Sovereign risk: Falling Brics

In 2015, emerging market economies, led by four of the Brics – Brazil, Russia, China and South Africa, but not India – effectively ground to a halt. Capital flows vanished, corporate leverage jumped and currencies tumbled to historic lows. The 7.6% expansion notched by developing economies in 2010 capped a decade of spectacular growth. But this rate of growth has slid year-on-year to a projected 3.2% in 2015. With EMs growing barely a percentage point faster than developed economies, the investment case is unravelling. 

Against this challenging market backdrop, Euromoney invited economists, investors, risk analysts, bankers, corporate treasurers and fixed income strategists to participate in a sovereign-risk survey to gauge opinion on global and regional challenges. We received responses from more than 100 institutions. 

In particular, respondents highlight the weakness of EM credit fundamentals as the principal driver of risk deterioration rather than the difficult external financing environment. This stance contrasts with emerging-market policymakers, who grumble that exchange rates and equity markets have fallen below valuations implied by medium-term fundamentals. 

Asked to rank the biggest risks facing global economic growth in 2016 in order of importance, they cite: uncertain G7 central bank policies creating market volatility; the commodity-price shock; and the risk of global deflation. By contrast, China, Middle Eastern conflicts, the eurozone and premature Fed hiking are ranked lower. The fact that US monetary tightening was seen as the least important out of the seven hazards for the global economy underscores market confidence that monetary conditions will remain broadly accommodative. 

When asked to be specific about US interest-rate rises, 70% shrug off the impact, 24% believe it will hamper growth, but only 6% think it will cause prolonged market dislocation. This finding strikes a chord with the growing belief among analysts that it is the uncertainty over G7 central bank policies – and not rate rises themselves – that is one of the biggest external drivers of capital-flow volatility in emerging markets. 

How worried are you about US Fed rate hikes?

Source: Euromoney

For the eurozone, respondents say the refugee crisis is the single biggest threat for 2016, followed by political pressure to ease austerity and Greece. Less weight is given to traditional concerns, such as the lack of business investment, a failure to reform and bad debts.

The risk of bad debt damaging eurozone credit supply is deemed the least-important out of the seven concerns for the single-currency bloc, reflecting a positive outlook for bank-credit supply and household demand in northern Europe. There is also some evidence that deleveraging in the business sector in southern Europe, principally Spain, has cooled. Bank credit to eurozone businesses recovered 0.6% year-on-year in October, the latest data available, while lending to eurozone households reached 1.2% year-on-year.

Asked to rank emerging market-specific fears in 2016 in order of importance, respondents cited weaker trade, a stronger dollar, China, productivity falls, tighter financial conditions and Middle Eastern tensions. Trade grew 2.8% in 2015 compared with an expected global GDP growth of 3.1%, reversing the decades-long trend of trade expansion outpacing GDP growth.

For 2016, fears are growing that weaker trade – driven by China’s waning commodity demand and Brics import demand as a whole – will again lead to a deterioration in balance-of-payments positions among exporting nations from Asia to Africa, weakening their ability to service foreign debt.

Dollar outlook

The outlook for the dollar is crucial for developing markets – its strengthening has historically preceded crises from Asia to Latin America. Respondents say a stronger dollar is the second biggest risk for emerging markets. Since 2009, the weakness of the dollar, combined with easy US monetary conditions, fuelled the global debt and liquidity cycle. These conditions allowed US banks to increase their foreign holdings and depressed yields on conventional asset classes, triggering a demand for EM assets and a surge in private-sector indebtedness. The Bank for International Settlements calculates net non-bank private debt issuance from emerging markets grew $660 billion between the fourth quarter of 2008 and the third quarter of 2014.

Respondents are, therefore, concerned about a reversal in the global liquidity cycle driven by a stronger dollar that threatens to tighten financial conditions in emerging markets. Weaker EM currencies relative to the dollar will increase foreign-currency denominated debt-servicing costs, say respondents. 

Weaker commodity prices have also hurt oil-producing regions from the Gulf and sub-Saharan Africa to Latin America. Mercifully, however, few respondents foresee a classic EM debt crisis – with the exception of Venezuela and perhaps Ukraine – triggering a wave of sovereign defaults for 2016.

Which under-loved EM will see its risk profile in 2016 improve the most?

Source: Euromoney

There is little consensus in the survey over which EM sovereigns will see their risk profile improve the most in 2016. Respondents are fairly evenly divided between South Africa (24%), Turkey (21%) and China (18%).

Respondents think Mexico and India could see their ranking fall the most from a high 2015 base. Some participants note the prospect of a backlash to domestic reforms in Mexico that could boost the opposition parties in the 2018 elections. Others cite the risk of a shift in the US monetary cycle might reduce the demand for Mexican imports. Several also note there is a prospect of a market backlash in India after prime minister Narendra Modi’s failure to implement a number of key legislative reforms.  

Which EM will see its risk profile in 2016 fall the most after a relative outperformance in 2015?

Source: Euromoney

Survey contributors’ bearish attitude to EM also reflects the poor market backdrop. As Euromoney was going to press in mid-December, a strong US employment report for October triggered a jump in expectations for tighter Fed monetary policy in 2016. Credit-specific challenges also weighed on sentiment. In December, Fitch downgraded South Africa to BBB-, feeding fears the country would lose its investment-grade status and be forced to tighten monetary and fiscal policy. The economic and political crisis in Brazil also deepened, culminating in impeachment proceedings against president Dilma Rousseff, the dramatic arrest of André Esteves, then-CEO of BTG Pactual, as well as the downgrading of Petrobras, and the sovereign to junk status. 

Adding to emerging-market gloom, contrary to sell-side expectations, oil prices fell below the $40 per barrel benchmark for the first time since 2009, sending high-beta EM currencies lower. 

China, which accounts for 38% of emerging-market GDP, remains the bellwether for EM sentiment. Asked to rank their concerns about China for 2016, respondents cite local government debt pressures, failure to reach its 6.5% growth target and the corporate debt burden. The focus is on leverage. Corporate debt in the country has risen from 100% of GDP in 2008 to 160%, a relatively fast pace of growth and a high absolute debt stock. State-owned companies – particularly in the construction, real-estate and mining sectors – face falling prices, high over-capacity and strong leverage. There have already been a number of defaults among state-backed issuers. 

John-Paul Smith of Ecstrat, an emerging market equity research boutique, sums up the case for the bears: “We believe that while the overwhelming consensus view among economists and investors is that the Chinese economy and financial market will muddle through, we believe that there is a considerable risk of a sudden stop in terms of the real as opposed to the official rate of growth, leading to a slow motion economic and financial crisis.” 

He adds: “Companies across a number of key industries appear to be on the verge of a liquidity crisis, while the efficacy of repeated monetary and fiscal stimulus measures appears to be diminishing. I believe that the extent of the moral hazard in the economy in terms of companies, which are too big to fail, is now at least equal to the Korean chaebol on the eve of the Asian crisis in 1997 and the US financial and housing-related sectors 10 years later.” 

Survey respondents are indeed concerned about Chinese debt, both at the government and corporate level, and the prospect of deflation pushing down nominal growth. They are less concerned about political instability and the need for structural reforms, such as the liberalization of state-owned enterprises or the introduction of competition in the financial system. However, respondents rank the fear of another economic shock in China as the fourth risk out of seven for the international economy, suggesting they do not quite share Smith’s pessimism. 

Crisis hotspot

In 2015, Latin America was shaken by a terms-of-trade shock, lower oil prices and capital outflows. Euromoney Country risk survey scores for sovereigns in the region fell in 2015, reflecting growing current-account deficits and worsening external funding conditions. The consensus view sees Mexico and Colombia outperform in 2016, with Chile, Argentina and Brazil all expected to grow at a slower pace than the US. 

Brazil is seen as the region’s possible crisis hotspot. Respondents fear political risks and fiscal adjustments will drive the macro picture, threatening its ability to make structural reforms and the corporate sector’s capacity to service dollar-denominated debt. For all the political instability, however, crime and popular protest are deemed the least important of the seven hazards facing Brazil. 

ECR data anticipated negative rating actions on Brazil, Cyprus, South Africa, Finland and Japan actions last year. In January 2015, Russia was kicked out of the club of investment-grade sovereign borrowers, as was Brazil in December. The prospect of South Africa joining them now looks more likely. 

Last year there were at least 20 sovereign downgrades and 16 upgrades by the three main rating agencies; there are currently 15 countries on negative outlook versus just six on positive.

In emerging Europe, ECR ratings for Russia and Hungary improved year on year driven, in part, by current-account surpluses that have reduced external debt-servicing requirements. The ratio of short-term claims relative to FX reserves is low for both countries compared with the emerging-market average.   

Russia’s performance will be key to EM sentiment in 2016. Low oil prices, the depletion of the reserve fund and rouble volatility are respondents’ three top concerns, followed by banking. Geopolitical concerns – military action, legislative elections and political instability – were deemed the least important of the eight risks to Russia’s risk profile.

The survey paints a bleak picture of structural reforms across emerging markets in general. In particular it points to the lack of willingness and ability among policymakers to boost productivity in line with wage gains to increase competitiveness. 

Structural reform inertia has reduced corporate profitability and investment returns across the emerging markets. This, combined with rising funding costs, has led to deteriorating public and private balance sheets. 

According to State Street Global Advisors, EM productivity growth has fallen 0.3%, 0.5% and 0.7% in 2012, 2013, 2014, respectively, despite a 7.4% gain in wage growth since 2009 compared with 2% in developed markets. Nevertheless, economists and rating agencies have credited China, Indonesia, Mexico and, to a lesser-extent, India, for efforts to implement structural reforms. 

Hard currency

Despite rising EM sovereign stress, the performance of hard-currency EM bonds has been moderately strong in relative terms. The JP-Morgan EMBI-Global Diversified index, the benchmark for EM sovereign paper, returned 2.8% in 2015. This was lower than Deutsche Bank’s December 2014 forecast of 4.6%, as credit spreads and 10-year treasuries were virtually flat for the year. Without the spread rally in Ukraine, Russia, Argentina and Venezuela, the benchmark would have notched -2%. 

Deutsche analysts say: “The diverse (but diminishing) return performances reflect continued deterioration in EM fundamentals, as growth trended lower, fiscal accounts deficit widened, debt ratio climbed up and policy reforms were mixed.” 

EM sovereign credit outperformed EM currencies and equities. The MSCI Emerging Market Index fell by more than 19% in the year to early December, compared with -0.6% for the S&P500. This outperformance confirms the view of survey respondents that the burden of EM macro adjustment will fall on the private sector through a combination of lower growth, weak corporate profits and weaker currencies. 

Deutsche Bank estimates there will be a net supply of $25 billion of hard-currency-denominated sovereign paper this year, the largest volume since 2012. Debt capital market bankers say Argentina could return to the primary markets in 2016, pending a bond-holdout resolution with creditors, while newer names such as Egypt and Saudi Arabia and traditional EM borrowers such as Colombia, South Africa, Philippines, Romania have increased financing requirements. 

As Euromoney’s survey shows, the divergence in credit outlook for many emerging market borrowers, combined with an increase in supply, will force investors to become more discerning in 2016.