Resilient world demand is underpinning better-than-expected economic growth, and S&P Global Ratings expects the global economy to grow by almost 3% in 2023 (see table 1).  In this context, as we near the end of the first half of the year, overall sovereign credit quality is stabilizing, albeit with divergent trends and a fair amount of lingering risks that could cause disruption.

While close to 12% of the sovereigns we rate have negative outlooks, some stabilizing trends have added more positive outlooks.  The outlook balance is now -8, versus -13 in January (see graphic). That said, except for those positively affected by the improvements in commodities or in services, fiscal consolidation is coming in at very slow pace--or, in some cases, not at all.

Table 1

In addition, the cost of funding stemming from central banks' substantive increases in monetary policy rates will make both consolidation and deficit financing more difficult and costly over the next 12 months. However, developed markets, as well as many investment-grade emerging markets, have longer-tenor debt maturities. As a result, they have a larger cushion until the higher financing costs make their way through the sovereigns' debt profiles. This is a key factor behind most of our stable outlooks, despite the headwinds many are facing.

On the other hand, most of our negative outlooks are on low-rated emerging and frontier markets. For these sovereigns, we see that inflation, higher financing costs, and elusive growth will continue to cause strains, and negative actions are likely over the next 12 months.

Three sovereigns (Argentina, El Salvador, and Mozambique) defaulted during 2023, and the risk of further defaults remains high.  In addition, a record six rated sovereign remain in default (Belarus, Ghana, Lebanon, Sri Lanka, Suriname, and Zambia). We also currently have eight sovereigns in the 'CCC' category, highlighting the high risk of more defaults coming later in the year (see table 2).

Table 2

Finally, the Russia-Ukraine conflict poses potentially destabilizing threats.  The beginning of the Ukrainian counteroffensive presents many uncertainties and risks on how events could turn out over the next few months. Some of those were evidenced by the recent revolt of the Russian paramilitary group Wagner. Also, the alleged step-up in Chinese involvement in the conflict, via supplies of equipment to the Russian forces, plus the already tense situation with Taiwan, only adds risks to a very fragile geopolitical environment. As a result, we could see a renewed set of pressures on food and energy and other commodity prices complicating the inflation-reduction efforts.

Regional Outlooks

Europe, the Middle East, and Africa (EMEA)

European developed markets.  Given that inflationary tailwinds continue to benefit wealthy European sovereigns' debt-to-GDP ratios, some larger European states' fiscal plans are lacking ambition. In contrast, some sovereigns operated underlying budgetary surpluses last year, including Andorra, Greece, Ireland, Liechtenstein, the Netherlands, Portugal, Sweden, and Switzerland.

A potential risk is that few governments today have sufficient fiscal space to deal with yet another fiscal shock. At the same time, fiscal policy remains somewhat accommodative, potentially forcing the European Central Bank to do more monetary tightening than it might prefer.

Emerging EMEA.  Several factors are stabilizing credit stories in some middle-income economies in emerging EMEA (Europe, the Middle East, and Africa), like Poland, Romania, and, to lesser degree, Hungary. These include improved visibility into the future of the U.S. Federal Reserve's monetary policy, generally prudent monetary and fiscal policy settings in most of emerging EMEA, and a reversal of the energy price shock.

Still, concerns over the next six to 12 months are that fiscal space is in short supply, and the cost of new debt remains notably higher than it was two years ago, particularly at lower rating levels. In this context, the threats emanating from the Russia-Ukraine conflict regarding another shock to food and other commodity prices remains high. This could put additional pressures on several sovereigns, but more so on the seven emerging EMEA sovereigns that carry negative outlooks.

Table 3

Americas

We expect that sovereign ratings in the Americas will largely remain stable in 2023.  Economic growth remains low, inflation is high, central banks are maintaining tight monetary policy, and governments are coping with higher cost of funding. We have negative outlooks on the ratings on five regional sovereigns (Argentina, Panama, Peru, Honduras, and Bolivia), indicating that further erosion in credit quality is possible.

U.S. and Canada.   After a long and protracted negotiation, the U.S. Congress passed a suspension for the U.S. debt ceiling until January 2025. We expect political polarization, including legislative impasses in Congress, will remain high with national elections due late next year.

On the other hand, Canada's national government is led by the Liberal party, which holds only a minority of seats in parliament. The government relies on the votes of a smaller center-left party to pass legislation. In contrast with the U.S., the lack of a majority government has not led to material policy or legislative impasses.

Latin America and the Caribbean.   The Latin American and Caribbean region suffered greater economic contraction during the pandemic years than other emerging markets and has shown a poorer long-term GDP growth rate. Its growth prospects remain modest amid higher interest rates, a large debt burden, and tighter monetary policy.

The risk the debt burden poses partly depends on its composition. In general, sovereigns with more reliance on short-term debt and on foreign currency debt are more vulnerable to sudden spikes in interest rates or depreciation of the currency.

A relatively high debt rollover rate in Brazil and Mexico is mitigated by the high share of sovereign debt denominated in local currency and held by domestic creditors. Conversely, Colombia, Peru, and the Dominican Republic benefit from very low rollover rates but have a much higher share of debt denominated in foreign currency. As a result, they're vulnerable to higher debt service in the event their currency depreciates substantially.

We maintain stable outlooks on 80% of the sovereigns in the Americas. This is the largest share of stable outlooks in a decade, though at a lower average rating level.

Table 4

Asia-Pacific

The post-pandemic rebound in domestic demand and regional travel in Asia-Pacific this year have been supportive of sovereign creditworthiness. Employment and wages in many economies are well supported by the still-recovering domestic consumer demand and stronger international travel activities. In most major emerging market economies in Asia, GDP growth should reach at least 4% this year.

In this context, the first half of 2023 saw no sovereign rating actions in the Asia-Pacific region. The stable outlooks on practically all long-term foreign-currency sovereign ratings in the region suggest that there will be few, if any, changes in the next year or so.

Pakistan and Sri Lanka are the most likely candidates for rating changes in the remainder of 2023. At the 'CCC+' level, the sovereign rating on Pakistan is highly sensitive to changes in credit conditions--both negative and positive. And Sri Lanka could end its state of default if it manages to reach an agreement with its creditors to restructure its commercial debts.

On the geopolitical front, the recent visits to China made by both the U.S. secretary of state and the secretary of the treasury present a step toward stabilizing bilateral relations. However, they're unlikely to ease the risk of further tensions by much. The U.S. is gearing up for a presidential election in late 2024. And the chance of accidents involving military assets in the China-Taiwan region appears to have risen lately.