Why Emerging Market Sovereign Ratings Are Falling While Portfolio Inflows Are Rising

Emerging market sovereign bonds are continuing to rally this year as yield-seeking investors flee ultra-low interest rates at home and expectations that the U.S. Federal Reserve will start raising interest rates have yet to materialize.

Investor interest in the emerging markets is growing unabated, with cumulative portfolio inflows since 2011 now exceeding $1.1 trillion. They are attracted not only because emerging markets offer higher yields than those achievable in advanced economies, but also because their share in the world economy is increasing: They are now worth 40% of world GDP from 20% during the Asian financial crisis 20 years ago. In the next 20 years, we estimate the GDP of the seven largest emerging economies will overshadow that of the G7 countries.

However, many risks could still hamper this growth scenario. In the near term, they include not just the likely gradual rise in U.S. interest rates luring investors back to safer developed markets, a slowdown in Chinese growth, or slower world trade. A growing focus on electorate-pleasing domestic issues to the detriment of economic progress, as well as the potential for geopolitical conflicts, also pose risks to emerging market sovereign creditworthiness. This is why our view of emerging markets’ underlying credit quality is less positive than the market view. Over the past five years, our average rating on the 20 top emerging market sovereigns (those with the largest absolute amount of sovereign debt outstanding) has been gradually declining while portfolio inflows into these countries have risen (see chart 1). Our negative outlook bias on this group of sovereigns suggests downgrades could accelerate over the coming year or two.

Rating Outlooks Indicate Downgrades Ahead
We don’t identify any single reason for this relatively gradual weakening in EM sovereign ratings of on average close to one notch in the past five years. Among the 10 sovereigns in the top 20 that we have downgraded since January 2012, none of the six main factors in our rating criteria have dominated (see chart 2). The chart displays the change of the assessments of the various factors of our ratings methodology, with each factor ranging from 1 (strongest) to 6 (weakest). A bar in chart 1 showing a value of minus one, for example, depicts a deterioration of an average of one category on the 1 to 6 scale. A positive number would show an average improvement. Weakening political institutions has been a common trend, but all other factors in our assessment have also featured.

Our ratings on nine of the top 20 sovereigns now carry a negative outlook, indicating a possible downgrade over the next two years, while only two have positive outlooks (see table 1). This is our heaviest ever negative bias on emerging market sovereigns and why we expect downgrades will outpace upgrades in the next year or two (see chart 3).

Governance Standards Are Weakening
One trend that could continue to weaken sovereign ratings is an increasing focus by many emerging market governments away from economic management towards politically more rewarding matters, such as law and order or geopolitical issues. We’ve seen examples of policymakers pursuing increasingly domestic political agendas at the cost of economic prospects and stability over the past several years in Brazil, Argentina, and Venezuela. In Europe, Polish policymakers’ changes to key institutions after last year’s parliamentary election and concerns about the independence of the central bank, among other factors, have damped our view of its credit quality. In Turkey, particularly after the failed coup earlier this summer, the authorities are refocusing priorities towards domestic political stability, as they envisage it, rather than economic management. We lowered the foreign currency ratings to ‘BB/B’ with a negative outlook in July because we believe the polarization of Turkey’s political landscape has further eroded its institutional checks and balances. In Russia, this refocus has taken a geopolitical slant, through the dispute over Crimea with Ukraine and involvement in the Syria conflict, which have helped to allay possible frustrations of the electorate about the prolonged recession the country had to endure. Far-reaching structural economic reforms remain conspicuous by their absence.

Engaging in geopolitical ventures in the face of a rapidly deteriorating economy is not a new pattern. One of the most remarkable examples was Argentina’s invasion of the Malvinas/Falkland Islands in 1982, which was an attempt to distract the population from the economy that was falling apart at home.

One future potential geopolitical risk going forward is the situation in the South China Sea, which is far from resolved despite the recent ruling of the international tribunal in the Hague in July that China’s claims to historic and economic rights had no legal basis. There is no signal that China is giving up any of its perceived exclusive right to large parts of maritime territory. Should the economy weaken in China, this may be one outlet with which the party might drum up support for the political system that is no longer possible through such a rapid pace of wealth creation as in the past.

We believe one reason for this trend is that, because the international environment has been exceptionally favorable for a very long time, governments haven’t needed to focus on the economy as much as before and still grow and secure their funding needs at what by historical experience are favorable rates. Generous terms of trade, global demand, and cheap financing have led some emerging market policymakers to succumb to complacency. However, signs are mounting that this tide may soon be turning.

The External Liquidity Tap Will Start Drying Up
Although the Fed recently decided to delay an interest rate hike, we’re now expecting it to start to raise rates in December. This will, ever so gradually, bring to an end the super-accommodative international financial environment from which emerging markets are benefiting. Not all emerging economies will be equally affected. The sovereigns most at risk in the event of the external liquidity tap being turned off are those most dependent on capital inflows.

In recent decades, sovereign financial stress or debt crises have not had their root course in fiscal profligacy but were triggered by the volatility on the financial account of the balance of payments. This is moving much faster and the sums involved are much larger than in the past, when balance of payment crises tended to originate in the current account flows. This is why we analyze sovereigns’ comprehensive external liquidity to assess an economy’s gross financing requirement. It includes not just the current account but all short- and long-term debt maturing, and puts it into the context of the ability to generate foreign exchange reserves (the reserves that exist plus the current account receipts). According to this measure, the most vulnerable emerging market is clearly Turkey, with gross funding needs equivalent to 180% of CARs and usable foreign exchange reserves (see chart 4). No other large emerging market relies so much on external financing.

But a number of other sovereigns would also be vulnerable. We regard countries with CARs above 100% of GDP as having heightened fragility. The international environment could quickly move against them because they need more in foreign exchange that they could generate. These include Venezuela, Argentina, Egypt, South Africa, Pakistan, and Lebanon. At the other end of the spectrum, creditor countries such as China, the Philippines, Thailand, Russia, but also Brazil are less dependent on capital inflows.

Rising Overall Debt Adds To Sensitivities
While not all countries would suffer equally from higher interest rates, almost all emerging markets are more sensitive than in the past because debt has continued to rise. The top 20 rated emerging markets have greatly increased their debt stock: commercial debt stock is now nearly $7 trillion in total. Overall, emerging market general government debt has risen significantly to nearly 50% of GDP on aggregate, a rise of more than 10 percentage points in five years (see chart 5). While these levels are still well below those typically observed in leading advanced economies, the debt-bearing capacity of the emerging markets is lower due to more limited resilience and resourcefulness. Once the interest rate tide turns, fiscal vulnerabilities might be exposed.

Beyond general government debt, many government-related entities (GREs) in emerging countries have significant debt. In Russia and, especially, China, GRE debt is far larger than general government debt (see “Contingent Liabilities And Sovereign Risk In Emerging Markets: A Mounting Menace?”, May 6, 2016). There is a good chance that some of this debt could migrate to governments’ balance sheets once credit growth slows and global funding conditions tighten.

Corporate debt levels in emerging markets will also likely continue to grow and influence the future economic trajectory. Both the Asian financial crisis as well as the debt crisis in the eurozone remind us that financial and sovereign crises can be triggered by excessive leverage in the private sector, even if a government’s own outright debt appears moderate. Before the 2009 global financial crisis, corporate debt in emerging markets was about 70% of GDP.
It’s now 100% and rising. We forecast that credit will grow faster than underlying GDP (credit-intensive) in many emerging markets and that the trend of corporate loans outstanding will continue to grow (see chart 6). According to data from the Institute of International Finance, emerging markets will face maturities in 2017 of over $1 trillion, over half of it corporate sector debt, with about one third of that in foreign currency. This will come due for refinancing at a time when monetary conditions may start to be less accommodative.

Slower Global Growth And World Trade Volumes
Slowing global growth and world trade also threatens emerging market economies’ growth. While high debt can be mitigated by higher growth, growth has now been slowing for some time (see chart 7). Many economies are trying to boost growth through monetary or fiscal stimulus. But the question as to what constitutes a sustainable growth rate is a key subject of economic debate: should countries stimulate growth or accept that economies cannot grow faster given demographic trends, the hiatus in globalization, and slower productivity growth?

The slowdown in world trade will also harm emerging market economies, many of which are small and open, and very dependent on trade. In good years, world trade has grown at twice the rate of GDP. As the world globalized and became more integrally intertwined, efficiency and world growth went up. Now, however, trade is not growing faster than GDP (see chart 8). U.S. imports from China have recently been falling. The World Trade Organisation (WTO) just lowered its forecast of world trade growth for 2016 to a paltry 1.7%. World trade volumes, the engine of globalization, have come to a stuttering halt.

The momentum for further globalization and efficiency-enhancing division of labor has therefore stopped, partly because the developed world has been struggling to make this work for the whole of society, not just for a privileged and educated minority. The backlash of those strata of society that feel that they have been left behind is most vividly, but not exclusively demonstrated by the vote of the U.K. electorate to leave the EU. This is engendering a tendency toward protectionism in developed markets. Both U.S. presidential candidates Hillary Clinton and Donald Trump have indicated they will not sign the Transpacific Partnership (TPP), aimed at promoting trade and economic growth. We’ve seen similar trends in Europe as well, as one European power after another has rescinded its support for TTIP. The World Economic Forum has collected evidence that the perception of openness of economies has dropped during the last decade in poor and rich countries alike.

A China Slowdown Would Dent Emerging Market Sovereign Ratings
The potential for a faster economic downturn in China than currently anticipated could also be prejudicial for the credit quality of emerging markets, as well as some advanced economies. Given the important and systemic role China plays within the global economy, a hard landing over the medium term would most affect emerging economies that have strong trade links with China or rely heavily on commodity production and exports. S&P Global Ratings has carried out a simulation to find out what would happen if China’s growth were to slow to about 3.5% a year, about half our base-case scenario for a China’s GDP growth rate of an average 6% a year 2017-2020.

According to our simulated scenario, the rating on China itself would fall by one notch. But some emerging markets would be hit just as hard, particularly those with strong direct trade links with China. The impact on the rating on Russia, for example, would be 1.4 notches, and on Brazil and Chile about one notch (see chart 9). The impact on the ratings on South Africa, Indonesia, Turkey, and Argentina would be between one and 0.5 rating notches. While these changes are hardly catastrophic, an economic softening in China could clearly add to other existing challenges.

Further Risks On The Horizon
Alongside these near-term risks to creditworthiness, emerging markets are not immune to longer-term challenges to global credit ratings. Both 21st century mega-trends, aging societies and climate change, could leave scars on the creditworthiness of EM sovereigns. We believe the need for structural changes to contain age-related spending, particularly to stabilize future pension costs is as pressing for some emerging market sovereigns as it is for advanced economies. China, but also the economies of the former Soviet bloc have the most adverse demographics, while some pension systems, such as those of Turkey and Brazil are unaffordable despite more positive demographic trends. In the absence of policy action, the median net general government debt in emerging market sovereigns will rise by 2050 to 136% of GDP.

Climate change is also likely to affect emerging markets more than advanced economies. This is not only because they have less economic and financial resilience and less developed insurance markets, but also because many of them are located in tropical areas that are expected to be particularly impacted by a warming planet.

 Moritz Kraemer – Credit Analyst – Standard & Poor’s Financial Services