommodate domestic stakeholders by increasing current government spending, for example on subsidies, or civil servants, or by directing credit into favored sectors or regions. Anecdotally, in some countries, perceptions of corruption have been on the rise. The vulnerabilities that were thus created are now being felt.
In the following, S&P Global Ratings' analysts answer questions we frequently receive from investors. They discuss the key political challenges facing sovereigns in 2017, two decades after the Asian crisis and one decade since the first rumblings of what would become known as the great financial crisis. Each country has its own idiosyncratic aspects and may be in a different stage of a "populism cycle." For example, the pendulum of political risk may be swinging back toward the traditional political mainstream in Brazil, Argentina, and Greece, while it is still in its early stages in places as diverse as the U.S. and the Philippines.
An analytical case-by-case approach is always appropriate when analyzing sovereign risk. But never more so than when political and institutional risks move to center stage.