Wednesday, November 13, 2019 /12:01 PM / By Moody's Investors Service / Header Image Credit: Africa.baobab.news
Our outlook for sovereign creditworthiness in 2020 is negative, reflecting our expectations for the fundamental conditions that will drive sovereign credit over the next 12-18 months. A disruptive and unpredictable domestic political and geopolitical environment is exacerbating the gradual slowdown in trend GDP growth, aggravating longstanding structural bottlenecks and increasing the risk of economic or financial shocks.
The starkest manifestation of the impact of geopolitical tensions is the disruption to trade, mainly resulting from the standoff between the US (Aaa stable) and China (A1 stable). The antagonistic political environment is also weakening global and national institutions, lowering the shock-absorption capacity of sovereigns with high debt burdens and low fiscal buffers.
Overall, the global environment is becoming less predictable for the 142 sovereigns we rate, encompassing $63.2 trillion in debt outstanding. Event risk is rising, raising the spectre of reversals in capital flows that would crystallize vulnerabilities facing the weakest sovereigns.
Domestic political and geopolitical instability, and in particular its detrimental impact on policy-making and in some cases growth, informed some of our key rating and outlook changes in 2019 across all regions as well as our research commentaries during the year. Our map of global hotspots (see Exhibit 2) identifies the sovereigns that will be at the centre of our monitoring efforts in 2020.
In Europe and Central Asia, the negative outlook change for the UK (Aa2 negative) was driven by the continued decline in institutional strength resulting from the ongoing uncertainty surrounding the UK's exit from the European Union (Aaa stable). The downgrade of Turkey (B1 negative), after two earlier downgrades in 2018, reflected the continued erosion in the government's institutional strength and policy effectiveness. However, Russia (Baa3 stable) was upgraded back into investment grade given its strengthened fiscal and external debt positions, which bolster its resilience to external shocks.
In Latin America and the Caribbean, the negative outlook change for Mexico (A3 negative) was the result of the government's increasingly unpredictable policy-making and the growing dependence of PEMEX, the state-owned oil company, on government support. Argentina's (Caa2 RUR-) default, which was the result of weak institutions, unpredictable politics and rapidly diminishing fiscal strength, drove the three-notch downgrade and ongoing review for further downgrade.
In Asia Pacific, we changed the outlook on Hong Kong (Aa2 negative) to negative to reflect the rising risk that ongoing protests are eroding government and policy effectiveness and damaging the territory's attractiveness as a trade and financial hub. The negative outlook change for India (Baa2 negative) reflects the rising risk that economic growth will remain lower than it was in the past, partly due to lower government and policy effectiveness, leading to a gradual rise in the government's already high debt burden.
Sovereigns in the Middle East and Africa recorded the majority of negative rating actions in 2019. The negative outlook change for South Africa (Baa3 negative) reflected the risk that the government will not reverse the deterioration in its finances and growth prospects, largely due to social and political obstacles to reform efforts. The weakening of Oman's (Ba1 negative) external and fiscal accounts linked to a high reliance on the oil and gas sector led to its downgrade into speculative grade. Lebanon's (Caa2 RUR-) dwindling external financing options, growing fiscal imbalances and policy paralysis resulted in two downgrades in 2019. However, Egypt (B2 stable) was upgraded further to fiscal and economic reforms that will support its fiscal metrics and GDP growth.
Increasingly antagonistic political environment is undermining trend growth, weakening global and national institutions, and reducing resilience to shocks
The increasingly confrontational domestic and global political environment has evolved from a catalyst for tail risks to a driver of lower growth and heightened risks of shocks. In many advanced economies and some emerging markets (EMs), influential "populist" movements have emerged in recent years, either from the political fringe or from within established parties, often in reaction to years of stagnant incomes and rising income inequality. Many reject policy orthodoxy and multilateralism, aiming to disrupt the established consensus or to supplant it. Often, the policies espoused create frictions felt beyond a country's borders, with domestic political risk morphing into geopolitical risk. Heightened domestic and geopolitical friction undermines policy predictability and effectiveness and, with it, institutional strength - particularly as growth slows. Escalating global and regional trade tensions increase the risk of financial or economic shocks, and the weakening of multilateral institutions dents policymakers' ability to deal with those shocks.
The increasingly antagonistic global political environment is exacerbating the slowdown in global growth, especially among the more trade-oriented economies. Across the G-20, we estimate that growth has fallen to 2.6% in 2019 from 3% in 2018. While recovery from weak or negative growth in a number of EMs will sustain that level overall in 2020, global growth will remain below trend and any recovery will be shallow and fragile. The slowdown partly reflects cyclical factors, partly structural drivers, including demographic trends. But the adverse impact of the increasingly antagonistic global political environment, particularly on global trade and investment, has been pervasive and will likely remain so. While the starkest example is clearly the trade war between the US and China, distracting and, in some cases, growth-diminishing tensions have also risen in the Gulf, between Japan (A1 stable) and Korea (Aa2 stable), India and Pakistan (B3 negative), the US and the EU, and the EU and the UK (see Exhibit 2 on previous page). The first-order direct effect of these tensions - for example, the impact of tariff increases on trade volumes (see Exhibits 3 and 4) - is not always severe. However, the second-order impact on investment and capital flows via confidence channels is likely to damage both near- and medium-term growth prospects across all regions.
In an unpredictable environment, growth and credit risks are tilted to the downside. There are few silver linings, and a rising risk of more negative outcomes. Unpredictable politics create an unpredictable economic and financial environment, prone to volatility in financial and commodities markets and sharp shifts in sentiment. That unpredictability, and the difficulty in envisaging positive shocks, are key drivers for the negative outlook for the sector. The two largest trading economies - the US and China - are slowing down and seemingly locked in an unwinnable trade war, with repercussions for other countries. Those embedded in global supply chains that rely on trade for growth - such as Hong Kong, Singapore (Aaa stable), Ireland (A2 stable), Vietnam (Ba3 RUR-), Belgium (Aa3 stable), the Czech Republic (Aa3 stable) and Malaysia (A3 stable) - face a slowdown in economic activity (see Exhibit 5 on the next page). Those with large current account deficits and most reliant on external capital - like Lebanon, Mongolia (B3 stable), Tunisia (B2 negative), Pakistan, Sri Lanka (B2 stable), Argentina, Turkey, and to a lesser extent Indonesia (Baa2 stable) and South Africa - are most exposed to financing shocks. Recent years offer ample evidence of the scope for reversals in capital flows, which, if sustained, can profoundly damage recipient country fundamentals.
Around the world, an increasingly populist tone is undermining domestic policy effectiveness, weakening institutional strength and compounding social and governance risks. The erosion in the geopolitical consensus has been mirrored by rising domestic political tensions, particularly - though not exclusively - in western democracies. Those tensions, and the unorthodox policies or policy inertia to which they give rise, have in common their damaging implications for the effectiveness of policymaking institutions. Our assessments of institutional strength for global sovereigns have generally deteriorated over the past five years (see Exhibits 6 and 7 on the next page), and these will remain under pressure in 2020 and beyond as slowing economic growth will likely increase social pressures and fuel populist policy agendas. Examples are varied.
- Among advanced western economies, the domestic travails and external confrontations of the Trump administration continue to distract US policymakers from the longer-term fiscal challenges - comprising widening federal budget deficits, a rising debt burden and falling debt affordability - facing the country. In the UK, the predictability and effectiveness of UK economic and fiscal policymaking has diminished as policymakers struggle to adjust to the inward-looking and anti-European sentiment that continues to drive the UK towards exiting the EU. In Italy (Baa3 stable), the rise of populist parties on both sides of the political spectrum has distracted policymakers from the reforms needed to address the deep-seated structural impediments to growth. In France (Aa2 positive), the "gilets jaunes" protests have prompted the government to accelerate tax reductions and implement spending cuts more slowly than originally planned.
- Throughout Central and Eastern Europe (CEE), increasingly nationalist sentiment and inward-looking politics in countries like Poland (A2 stable) and Hungary (Baa3 stable) continue to pose challenges to domestic institutions and, externally, to the integration and cohesion of the EU. The continued weakening of Turkey's public institutions and unpredictable policy-making have highlighted the lack of a clear and credible plan to address the underlying causes of the country's macro-financial distress.
- In Latin America, increased social demands against a backdrop of slowing growth and high income inequality are constraining policymakers' room to adopt reforms and fiscal measures to support growth and public finances. Chile (A1 stable) and Ecuador (B3 negative) have seen waves of protests. In Argentina, the default triggered by the surge in support for the victorious populist candidate has laid bare once again the weakness of the country's policy-making institutions. In Mexico, the credit implications of the shift in policy direction under the latest administration remain to be seen, given the contrast between its conservative fiscal stance and the populist rhetoric.
- In Africa and the Middle East, geopolitical risks and domestic political tensions drive policy inertia. The protests that recently erupted in Iraq (Caa1 stable) and Lebanon threaten government stability in the former and led to the resignation of the prime minister and government in the latter. In Tunisia, the elections have handed a defeat to the incumbent government linked to rising austerity fatigue among voters. In Oman, the political imperative of maintaining economic and social stability has frustrated efforts to curb further fiscal deterioration. In Ethiopia (B1 negative), the attempted coup in Amhara underscores the government's underlying susceptibility to domestic political risk. These risks are unlikely to dissipate in the run-up to elections scheduled for 2020 given that the Ethiopian government's reform agenda risks exacerbating ethnic tensions in some parts of the country. In South Africa, deep inequalities and resistance from key stakeholders inhibit policymakers' efforts to stabilize public finances, stimulate investment and reinvigorate growth.
- In Asia, policy challenges stem less from rising populist sentiment than from longstanding structural economic challenges facing policymakers in a less benign global environment. In India, waning growth both reflects and exacerbates the vested interests that are barriers to reform and also the authorities' challenges with effective implementation of their original reform efforts to broaden the tax base, reduce fiscal deficits, strengthen the financial system and stimulate investment. In China, policymakers face increasing challenges as declining global growth and rising geopolitical tensions expose the challenge inherent in simultaneously maintaining growth, financial and economic stability and wide-ranging reform efforts. In Sri Lanka, reforms and most policy decisions are on hold ahead of the presidential and parliamentary elections which could extend well into mid-2020. So far, the fiscal policy proposals by the main parties have failed to identify funding for significant expenditure measures.
Weaker institutions in turn undermine creditworthiness and resilience to shocks. Weakening, distracted institutions and confrontational political environments do not merely heighten susceptibility to shocks, they also undermine policymakers' capacity to respond to them. At a global level, the erosion in cohesion evident in the continued weakening of multilateral frameworks such as the G-20 or the WTO, not to mention the bilateral tensions inherent in multiple trade or other disputes, suggests that the international community would struggle to respond cooperatively to an acute confidence shock that required any meaningful policy coordination. At the domestic level, the capacity for consensus - in any of the countries listed above and many more - is limited. So is the capacity for decisive action, given the legislative consequences of fragmenting social and electoral consensus, with authoritative majority governments increasingly rare. Policymakers are poorly placed to deal with a crisis, and the world's domestic and multilateral institutions are the weaker for it.
Entrenched credit pressures in advanced economies are alleviated by loose monetary policy, but accumulation of imbalances poses risks
Advanced economies face a number of long-term structural challenges, in particular from low productivity and fast-rising demographic pressures. These suggest that economic growth will remain at historically low levels, and will continue to decline slowly on average for the foreseeable future. At the same time, public finances remain strained, weighed down by the debt burdens that are the legacy of the global financial and European debt crises. The risks associated with high debt and low growth are currently somewhat masked by historically low interest rates, which seem likely to persist over the coming years given low global growth. However, the efficacy of accommodative monetary policy in an already low interest rate environment remains to be seen, while an even longer period of low interest rates raises financial stability concerns. While some governments have taken advantage of low interest rates to lengthen debt maturities, it also seems likely that the enhanced debt affordability offered by low interest rates has lowered policymakers' willingness to stand up to electoral aversion to structural economic and fiscal reforms that may enhance longer-term growth.
Advanced economies' progress in rebuilding lost fiscal space has been slow, despite a long period of growth and low interest rates. Overall, progress on reducing macroeconomic imbalances has been tepid and fragile. While public debt levels in advanced economies and highly rated EMs have fallen in aggregate from their peaks (see Exhibit 8), the fall has generally been small. Private-sector leverage remains stubbornly high in many countries, with the risk that a shock would push some of this debt onto the government's balance sheet once again (see Exhibit 9). While the decline in public debt levels reflected a number of factors, it was driven mostly by cyclical growth. With the global cyclical rebound running out of steam, much will rest in the coming years on policymakers' resolve in implementing the painful fiscal reforms that are generally needed to lower debt levels further still over the longer term, including cuts in social benefits to curb long-term liabilities.
Reform fatigue is rising. However, progress on reforms is increasingly patchy. In the US, recent years have seen little appetite to address longer-term fiscal or economic (infrastructure-related) challenges. Across Europe, reform momentum has slowed as electorates have turned against "austerity politics". In Slovakia (A2 stable), the parliament recently capped the statutory retirement age - which was previously fully indexed to life expectancy - at 65 years, leading to a marked deterioration in cost projections linked to long-term ageing. In Germany (Aaa stable), the coalition government's reform efforts have so far only resulted in very limited tax measures as well as credit negative pension and labour measures, which actually worsen the economy's flexibility and growth outlook. Although Germany's pension reform commission has been tasked with developing proposals for ensuring the longterm sustainability of the pension system, there seems little appetite for reform.
Reversal of monetary tightening will alleviate near-term pressures somewhat but is a symptom of a weak global backdrop. Over the course of 2019, a number of advanced economy monetary authorities abandoned plans to tighten policy in favour of cutting or maintaining low rates. That dynamic is expected to continue through 2020 (see Exhibit 10). Among major advanced economies, the Federal Reserve has reduced its federal funds rate three times in 2019, citing factors including the slowing global economy and rising trade tensions. The peak in effective US policy rates this economic cycle was thus 2.45%, compared with the 3-4% level commonly expected a few years ago. In other major economies, the so-called natural rate of interest also appears materially lower than a year ago. Other things being equal, lower interest rates enhance sovereign credit quality. In this case, however, the accommodative stance simply mitigates somewhat a weaker-than-expected economic environment and masks limited progress in debt reduction.
Loose monetary conditions support short-term growth, but their longer-term impact is uncertain and they introduce distortions. The effectiveness of further monetary accommodation remains to be seen. In principle, the favourable financing conditions brought about by the monetary stimulus should support stronger consumption and investment and durable employment creation. In practice, however, policymakers have little experience of implementing a still looser monetary stance from already highly accommodative levels. Those that do can bear witness to the uncertain and sometimes unintended consequences of very low, or even negative, interest rates, such as the weaker profitability of banking systems in Japan and the euro area. Persistently low interest rates could lead to distortions that may hamper long-term growth and create risks, such as frothy asset prices in financial markets, higher leverage or disincentives for saving across the broader global economy.
Nevertheless, advanced economies have benefited from favourable funding conditions brought about by accommodative monetary policies. Lower-for-longer policy rates have provided substantial respite to fiscal accounts despite the impact of falling growth on revenues. Sovereigns around the world, but particularly in advanced economies, have benefited from lower funding costs (see Exhibit 11) and are expected to continue to do so throughout 2020. Lower interest costs have helped narrow fiscal deficits and in a number of cases supported the reversal of previously rising debt trajectories. Moreover, some sovereigns have taken the opportunity to lengthen maturities and lock in low interest rates, further helping to regain some lost fiscal space. However, favourable funding conditions have undoubtedly also contributed to the diminished pace of reform in recent years, fostering a degree of complacency which leaves many sovereigns still highly exposed to future rises in interest rates or, more likely in the near term, to confidence shocks that increase credit spreads.
Less predictable environment heightens event risk for weakest emerging market sovereigns
The increasingly unpredictable global - and in some cases domestic - political environment has resulted in intermittent and abrupt shifts in risk appetite. Combined with the slowdown among advanced economies, this risk aversion has exacerbated the broad slowdown in growth in EMs. In Asia, domestic demand has generally held up well and inflation has remained subdued, but external demand has weakened considerably. Elsewhere, softening domestic demand has increased dependency on external demand and capital flows. Many central banks have been constrained by the need to sustain inward capital flows and respond to volatility in international financial markets. A "risk-off" episode, depending on its severity, could expose financial vulnerabilities accumulated during years of low interest rates as highly leveraged borrowers struggle to roll over their debt and as capital flows retrench.
Slowing growth and an unfavourable external environment are shifting many EM governments' focus away from longerterm challenges towards mitigating shorter-term pressures. In 2019, growth in the EM G-20 countries will have further moderated to around 4.3%. While we expect a small pick-up in 2020, this largely reflects reversals in countries experiencing unusually low growth in 2019, including India and Turkey. Overall, growth will remain below historical levels, with downside risks. The primary growth engines of many EMs have, to varying degrees, faded in the years since the global financial crisis. In Latin America and Sub-Saharan Africa, the benefits of the "commodities supercycle" are a distant memory, leaving just residual exposure to growth shocks in China (see Exhibit 12). In APAC, as in Central and Eastern Europe, exports and investment have slumped under threat from the US-China trade war. Many EMs face structural challenges of rapidly ageing populations or a large influx of young people into the labour market, technological disruptions such as AI and robotization (see Exhibit 13), pervasive vested interests and other institutional constraints, and recurring climate shocks. Progress in addressing these hurdles has been mixed at best, with few achieving tangible increases in potential output growth rates.
Political challenges are also hampering economic and fiscal adjustments. Progress on debt reduction has been mixed, with material reductions evident in only a handful of cases and rising debt burdens more common. Domestic and external political shocks hamper progress on fiscal adjustment and structural reforms, with many governments' fiscal positions weakening even during the relatively benign recent period of growth. Latin America recently exemplified the potential for domestic political events to derail longer-term policy programmes, with particularly serious political disturbances in Peru (A3 stable), Chile and Ecuador. In the Levant area, Iraq and Lebanon have experienced similar political volatility. Domestic political challenges are less acute in other regions but present nonetheless. Falling growth, sticky or rising debt, and political disruption leave many EM sovereigns vulnerable to abrupt shifts in global sentiment or shocks that can undermine macro-financial stability or jeopardize fiscal sustainability. Investors' sentiment towards a number of large EM sovereigns has soured, in particular Argentina and Turkey, which are in the midst of difficult macroeconomic adjustment processes.
EM and Frontier Market (FM) sovereigns with weak policy credibility face the most demanding financial market conditions. Financial conditions in many EMs and FMs are deteriorating, reflecting the stresses facing troubled EM sovereigns (see Exhibit 14) and FM sovereigns' high exposure to shifts in sentiment. As shown in our heat map (see Exhibit 16), that picture is not uniform: EM sovereigns with stronger fiscal profiles have faced more benign financial conditions which have facilitated improvements to debt profiles. Compared with five years ago, debt structures have improved for sovereigns like Peru, Romania (Baa3 stable) and Slovenia (Baa1 positive), which have extended their already long debt maturity profiles through liability management operations, while Hungary has seen significant progress in reducing foreign-currency exposure. Others have been less fortunate. Foreign-currency exposure has increased for the likes of Turkey and Argentina, which have also seen the largest increase in funding costs. In the Levant and Africa, spreads remain very high for Lebanon, Zambia (Caa2 negative), Ghana (B3 stable) and Tunisia, reflecting investors' anticipation of how governments may struggle to manage the upcoming maturity walls beyond 2021. High spreads build exposure to shocks and in some cases reflect or anticipate loss of market access.
Most EM and FM sovereigns have limited policy space. Fiscal and monetary policy space is more limited for EM governments than a generally higher level of interest rates and lower level of debt than in advanced economies would suggest, given EMs' vulnerability to reversals of capital flows. Overall, capital flows into EMs have fallen compared with 2017 levels, and will remain under pressure in 2020 and beyond (see Exhibit 15 on the previous page). Net portfolio inflows are decreasing for every region except for Asia where China remains an outsized recipient. Potential triggers for further risk-off episodes include further increases in trade tensions or evidence that the toll of the current tensions will be larger than previously thought, protracted policy uncertainty, as well as worsening growth and fiscal dynamics in higher-debt countries. The scope for supporting growth with fiscal stimulus or lower policy rates is therefore limited. Meanwhile, weaker external finances leave a number of EM and - particularly - FM sovereigns vulnerable to shocks (see Exhibit 17).