The post pandemic economic recovery continues to slow and is now further at risk because of increasing geopolitical conflicts, global inflation, and interest rates.  After posting solid 6% growth in 2021, we expect global economic growth to slow in 2022 to 3.6% and 3.5% in 2023. That said, rising global inflation is pressuring central banks to increase interest rates to bring it under control. However, the evolving nature of the factors pushing inflation up are increasing the risk of recession.

Table 1

Evolving forces keep inflation high for longer than expected, increasing the risk of recession.  Inflationary pressures started to become more evident toward the fourth quarter of 2021 when pent up demand that could not be fully covered by labor shortages--as business coped with pandemic work restrictions--and disrupted supply chains impaired the lag at which economies reopened. In that context, inflation was thought to mostly be the product of temporary factors that would curve itself as economies reopen. However, the speed at which the labor force went back to its pre-pandemic levels in the U.S., for example, is slower than expected, straining wages. In addition, the zero-COVID-19 policy implemented by China is lasting much longer than expected, keeping Chinese industries operating at limited capacity as they continue to be in and out of long-lasting lockdowns. This in turn is highly disruptive for the normalization of supply chains.

Geopolitical events take the front seat.  On Feb. 24, the Russian armed forces invaded Ukraine, starting a military conflict of a magnitude not seen in Europe since the end of World War II. The world's response to Russia's aggression came swiftly with the EU, the U.S., and other major G-20 nations imposing a severe set of economic sanctions that included Russia's ally Belarus.

The conflict, and the world's response to it, has added major complexities to global inflation and economic growth. Both Russia and Ukraine are among the largest world producers of food and energy. Since the beginning of the conflict, these two heavy components of any consumer price index (CPI) basket have skyrocketed. We expect the conflict to become protracted and pose serious disruptions to global trade and consumer confidence. In addition, the risk interest rates will rise in a disorderly fashion has risen significantly because nonconventional factors are affecting demand and inflation. In this case, a global recession could follow. None of this bodes well for the future of government creditworthiness and its recovery to pre-pandemic levels.

Not all are losing.  Geopolitical tensions like the ones we are seeing now are not positive for anyone, but some of the consequences have helped some sovereigns improve their overall fiscal position or helped to provide a cushion to deal with higher inflation. This is most clearly the case in emerging markets that are large or net commodity exporters. During the first half of the year, we have raised the ratings or revised outlooks positively on Saudi Arabia, Oman, Malaysia, South Africa, and Mexico, among others.

Rating Trends

S&P Global Ratings rates 137 sovereigns globally. Over the last decade, sovereign credit quality has continued to deteriorate, as indicated by a decline in investment-grade sovereign ratings (as a proportion of total sovereign ratings) of almost five percentage points to 51.8% as of June 2022 (see chart 1). In addition, the average rating is now 'BBB-', one notch lower than in 2011, a trend that accelerated during the pandemic (see chart 2).

Chart 1

Chart 2

As of June 17, 2022, 14 sovereigns had negative outlooks and eight had positive outlooks. All the negative outlooks are in emerging or frontier market economies (see chart 3 and table 2).

Chart 3

Table 2

Default risk is rising and will likely remain high well into 2023.  The number of rated sovereigns in default have increased to four: Lebanon, Suriname, Sri Lanka, and Zambia. Russia also defaulted in April, but we have since withdrawn the ratings. In addition, the number of rated sovereigns in the 'CCC+', 'CCC', or 'CC' category also increased to eight (see table 2), four with negative outlooks, amid more difficult financing conditions as funding costs are increasing globally.

Table 3

Regional Outlooks

Chart 4

Europe, Middle East, and Africa (EMEA)

Table 4

Developed Europe.  As of June 2022, 24 of the 30 European developed sovereigns we rate have stable outlooks. However, four sovereigns--Cyprus, Austria, Italy, and Andorra--have positive outlooks, and two--Slovakia and Guernsey--are negative.

Although most European economies have already recovered to pre-pandemic levels in nominal terms, the ongoing conflict in Ukraine, supply shock, and rising borrowing costs are posing additional risks for the stability of many developed sovereigns.

The Russia-Ukraine conflict and Western firm sanctions are causing widespread economic uncertainties in the euro area, destabilizing energy markets and pushing inflation to historical highs that in turn will likely hinder the post-pandemic economic recovery.

We think the capacity to implement progrowth reforms to capitalize on the support from facilities like the Next Generation EU program will be key for creditworthiness. In turn, failure to address persistent structural weaknesses could strain investment and growth, reversing the somewhat positive ratings momentum.

Emerging EMEA.  The post-pandemic economic dynamics and the Russia-Ukraine conflict have had a diverse impact on Europe, the Middle East, and Africa emerging market (EMEA EM) sovereigns. A small group benefited from higher commodity prices (primarily those net energy exporters), but most households in EM sovereigns have been severely hit. Balance of payments and fiscal accounts are feeling the stress of the situation while financing costs and, in some cases even access to financing, is becoming more difficult.

Overall, ratings on EMEA EM sovereigns remain on a downward trajectory, with the number rated 'CCC' and below (including three currently in default) exceeding the number in the 'BBB' rating category for the first time ever. Most notably, the average rating and average GDP weighted ratings for EMEA EM sovereigns hit an all-time low in April 2022 on the back of the downgrade of Russia to 'SD' (selective default),. The ratings were withdrawn later the same month.

Lastly, negative outlooks exceed positive ones by five, but most of these predate the Russia-Ukraine conflict and reflect idiosyncratic factors. For example, our positive outlook on Saudi Arabia reflects not only the fiscal and external benefits of higher oil prices, but its delivery of a series of economic and political reforms

Americas

Table 5

U.S. and Canada.  Global and domestic developments have worsened the economic prospects of both countries in 2022. Policymakers have less room to maneuver due to worsening economic conditions, including higher inflation, shortages in key products, and higher interest rates (as well as a polarized political environment in the U.S.). That said, the wealth, institutional effectiveness, monetary flexibility, deep domestic capital markets, and other credit strengths of Canada and the U.S. should sustain the high sovereign ratings despite decelerating growth and rising inflation this year.

Latin America and the Caribbean.  Economic performance will suffer in much of Latin America and the Caribbean in 2022 due to both external factors (slower global growth, rising inflation, and higher interest rates) and domestic factors (including the social legacy of the pandemic and political uncertainty in many countries). However, the credit rating impact of these negative trends may be moderate, given sovereign ratings in the region are already quite low (nearly 60% of the regional sovereigns have suffered downgrades since the start of the pandemic).

Central banks throughout the region have been raising their policy interest rates in recent months--before the central banks of the U.S. and the eurozone. We expect the active monetary policy will limit the rise in inflation and ensure that Latin America does not return to the high inflation of the 1980s and 1990s.

Besides the perennial failure to address structural weaknesses to provide sustainable economic growth, Latin America is facing difficult political conditions that severely limit governments' capacity to take corrective measures and reduce the credibility of their execution.

Asia-Pacific

Table 6

We expect stability across Asia-Pacific sovereign credit ratings in the next one to two years despite rising prices and interest rates and remaining risk from COVID-19. All sovereigns in Asia-Pacific have stable outlooks, with one exception: Sri Lanka, which defaulted on April 25.

On the other hand, during the first half of 2022 we revised the outlooks on Indonesia, Malaysia, and Papua New Guinea to stable from negative based on fewer uncertainties as COVID-19 risks receded and strong economic growth prospects (among the highest of all EMs). In addition, we also upgraded Vietnam to 'BB+' and Taiwan to 'AA+', both with stable outlooks.

Our attention is on China, where the government continues its strict zero-COVID-19 policy. This has continued to strain supply chains as severe lockdowns limit manufacturing capacity. There is also risk that a more deadly and contagious strain of COVID-19 would send the Chinese economy into another wave of lockdowns, significantly affecting its trade partners in the Asia-Pacific. In addition, concerns over U.S.-China relations are a threat to regional credit metrics. Considering the busy political calendar this year, with both midterm elections in the U.S. and the 20th Party Congress in China, reaching political compromises could be more difficult.

The higher inflation in the region will likely not affect most Asia-Pacific sovereign ratings as many sovereigns continue to enjoy healthy external surpluses. In fact, several sovereigns seeing a widening of their current account deficits are doing so from a position of strength that should serve as a buffer within the next 12 months.

Sovereigns in the South Asian region have been most negatively affected by recent developments. These pressures contributed to the Sri Lankan government's default and political unrest in Pakistan, and increased Bangladesh's current account deficits.