Eurozone Crisis and US Fiscal Cliff Risk Dominate Sovereign Outlook, but Some Asian and EMs Offer Stability

Weaknesses in the major advanced economies (MAEs) – dominated by the continuing eurozone crisis and the looming threat of the US ‘fiscal cliff’ – are exerting a negative influence on global sovereign credit quality, says Fitch Ratings in its bi-annual global
‘Sovereign Review and Outlook’

The credit ratings agency (CRA) adds that while emerging market (EM) economies are proving more resilient, their continuing exposure to the MAEs, combined with their own vulnerabilities, is constraining the upward rating momentum of EM sovereigns.

The report notes that the ratings of seven of the world’s 10 largest economies are currently on negative outlook, including three major AAA-rated sovereigns – the US, the UK and France, highlighting the strained credit quality of the countries underpinning the global economy. Fitch expects to resolve these three negative outlooks in 2013, against a challenging backdrop, with the eurozone back in recession and a US recovery not expected to gain traction until H2.

The eurozone crisis has entered a period of relative calm, influenced heavily by the announcement of the European Central Bank’s (ECB) ‘Outright Monetary Transactions’ (OMT) programme in early September. Mario Draghi’s policy initiative has effectively addressed near term liquidity risks for troubled eurozone sovereigns, buying time for the necessary but painful adjustments required to secure solvency. However, notwithstanding some progress on banking union at
last week’s EU summit
, significant challenges still confront policy-makers, both in terms of moving towards greater fiscal and financial risk sharing and in breaking the negative feedback loop between sovereigns and their banking systems.

Fitch is concerned that the current easing of market pressure on sovereign bond yields – combined with the specifics of 2013’s electoral calendar, including Italian and German general elections – could induce complacency and slow policy momentum to a crawl. More positively, the recent Troika agreement to provide additional debt service relief measures in order to secure Greek sovereign debt sustainability reflected a concerted commitment to avoid a Greek exit and supported Fitch’s view that a eurozone break-up will be avoided.

US Fiscal Cliff

The CRA has identified the US fiscal cliff as the single biggest, near-term threat to the world economy, given its potential to tip the US into an unnecessary and avoidable recession, with negative implications for global growth. However, Fitch’s base case expectation is that a compromise will be reached to avoid the US$600bn of tax increases and spending cuts due to come into effect on 1 January 2013.

Fitch still anticipates a material fiscal tightening of 1.5% in the US economy in 2013, but this falls well short of the 5% implied by the fiscal cliff. If the negotiations on the fiscal cliff and raising the debt ceiling extend into 2013 and appear likely to be prolonged with adverse implications for the economy and financial stability, the US sovereign rating could be subject to review, potentially leading to a negative rating action.

Eurozone Crisis

The crisis took a further heavy toll on ratings in 2012, as Fitch downgraded six eurozone sovereigns by a total of 19 notches (15 excluding Greece), although the vast majority of the downgrades occurred in H112, indicating an easing of tail risks in the second half of the year following the OMT announcement. Spain was particularly hard hit by two multi-notch downgrades, taking its rating to BBB. In March, Greece set a record €199bn sovereign default, the first in an advanced economy as classified by the International Monetary Fund (IMF) in the modern era. In May, Fitch also downgraded Japan, the world’s second largest debtor, to A+/negative.

Ten developed market countries are on negative outlook and none on positive outlook, although – in one more positive development – the outlook on Ireland’s BBB+ rating was revised to stable in November, representing the first positive rating action Fitch has taken on a eurozone peripheral sovereign since the crisis began, reflecting Ireland’s progress with its fiscal consolidation, external adjustment and economic recovery, as well as its improved financing options.

Global Growth

Global growth outturns are undershooting expectations and risks remain skewed to the downside. The contraction in the eurozone and Japan, as well as weaker growth in Brazil and India in Q312, highlights the underlying weaknesses and risks still facing the global economy. Fitch anticipates fragile global growth in 2013, with the MAEs in particular likely to record only a marginal improvement year-on-year as the weak recovery from the 2008 financial crisis continues. For the MAEs, Fitch forecasts economic growth of 0.9% in 2012, followed by 1.2% in 2013 and 1.9% in 2014. Global growth is forecast at 2.0% in 2012, 2.4% in 2013 and 2.9% in 2014.

EM economies are continuing to show relative resilience to tough global conditions and to outperform so-called advanced countries. Although the overall medium-term trend is one of moderating growth, Fitch expects that the major EM economies, particularly China (A+/stable), India (BBB-/negative) and Brazil (BBB/stable), will regain momentum in 2013, with gross domestic product (GDP) growing by 8.0%, 7.0% (to March 2014) and 4.0% respectively. However, this will fall some way short of recent multi-year peaks, and reflects the combination of weak import demand from the MAEs and domestic vulnerabilities reflected in tighter policy settings and the need to address longer term structural issues, such as China’s rebalancing towards higher domestic consumption and lower investment to generate growth.

Upward momentum in EM sovereign ratings has slowed. There have been six EM sovereign upgrades so far in 2012, following 18 in 2011 and 13 in 2010, although all six occurred in H2, again indicating an improved trajectory since the first half of the year. The balance of negative outlooks to positive for EM sovereigns now stands at 2:1, representing a clear deterioration from the December 2011 ratio of 1:1. However, bucking the general weakening trend were significant upgrades for Turkey, to BBB-/stable from BB+ – and Korea to AA-/stable from A+.


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