For the world's 20 largest emerging-market sovereigns, S&P Global Ratings expects more downgrades than upgrades over the coming year. That expectation derives from the outlooks on the sovereign ratings, where negative outlooks outnumber positive outlooks, despite the global economic recovery (see table 1). One reason is that this observed economic strength is predicated on an unusually positive environment that may not last. In their latest monthly webcast on Oct. 12, 2017, S&P Global Ratings sovereign credit analysts explained what's behind the negative rating bias and fielded questions from participants about the drivers behind its ratings on the countries--from Argentina to Indonesia. Here, we present responses from sovereign analysts Moritz Kraemer, KimEng Tan, Frank Gill, and Joydeep Mukherji.
The negative rating bias is largely explained by domestic policy risk and monetary tightening, explained Mr. Kraemer, but has weakened over the past year. Although the liquidity position of emerging-market sovereigns is benign given accommodative monetary policies at leading central banks around the world, we expect the situation to change in the coming year. Those that depend most on capital inflows are most at risk, such as Turkey and Qatar, with the latter nevertheless having a fluffy asset cushion to fall back on. Another related factor is that easy funding conditions have tempted some policy makers to take their eye off the ball regarding macroeconomic management to focus on issues of more immediate domestic political payoff. Two sovereigns that have gone the furthest down this path are Brazil and Argentina. When global liquidity starts to dry up, the vulnerabilities will be exposed more clearly.
The Top-20 Emerging Market Sovereigns By Outstanding Commercial Debt (Foreign Currency Ratings)
|Positive Outlook||Stable Outlook||Negative Outlook|
|Hungary (BBB-/Positive/A-3)||Argentina (B/Stable/B)||Brazil (BB/Negative/B)|
|Russia (BB+/Positive/B)||China (A+/Stable/A-1)||Colombia (BBB/Negative/A-2)|
|Egypt (B-/Stable/B)||Qatar (AA-/Negative/A-1+)|
|India (BBB-/Stable/A-3)||South Africa (BB+/Negative/B)|
|Indonesia (BBB-/Stable/A-3)||Turkey (BB/Negative/B)|
|Malaysia (A-/Stable/A-2)||Venezuela (CCC-/Negative/C)|
|Saudi Arabia (A-/Stable/A-2)|
Ratings as of Oct. 22, 2017.
How could NAFTA negotiations affect the rating on Mexico?
Joydeep Mukherji: We should be prepared for ups and downs over the course of the negotiations. Remember, during the original talks, negotiators walked out, and talked about Plan B—there was a lot of drama that we've forgotten about. We assume now that NAFTA was an easy thing to pass. It wasn't. In the past few days, we've seen some more drama taking place at the current talks, which is not unusual. We expect that to happen. What we will focus on is what effect the new NAFTA agreement will have on Mexico's economy and, by extension, on the sovereign ratings. Our base case is despite the uncertainty and drama, we believe negotiators will forge a new NAFTA agreement, under which production chains are maintained and capital keeps flowing, and business proceeds as usual supported by investor confidence and investment.
The second issue is that even if you come to an agreement on the new NAFTA, three governments will need to approve it. That won't take much time in Canada, but is likely to take a long time for the U.S. However, that won't necessarily be a bad thing because the current NAFTA will remain in place. We see a lot of risks, but our base case is that the three countries will muddle through and preserve this relationship. If we think our base case should be different, we will signal it. This would have an impact on Mexico's rating through the investment climate, the whole strategy of integration of Mexico, especially the northern part, in the American economy as far as trade and investment, and would have an impact on GDP growth, among many other things. It's too early to speculate about that, but this is clearly something we are watching very carefully.
Is a downgrade more likely for Brazil than an affirmation?
Joydeep Mukherji: Over the past year, we've gone back and forth about whether to lower the 'BB' rating, which currently carries a negative outlook, meaning there's at least a one-to-three chance of a downgrade in the year ahead. Our main concern is about the longer-term fiscal and debt profile of the country. The government debt burden has increased sharply and projections for Brazil's debt metrics take the country into almost uncharted waters. We've already incorporated increased debt in our ratings. That said, we're not looking for a miraculous stabilization of the debt burden, because that's going to easily go up in the next three to four years under any kind of scenario. We're looking at whether the government can take steps now before the 2018 elections to give more space to next government to deal with this issue.
Last year, the government passed a constitutional amendment to cap spending, to address the problem that spending has consistently risen no matter who is in power. To adhere to that cap, pension reform is key. We're looking at whether the Temer government, which is in a weak political position, is still able to advance with pension reform in particular. There are other reforms that are important but none is as emblematic today as pension reform. Passage of the reform would give the next government some breathing space, which will be required to enact further reforms to bring the fiscal accounts back on an even keel. If that happens, the rating can stabilize. If it doesn't we could lower the ratings. So we're looking for some progress and hope to resolve the negative outlook well before the election next year.
Given presidential elections in several larger Latin American countries, how is uncertainty about future policy choices factored into the ratings?
Joydeep Mukherji: Next year will indeed be a supercharged election year in Latin America. We have stable outlooks on Argentina, Chile, and Mexico, and a negative outlook on Brazil, but that doesn't mean things can't change based on the upcoming elections in these countries.
In the case of Chile, we have the highest expectation of continuity as far as institutional strength and predictability and transparency of policies—including economic policies.
For Mexico, our stable outlook is based on our base-case assumptions that NAFTA will be renegotiated and the new deal will broadly preserve the existing trade and investment flows between the two countries. That is, it will not have a material impact on the variables that we monitor. If we are wrong about that and NAFTA is materially dismantled, obviously we'll have to revisit the situation. We note that no emerging-market economy is as export dependent on the U.S. as Mexico. Similarly, regarding who wins the upcoming presidential elections, our assumption is for continuity in key policies such as monetary policy, exchange rate policy, and commitment to moderate fiscal deficits. While there is a lot of speculation about what a presidency of Andres Manuel Lopez Obrador (usually referred to as AMLO) might mean for policymaking, we note that he is not a political outsider like, for example, Hugo Chavez in Venezuela. Instead, he has been in politics in Mexico for decades. As mayor of Mexico City he has shown a political performance that has not been fundamentally at odds with the political mainstream in the country. It is early to speculate who will win Mexico's presidential elections in July (or even who would run). Accordingly, it is also too early to consider that whoever might move into Los Pinos in December 2018 could move Mexico's rating today.
Regarding Brazil, the next president will inherit a difficult situation because trend growth is low due to weak investment over the past several years and infrastructure bottlenecks. And its fiscal situation, even if it does improve on the back of the recovery in economic growth, will still remain challenging. So the next president faces serious challenges, where the composition and cohesiveness of the new congress amid numerous scandals is an open question.
While Argentina is facing not presidential but midterm elections, they are important nonetheless. The election will send signals to political players and the private sector. If the Macri administration emerges in a somewhat stronger position, that would increase the prospects for the government to move ahead with confidence with the reforms they've announced. It may not change things overnight. But if they do well, they may be encouraged to go forward and to introduce legislation that's already been discussed. If they do badly, that might change the calculus of various people in the congress who have been voting with the administration on various issues, which could slow things down. So we're looking at governability and policy management that could arise from the results of the elections. But as I said, it's not a presidential election and it's not the entire congress. We probably had more concerns about the national elections in the past. Things have become more stable.
Will the political and electoral landscape be among the triggers that influence the ratings on Colombia?
Joydeep Mukherji: If we would downgrade Colombia (BBB/Negative), hypothetically speaking, it wouldn't be a story about an issuer falling from investment grade to speculative grade. The negative outlook reflects the deterioration in its overall financial profile. The country took a hit when commodity prices plunged, growth has been fairly low this year, and the budget numbers worsened substantially last and this year. The outlook also takes into account an erosion in Colombia's external profile, particularly liquidity and debt ratios—especially the rapid rise of non-resident holding peso-denominated government debt. On the whole, the balance sheet looks weaker. What we're looking at is the government's response, which has primarily been fiscal, with the tax reform they passed last year and implementation currently. A big 4G infrastructure project has been somewhat delayed, and getting those projects underway could boost growth and investment, staunching the erosion in the sovereign's debt profile. Finally, we're looking at projections for the economy and politics next year. We're not expecting any dramatic change with the incoming administration, but whoever wins the May 2018 election will face some difficult circumstances. The fiscal situation is tight. The peace accords are going to be time-consuming and difficult to fully implement, and come at a cost—and there are many estimates about the total final tally and questions about who will pay.
So the question is whether Colombia's overall financial profile will stay where it is today or decline to the point where we will lower the ratings to 'BBB-'. So we're not warning about a specific event or an individual candidate. And we are not rating to Colombia's fiscal rule. We are looking at Colombia through our own criteria, making our own estimates of fiscal outcomes and debt.
When will Venezuela default and what will the workout mechanism look like? Are the legal restrictions imposed by the U.S. a roadblock?
Joydeep Mukherji: We currently rate Venezuela 'CCC-' with a negative outlook, which is about as close as you can be before you default. We're saying default is not far away, but with such a high degree of uncertainty in the country it's difficult to say when. Clearly, the U.S. sanctions if anything have made it more difficult for the government to undertake a distressed debt exchange if it were planning to do so. Last year, Petroleos de Venezuela (PdVSA; the government-owned energy company) undertook such an exchange and is to make distressed debt payments this month and November. There are sovereign payments due next year. So this looks like it's going to be a messy story.
Given your negative outlook on Turkey, what would be a trigger for a downgrade?
Frank Gill: It's clear that the economy of Turkey (BB/Negative) is showing a decent recovery according to the official national accounts data, particularly in consumption and some components of investments, mostly public. This is once again leading to a deterioration in Turkey's current account deficit, which is likely to climb over 4.5% of GDP this year. Our concern, which has been more or less the same over the past half-decade, is the size of the current account deficit and the quality of funding, which has been declining, as it increasingly depends on potentially more volatile portfolio funding and decreasingly on net foreign direct investment.
The official GDP data, which we understand is currently audited by Eurostat, shows an historical increase in construction and other components of investment. If there's anything to be concerned about it may be that the data show the economy has been overheating more in the past than we had expected, though there are some lingering questions about where the savings have come from. In any case, the big issue remains to be whether current account funding will survive a ramp-up in global interest rates and what this means for the banks, which now have a loan-to-deposit ratio of 125%, compared with about 85% back in 2010. So the question is whether Turkey's banks can roll over that debt at close to current rates because of course they have been intermediating the financing of the country's high current account deficits.
The fiscal deficit will widen this year, we think, to around 2.5% of GDP, but perhaps a little less if headline GDP growth really is over 5% as some data suggest. We may be seeing a procyclical fiscal position, which is also a concern because it indicates that in addition to rising budgetary support for the banks and for consumption this year, more quasifiscal activity is taking place at the country's state-owned banks, which represent a large share of Turkey's banking system. So in short we're looking at the possibility of a hard landing. But as always we are not particularly good at predicting when that hard landing will actually occur.
When will Russia again merit investment-grade level ratings?
Frank Gill: We just affirmed the 'BB+' ratings on Russia and the positive outlook in September. We continue to flag Russia's fiscal resilience despite a continued fairly weak economic performance in 2016. We're fairly confident the government will run a primary surplus as soon as next year. And as you know, net general government debt is pretty low, at around 12% of GDP. The more recent concerns regarding Russian macro fundamentals have centered on financial stability; the central bank intervened to liquidate and recapitalize several smaller banks, which leads us to ask whether there are other institutions in the system that will require central bank support. We don't think that another round of small bank failures will jeopardize the Russian economy's gradual recovery toward GDP of around 2%. We would expect to resolve the outlook on Russia's ratings accordingly during that time frame.
What is the impact of the current standoff in the Gulf on the rating on Qatar?
Frank Gill: We lowered Qatar's rating one notch to 'AA-' over the summer with the outlook remaining negative. It's important to remember that Qatar not only remains an important net external creditor but also that the general government has a net asset position exceeding 100% of GDP. The tensions between Qatar and the rest of the countries in the Gulf Cooperation Council (GCC) have led to a protracted embargo on trade between it and its most important trading partners. That is weighing on what has been a pretty weak growth story to begin with. For this year we expect GDP per capita to be negative to the tune of almost 4%, notwithstanding the investments related to the 2022 FIFA World Cup. Our baseline expectation is that an agreement will be reached, that the embargo will gradually be lifted, not least due to the potential intermediation of the U.S., which has important naval and military bases in Qatar. If that were not to occur, we would expect downward pressure on Qatar's rating. Back in 2014, Qatar was running the two largest twin surpluses in the world, a fiscal surplus of 30% of GDP, and a current account of around 24% of GDP. This year, Qatar will be a twin-deficit economy. So, to summarize, during good times, Qatar accumulated large fiscal and external buffers; and now, during the bad times, they are tapping these buffers, which is as it should be. But the real concern is whether they can gradually return the non-oil budgetary position toward balance in a world of oil prices below $60 a barrel. So I think there could be further downward pressure on what remains a high rating; and it could be exacerbated by a failure to reach key terms with their trading partners.
For Sri Lanka, what are the triggers for a downgrade and would the IMF program be a mitigating factor?
KimEng Tan: We assigned a negative outlook on the 'B+' ratings on Sri Lanka in early 2016 on weakening fiscal and external metrics. We expect to lower the ratings if these weakening trends continue.
Sri Lanka is now undergoing an IMF-supported program that has created an environment for the government to start addressing the deterioration on these fronts. We have begun to see early signs of progress. For instance, the revenue bill has successfully cleared the parliament and should be implemented in 2018.
However, Sri Lankan credit metrics face some headwinds in the meantime. The drought and floods, which affected different parts of the country last year and this year, haven't lessened pressure on the external and fiscal fronts. However, if the government continues to implement reforms in line with what is required under the IMF program, we believe that we will see a rebound and the pressures on ratings metrics are likely to dissipate. But for the moment the risks to this stabilization scenario remain relatively high, which is why we maintained the negative outlook.
Since the ratings on Indonesia were elevated to investment grade, do developments in the country leave something to be desired?
KimEng Tan: I don't think much has changed since we upgraded Indonesia in May in terms of economic and financial indicators. The economy is broadly developing along the lines we had expected when raising the rating to 'BBB-', with a stable outlook.
However, we have seen a change in the government's emphasis. Politicians now seem to be gearing up for the next presidential elections and the policy emphasis seems to have shifted toward supporting growth. We've seen an interest rate cut and plans to increase the budget deficit, which nevertheless would have a modest impact and given that the budget deficit is legally limited to 3% of GDP. The government has been able to keep within the limit even when revenues come in less than targeted by cutting spending. So the fiscal deterioration has been slight and legally should remained contained.
The size of the government debt, at around 26% of GDP, is rather low and in itself not a constraining factor for the rating. The Achilles heel of the fiscal picture remains the weak ability to raise public revenue. At below 15% of GDP, Indonesia's revenue intake is the lowest among all of the top-20 emerging-market sovereigns (bar Venezuela that we rate 'CCC-'); see Sovereign Risk Indicators). On other fronts, there have been no major surprises. Even with the coming focus on the presidential elections, we're not expecting to see major policy changes that would hurt investment confidence. In the meantime, we still believe that the rating outlook is suitably at stable.
Could you explain the timing of the downgrade of China in September? Will other negative rating actions follow?
KimEng Tan: The downgrade of China to 'A+' on Sept. 21, 2017, is related to the increase in financial risk that we see arising from the very rapid increase in leverage especially in the first few years since the global financial crisis in 2008. Still, credit growth remains slightly above income growth, and as a consequence, the erosion of liquidity and savings cushions continue to erode. Therefore, the government will have less room in the future to deal with policy mistakes or shocks to the economy.
More recently, the government has become more concerned about this matter and has said that it would put into place "deleveraging policies" to restrain credit growth in the country. We have seen some improvements, such as a decline in corporate credit growth. By September this year, however, it became clear that the policy would not be implemented as strongly as we expected early in 2017. Consequently, in the next few years we continue to believe that credit growth will stay somewhat above income growth and that financial risk is likely to continue to increase—albeit not as quickly as in the period from 2008 to 2013.
This continuous credit dependence on growth was the key reason for our downgrade. Going forward, the rating will depend on how seriously the government implements its deleveraging policy to the extent that it can bring credit growth below income growth. That would help stabilize credit metrics or improve them over the longer term. If the government is unable to do that, in our view government support for the sovereign rating would continue to deteriorate. Meanwhile, if a shock hits the Chinese economic system, then we could see an abrupt or more rapid deterioration in credit metrics that would increase chances for another downgrade.
Why haven't you upgraded India despite recent reforms and solid growth performance?
KimEng Tan: We do recognize India's very strong growth in a very explicit way. Of all investment-grade sovereigns, India displays by far the lowest level of prosperity. At about $2,000 per capita, its income level is a third lower than Morocco's and The Philippines' (see Sovereign Risk Indicators). Its fast economic growth, compared with other economies of similar income levels, has been the reason why economic support for this rating has been as strong as it is. Without this economic growth story, we would have assessed economic support at a weaker level and the rating would probably not be investment grade.
For an upgrade, India would have to address its weak fiscal balance sheet and weak fiscal performance. India has one of the highest general government debt to GDP levels (68%) among emerging market sovereigns. Year after year, the fiscal deficit remains relatively large with the interest burden and subsidies take a big chunk of government spending. So there's not a lot of room for the government to maneuver, despite pressing infrastructure needs. A potential rating upgrade is likely to come from improved fiscal performance.
Investment hasn't picked up much in India in recent years. If investment demand rebounds in the near future, demand for bank credit could increase. Meanwhile, financial costs would be quite high because of high nonperforming loans at state-owned banks that are constraining credit supply. Therefore, a large part of the banking system is unlikely unable to provide credit normally unless the government recapitalizes these banks substantially in the near future.
All in all, we still see rather healthy prospects but there are significant headwinds and the credit metrics are unlikely to materially improve in the next one to two years.
Writer: Rose Marie Burke