Rating Trends: Sovereign Debt Build-up Continues

As a class, sovereign ratings globally continue to indicate an overall deterioration of credit quality. A prolonged period of low interest rates along with expectations of low inflation have contributed to a large buildup of sovereign debt.

Interest rates set by central banks and other monetary authorities in developed countries decreased in the aftermath of the world financial crises to provide support to the markets and help them to recover (see chart 1).

Since then, economic growth has picked up, first in emerging markets and subsequently in the U.S. By contrast, growth has remained weak in Western Europe and Japan.

Chart 1

In addition, the geopolitical environment has changed over the last few years with the increase of populism, international trade frictions, and protectionism, which have affected sovereign economic outlooks. As a result, central banks have kept their policy rates low in an attempt to continue to support recovery.

In this context of low growth and low interest rates, and with some exceptions, the stock of sovereign debt across all rating categories had steadily increased over the last decade (see chart 2). On the other hand, debt service did not increase in proportion to debt as low interest rates allowed sovereigns to borrow more while maintaining their interest-to-revenue ratio relatively stable (see chart 3). Debt service even decreased at the higher end of the ratings scale. However, and considering that most sovereigns do not actually pay down their debt but refinance it on maturity, the sustainability of current debt dynamics, particularly at the speculative-grade level ('BB+' and lower), relies heavily on the ability to continue to refinance at current or lower rates.

Chart 2

Chart 3

The view that inflation and interest rates will remain steady or decrease could be problematic to the extent that it encourages large amounts of liquidity to be invested in lower credit-quality assets.

In this context, between 2008 and 2019, we downgraded seven out of 19 sovereigns previously rated 'AAA' on average by two notches (see chart 4). We downgraded eight other sovereigns to speculative-grade from their previous investment-grade rating category (see chart 5).

Chart 4

Chart 5

Several other large issuers of sovereign debt (see table 1), including China, Italy, Portugal, Japan, Colombia, Turkey, and Argentina, also experienced downgrades during the same period. In sum, over the last decade, as sovereign balance sheets weakened and debt levels rose, we have taken negative ratings actions on governments that account for more than 80% of all outstanding sovereign debt in 2019.

Table 1

Meanwhile, as the search for yield increases, investors appear to have become less risk-averse and more willing to lend to sovereigns that are rated lower today than a decade ago, accepting a lower return. Or, of perhaps greater significance, investors may have shifted their sovereign portfolio allocations to lower credit quality names to maintain rates of return.

How could this play out? A sudden change in inflationary dynamics could precipitate a rise in borrowing costs for refinanced sovereign debt, pressuring government finances.

In such scenario, we believe that sovereigns rated within the investment-grade category ('BBB-' and above) will be able to weather potential changes in market conditions with relative stability or remain in line with rating transitions that we expect for their respective rating categories. Over the last decade, many sovereigns, particularly in emerging markets, improved the composition and profile of their debt to reduce vulnerabilities while taking advantage of the ample liquidity in the market to issue more debt. These re-profilings included, among other things, issuing more long-term debt at fixed rates to reduce vulnerability to sudden spikes in interest rates. More importantly, many countries have deepened their local capital markets and enlarged their capacity to issue debt in local currency, reducing their vulnerability to sudden changes in the exchange rate and their reliance on nonresident creditors.

On the other hand, speculative-grade sovereigns that have accumulated a large stock of debt and have limited room to maneuver could be more exposed to negative rating actions under such a scenario, which is in line with the level of risk indicated by our current ratings.

It is difficult to say how the recent buildup of sovereign debt and today's "low for longer" scenario for interest rates will unfold. Financial markets usually become more fragile when, like nowadays, there are mismatches between perceptions of risk and expected returns based on potentially overconfident expectations that interest rates, inflation, and other variables are likely to move only in one direction. History has taught us that such conditions do not usually hold for as long as originally thought.

2020 Ratings Outlook: Balanced

• S&P Global Ratings rates 135 sovereigns globally (see chart 6).
• Overall, sovereign ratings remain at least one full notch below their 2008 average (see chart 7).
• The overall rating outlook in the portfolio is stable, with a marginal bias toward the positive over the next six months (see chart 8).

Chart 6

Chart 7

Chart 8

Looking into the next six months, the global outlook for sovereign ratings is balanced with the expected upgrades broadly equally as likely as downgrades (see chart 9).

As liquidity remains ample and in the absence of a sudden change in the monetary stance by most central banks in the developed world, we expect that credit and financing conditions will remain supportive of sovereign creditworthiness.

In this context, geopolitical tensions, domestic politics, the increase in populism, and the recent outbreak of a deadly virus in China are likely to be the most immediate key risks for sovereign ratings over the next six months.

Chart 9

Regional Outlooks

• Regionally, trends among developed EMEA sovereigns suggest an overall sovereign rating stability there in 2020. In emerging EMEA, prospects for upgrades continue to be brightest in the Commonwealth of Independent States, Central, and Eastern Europe.
• The balance of outlooks in the Middle East and North Africa, and Sub-Saharan Africa remains negative, with negative ratings pressures increasing in Lebanon and South Africa.
• In Asia-Pacific, a new disease threatens the outlook for the region. However, steady strong growth has supported stable outlooks overall in the region, while New Zealand, Japan, and Thailand have positive outlooks.
• Although our ratings on the U.S. and Canada are stable, some of the largest economies in Latin America could experience rating actions within the next six months. Brazil has a positive outlook, the outlook on Mexico is negative, and Argentina recently defaulted on local currency debt.

Table 2

Europe, the Middle East, and Africa (EMEA)

Developed Europe.   Four sovereigns currently carry positive outlooks (Andorra, Greece, Malta, and Portugal), and only one sovereign has a negative outlook (Italy).

Although uncertainties regarding global trade persist, we consider that the overall European developed macro developments have improved recently. While the economic outlook among the sovereigns is mixed, in absence of a significant and negative external shock, including with respect to the negotiations of a trade deal between the European Union and the U.K., trends in European developed sovereigns point to an overall sovereign rating stability in 2020.

Emerging EMEA.   The current net balance of positive versus negative outlooks in emerging market Europe, the Middle East, and Africa (EMEA) is negative, with five sovereign ratings with a positive outlook and six with negative.

In Central and Eastern Europe and the Commonwealth of Independent States (CEE/CIS), the ratings trend continues to be more positive than in the other two emerging EMEA subregions. Of the five positive outlooks S&P Global Ratings maintains on emerging market EMEA sovereigns, three are on CIS/CEE countries: Bosnia, Bulgaria, and Serbia. We upgraded Bulgaria and Serbia already during the second half of last year. On the other hand, our 'BBB-' rating on Romania has a negative outlook, given our expectation that last year's fiscal overrun will spill over into this year and potentially 2021, leading to further stimulation of an already overheated economy. Romania's expected current account deficits of an estimated 5.6% to GDP is one of the largest in the emerging market universe--a major outlier in a CEE/CIS region generally characterized by balanced external accounts, particularly in the larger economies.

The trend for Middle East and North Africa (MENA) ratings has been mixed. Fiscal reforms in Bahrain appear to be paying off, leading to us revising the outlook to positive. Also since last summer, we revised the outlook on our 'BBB-' rating on Morocco to stable, reflecting steadying growth and stabilizing public finances. What hasn't changed are the external and fiscal pressures mounting in two sovereigns: Oman and Lebanon.

Finally, we revised our rating outlook for South Africa to negative in November 2019. Sluggish economic growth continues to dampen revenue collections, which in addition to enduring problems at key public enterprises have complicated further the fiscal stance of the government and rapidly deteriorated debt metrics. Efforts and its effectiveness to revert these deteriorating fiscal dynamics will be at the center of our analysis over the next few months.

Asia-Pacific.   The outlook balance for the Asia-Pacific (APAC) region going into 2020 is broadly stable. As of Dec. 30, 2019, there were 18 sovereign credit ratings with stable outlooks, and three with positive outlooks (Japan, New Zealand, and Thailand). However, the emergence of a new virus threatens the region.

In addition, a U.S.-China "trade war" may be averted for the time being, but renewed tensions in the Middle East increase risks to the Asia-Pacific region.

The recently signed "phase one" agreement between China and the U.S. ushered in a period of truce that could last until the U.S. presidential elections near the end of the year. Given the strategic nature of the tensions between the two nations, trade tariffs could once again go up after that. Nevertheless, the agreement gives both economies some breathing space at a time when growth is slowing.

Finally, the situation in Hong Kong remains unpredictable in 2020. Although the frequency of violent protests has declined since late last year, the underlying social tensions remain. Protestors view the government as largely unresponsive to their demands. A resurgence in street violence, triggered by future events, is still likely. The risks to the ratings is that continuing social tensions result in abrupt changes in the relations between the central government of China and the Hong Kong Special Administrative Region (SAR) government, which could reduce policy predictability and undermine confidence in the autonomy of the SAR government.

Americas

U.S. and Canada.   In 2020, we expect continuity in key economic policies in Canada, with GDP growing by 1.6%. The advent of a minority government after elections last year is not likely to change Canada's economic policies or its rating trajectory. We expect that the U.S. economy will grow 1.9% in 2020 as the country experiences its longest economic recovery in history (starting in 2009), with low unemployment and inflation, and falling poverty. However, its impressive macroeconomic performance contains a notable weakness: the general government fiscal deficit is likely to exceed 4.5% of GDP in 2020, a comparatively high level for an economy at this stage of its business cycle. We expect no significant change in U.S. economic policy in 2020, an election year.

Latin America.   We have negative outlooks on four sovereigns in the region, making Latin America relatively the most likely to see negative ratings actions over 2020. The region is again facing a year of subdued economic performance, largely reflecting domestic economic weaknesses in many countries. The reasons for this performance vary from country to country, but the common denominator across the region is a deterioration of the political landscape that has delayed an appropriate reaction to adversity.

Our rating outlook on Mexico remains negative. Failure to reverse a recent decline in GDP growth and avoid potential weakening of public finances could erode its creditworthiness.

Argentina recently defaulted on its local currency debt. The government is likely to renegotiate its debt with external creditors, both private and public, in first-quarter 2020.

On the other hand, In December 2019, we revised the outlook on Brazil to positive. We could upgrade Brazil if economic policies improve GDP dynamics beyond our expectations, or if rapid progress with the government's plans results in a more rapid reduction of fiscal deficits and a stabilization of debt dynamics.

Finally, economic performance will suffer in Chile following massive social protests in recent months. Our analysis will focus on the long-term impact of recent developments in GDP growth and public finances. We will also focus on the ability of Chile's political leadership to contain public demands within institutional channels to maintain stability and predictability in economic policies while the country likely changes its constitution.

Related Research

• Sovereign Ratings Score Snapshot, Jan. 2, 2020
• Sovereign Risk Indicators, Dec. 12, 2019; a free interactive version is available at http://www.spratings.com/sri
• Global Sovereign Rating Trends: Third-Quarter 2019, Oct. 15, 2019
• Global Sovereign Rating Trends: Midyear 2019, July 25, 2019
• 2018 Annual Sovereign Default And Rating Transition Study, March 15, 2019
• Sovereign Debt 2019: Global Borrowing To Increase By 3.2% To US$7.8 Trillion, Feb. 21, 2019
• 2016 Sovereign Ratings Update: Outlook And CreditWatch Resolutions, April 18, 2017