Sovereign Credit Stages a Tentative Recovery

Sovereign creditworthiness is showing tentative signs of improvement, but there is still little feel-good factor in the global economy.

The average credit rating of countries around the world edged up 0.4 point, to 44.5 on a scale of zero to 100, according to Institutional Investor’s semiannual Country Credit survey. The modest increase, the first such gain in 18 months, reflects improvements in Eastern Europe and Asia, which offset continuing declines in Western Europe and a sizable drop in the Middle East. The rating is still well below its peak of 48.0 tallied in September 2008, just before the global financial crisis erupted with the collapse of Lehman Brothers Holdings.

Although the survey contains a sprinkling of positive news and ratings increases, several respondents say the improvement is fragile. “I’ve been doing this for quite a while now, and I’ve never seen so many downside scenarios, and I’ve never seen so many uncertainties,” notes Paul Koenekoop, head of country risk research at ING Group in Amsterdam. “The risks in some European countries may be a little bit overestimated, but some of the risks in a number of fast-growing emerging markets are maybe a little underestimated: Even though they have been doing so well for the last few years, they still have their structural problems.”

Europe, with its toxic cocktail of sovereign debt crisis and recession, continues to suffer some of the worst ratings downgrades, led by Spain. Madrid is negotiating a possible bailout program with European authorities, which European Central Bank president Mario Draghi has insisted is necessary before the ECB will support the country’s debt. Spain needs the backing of Chancellor Angela Merkel, who is trying to keep the euro together while limiting the cost to Germany, and President François Hollande of France.

Spain’s rating drops 7.1 points, the largest fall of any country. Says Victoria Marklew, head of country risk management at Northern Trust Co., “There is a realization that the potential contingent liabilities of the sovereign emanating from the banking sector are higher than people had realized. Plus, the unemployment rate [in Spain] has climbed to 25 percent and is not showing any signs of coming down soon.”

Elsewhere, most countries post more-modest declines. Italy, which fell 5.9 points six months ago, is down 2.9 this time; France’s decline slows to 1.3 points compared with 2.7 points in March, while Portugal slips 1.2 points versus 3.4 points. Yet the long-term trend for many European countries is decidedly negative. A perennial member of the top ten for the first three decades since this survey began in 1979, France gains just one place from March, to 16th. Italy, which ranked 21st five years ago, falls to No. 45, down three places from March. And Greece, at No. 27 five years ago, falls five places from March to stand at No. 156 out of 179 countries.

Germany, which dropped 2.8 points in March, is actually up 1.7 points this time. “It’s good to be the country that everybody believes to be the stable linchpin of the euro zone and the one that still has positive GDP growth at the moment,” says Marklew. But not everyone is so sanguine. “My perspective is not that Germany is improving, but rather that they’re even more at risk,” asserts George Estes, a partner and sovereign credit analyst at investment manager GMO.

Indeed, when asked how various countries will be rated in six months, 71.4 percent of respondents predict Spain will fall, and expectations of declines elsewhere are 51.8 percent for Italy, 35.7 percent for France, 33.9 percent for Greece and 28.6 percent for Portugal. The five countries voted most likely to have a lower rating are all in Western Europe.

The slower pace of ratings declines reflects a market view that Europe will continue to avoid a breakup of the euro without resolving the underlying debt crisis. In regard to the likelihood of countries defaulting, 65.2 percent of repondents say it is “likely” or “highly likely” that Greece will default, compared with 33.3 percent for Portugal, 27.8 percent for Spain and 4.4 percent for Italy.

Despite Western Europe’s woes, ratings improve for most Eastern European and Central Asian countries. Seventeen of the 29 countries in these regions climb a point or more, while only three decline by at least that amount. Northern Trust’s Marklew notes that many Eastern European countries “tend to be dependent on exports to Germany” — the one major nation in Western Europe that is growing.

Ratings tumble sharply for most countries in the Middle East and North Africa. Syria, which appears to be on the verge of a full-scale civil war, suffers the biggest decline, down 6.9 percentage points, while Egypt, where new President Mohammed Morsi has moved to curb the power of the military, sheds 4.9 points. Qatar falls 3.4 points, the United Arab Emirates drops 2.3 points, Morocco and Tunisia each lose 2.1 points, and Saudi Arabia slips 1.4 points. The region’s only significant increases are in Iraq (+2.9) and Libya (+1.3), both countries “just coming back a little from their lows,” says one London credit analyst.

In Asia, China falls 1.8 points, apparently reflecting fears of a hard landing. “Growth is coming down faster than anyone expected last year,” says ING’s Koenekoop, “and trade for Asia overall is coming down dramatically.” The growth slowdown also hurts most of the region’s other budding economies, including India (–1.3), Indonesia (–1.1), Malaysia (–1.2) and Thailand (–1.3). Several frontier markets post strong gains, however, including Mongolia (+5.3), Myanmar (+5.4), the Philippines (+1.4) and Vietnam (+2.7). GMO’s Estes observes that Myanmar’s repressive politics seem to be receding, and Mongolia “has become a natural-resource play.” In the Philippines, President Benigno Aquino Jr. “has cracked down on corruptions, and the economy is growing pretty well,” says Estes.

Debt exerts a strong influence on Asia’s advanced economies. Japan, by far the world’s most indebted major country, sees its rating drop 1.1 points and slips one place, to 20th. It is now sandwiched by upwardly mobile Taiwan (up three places to 19th) and South Korea (up four to 21st).

In Latin America ten countries, most small, rise a point or more, while the majority of the eight countries that fall are sizable. “It’s partially commodity prices, partially the slow growth of the global economy, and part of it is the very quick slowdown of the economy in Brazil, which has repercussions for the countries around it,” says Koenekoop. Brazil falls 1.8 points, while Argentina slips 1.6 points and Venezuela sheds 2.4 points.

Africa’s regional rating climbed 1.1 points as 33 African countries rose by a point or more while five declined. Côte d’Ivoire leads the gainers with a rise of 5.4 points thanks to a June agreement with the Paris Club that will cancel virtually all of the country’s $6.5 billion debt to Western nations.

The prospects for creditworthiness remain highly uncertain, analysts say. Christine Shields, head of country risk at Standard Chartered, predicts that Asian nations’ ratings will improve over the coming six months because of fresh stimulus efforts in China, but Europe continues to overshadow the global outlook. “The sense that the worst has not happened, and therefore it won’t happen, may be a little overly optimistic,” she says.  •  •