Policy Risks, Not Tapering, Are Key To Emerging Market Sovereign Ratings

Primary Credit Analyst: Moritz Kraemer, Frankfurt (49) 69-33-999-249; moritz.kraemer@standardandpoors.com

Table Of Contents
The Ebb And Flow Of Capital Into Emerging Markets Vulnerabilities To Tighter Global Liquidity Differ Significantly Why Sovereign Ratings Have So Far Been Unaffected By Capital Flow Reversals

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Policy Risks, Not Tapering, Are Key To Emerging Market Sovereign Ratings
Since the U.S. Federal Reserve first announced its intention to gradually tighten monetary conditions in mid-2013, the torrent of capital that had been flowing into emerging markets has slowed to a trickle. Indeed, with the Fed's so-called "tapering" now in full swing, based on its view of the growing momentum behind the U.S. recovery, global liquidity conditions have tightened appreciably. At the same time, domestic political events in a number of countries, as well as concerns about a potential slowdown of the Chinese economy, have further altered the risk appetite of international investors. They are now faced with the prospect of higher interest rates in the U.S., making the emerging market (EM) carry trade less attractive. Consequently, currency, equity, and bond markets in most emerging markets have come under pressure, although the impact varies by country and region. Overview • Our data suggests that the top-three emerging market sovereigns vulnerable to shifting capital flows are Ukraine, Turkey, and Ghana, whereas China, Philippines, and Angola appear on the strong end of the spectrum. • However, we do not currently expect the impact of the current market conditions to lead to widespread sovereign rating actions. In fact, we believe the current conditions for government bond markets now better reflect underlying fundamentals. • The key risks for many of our ratings on emerging market sovereigns are, in our view, not tapering and its effects, but domestic policy choices and implementation.

Inevitably, these pressures raise questions about the impact on sovereign ratings. In Standard & Poor's Ratings Services' view, however, the current market conditions and their impact on the economic outlook should not lead to widespread sovereign rating actions. In fact, we believe the current government bond market conditions now better reflect underlying fundamentals (as expressed in our sovereign ratings) than a year ago. Our EM sovereign ratings have held steady during the past few years, in contrast to volatile market behaviour. This is not to say the downside risks to EM sovereign ratings are negligible. Indeed, many of our ratings on these sovereigns carry a negative outlook, reflecting our view that there is at least a one-in-three chance of a downgrade. However, the key risk for many of these ratings is, in our view, not the possible effects of tapering. Instead, we stress what we consider to be mounting risks to domestic policy choices and implementation.

The Ebb And Flow Of Capital Into Emerging Markets
The Institute for International Finance (IIF) estimates that the retrenchment from a sample of 30 emerging markets has been more subdued than is often perceived ("Capital Flows to Emerging Market Economies", IIF, Jan. 30, 2014). According to the IIF, the year-on-year fall in aggregate total inflows globally was around 10% during 2013, with deeper contractions in Latin America (16%) and Emerging Asia (14%). Outflows rose by a modest 6%.

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Policy Risks, Not Tapering, Are Key To Emerging Market Sovereign Ratings

While foreign direct investment into emerging economies has actually increased, the flightiest capital has contracted the most. For example, portfolio equity investment has fallen by one third and portfolio debt investment by almost a quarter. In January 2014, the renewed EM turbulence led to another wave of international capital flows being repatriated to advanced economies. By mid-February, global investors had pulled more money out of EM stock and bond funds (especially exchange traded funds) in the first few weeks of the year than during the whole of 2013 (based on data provided by Emerging Portfolio Fund Research). Of course fund investors are only one relevant investor segment to consider, and the IIF considers that institutional investors "appear to have maintained their exposures to EMs, responding to strategic mandates to gradually raise their underweight allocation to EMs in overall portfolios". Nevertheless, we believe that the risks to overall capital flows are still present. In our view, these risks may be accentuated should interest rates in the developed world rise faster than currently anticipated by capital market participants. The fact that foreign investors have increased their share of domestic currency government debt over the last decade may also impact domestic interest rates more than has been the case in the past. As chart 1 indicates, EM exchange rates and government bonds have come under strong pressure since the beginning of 2013. The real effective exchange rates of almost all EM currencies have depreciated, with those of India, Brazil, Indonesia, South Africa, Turkey, and Argentina falling by more than 10% since May 2013. Local equity markets have also dropped by over 10% on average, with much steeper drops in countries like Turkey, Indonesia, and Brazil. The 12-month returns on government foreign currency bonds have been negative across the board, with the JP Morgan EMBI+ index (tracking the major emerging markets' government bond returns) declining by 7.9%. The weaker performance of EM currencies as compared to Eurobonds is in our view due to the fact that since the Fed's tapering announcement in June 2013, close to 70% of net outflows from dedicated bond funds were estimated to be from local-currency funds.

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Policy Risks, Not Tapering, Are Key To Emerging Market Sovereign Ratings

Chart 1

In general, the less liquid frontier markets have weathered the wave of tapering-triggered correction relatively well. The JP Morgan Next Generation Market Index (which tracks the total return for smaller and less liquid and markets) actually reported a moderate positive return of 1% in the 12 months through January 2014. A similar divergence between emerging and frontier markets has also been observed for the equity markets. Furthermore, the downward market moves have been far from synchronized among the more mature and liquid emerging markets. While currencies and bond prices softened broadly and rather indiscriminately in June 2013, Asian emerging markets (such as India and Indonesia) held steady during the second wave of EM selling in January 2014, while others, such as Turkey and South Africa, faced renewed outflows. Nor has the correction been steady and gradual, as evidenced by renewed net inflows to most large emerging markets in February 2014.

Vulnerabilities To Tighter Global Liquidity Differ Significantly
The appearance of an increasingly differentiated response from cross-border investors chimes with our view that the vulnerability across the heterogeneous EM universe differs significantly between sovereigns. We continue to believe that some sovereigns are better prepared to confront the potentially sustained outflows in their financial account of the

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Policy Risks, Not Tapering, Are Key To Emerging Market Sovereign Ratings

balance of payments either because their currencies float and provide an automatic shock absorber or because they can fall back on a large stockpile of reserves and/or official funding sources. These are important differences compared to the situation prior to the Asian financial crisis in the late 1990s, another episode of capital flow reversals. Furthermore, today, in most emerging markets, local banks also tend to be better run and better capitalized than they were in Asia in the mid-to-late 1990s, reducing the risks of a negative feedback loop. In mid-2013, we published our rankings of which sovereigns are likely to be most vulnerable to shifting capital flows (“Emerging Market Sovereigns in Europe Could Be Most At Risk In A Liquidity Squeeze,” July 4, 2013). We concluded that "the larger the economy's dependence on external funding is compared to its own stock of and capacity to generate foreign reserves, the more vulnerable it is to the change in the extraordinarily loose monetary conditions currently prevailing worldwide. This is a pattern evident in almost all recent sovereign debt crises, from Latin America in the 1980s, the tequila-shock and the Asian crisis in the late 1990s, and the latest euro area crisis." We found that sovereigns like Turkey and Ukraine would be particularly exposed. We continue to hold this view and have updated our rankings using our 2014 full-year estimates for what we consider relevant measures of external vulnerability. Table 1 summarizes our findings. We do not use one single measure to assess an economy's external liquidity position. Instead, we consider a number of indicators to capture the various facets of external liquidity risks. For the purpose of assessing vulnerability we have selected the three below. In practice, we take longer-term trends into account when assessing sovereign credit risk. Here, for simplicity, we will use our estimates for 2014, as published in our quarterly Sovereign Risk Indicators (spratings.com/sri), last published on Dec. 13, 2013. • Gross external financing needs as a percentage of the sum of current account receipts plus usable foreign exchange reserves. This is our standard measure for a country's external liquidity, as described in our sovereign rating methodology. We define gross external financing needs as current account payments plus short-term debt by remaining maturity, including nonresident deposits. This comprehensive measure captures all cross-border inflows and outflows, as well as the potential buffer provided by official exchange reserves. The ranking of emerging market sovereigns by this measure can be seen in the left column of table 1. • External short-term debt by remaining maturity as a percentage of usable official foreign exchange reserves. In a financially ever-more-interconnected world where balance of payment crises are increasingly caused by reversals on the capital account, a large stock of short-term debt (by remaining maturity) can render an economy more susceptible to sudden-stop scenarios, especially if the central bank's foreign exchange reserves are small in proportion. Our ranking of sovereigns by this measure is shown in the middle column. • Twin-deficit as a share of GDP. This adds the general government balance to the current account balance, a traditional and much-used measure of external flow imbalances reflecting the funding needs of a country that arise because of its current external transactions such as cross-border trade or factor payments. As external debt funding has become more accessible, fiscal and external deficits have risen recently in a number of EM economies. This makes these sovereigns susceptible to a potentially disorderly unwinding of the imbalances should funding conditions tighten significantly, or dry up entirely. The right column of table 1 shows the corresponding ranking. The table lists the sovereigns by their average rank across the three measures, with the top 10 in each vulnerability category highlighted in red and the bottom 10 in green. The data suggests that the top-three vulnerable sovereigns are Ukraine, Turkey, and Ghana, whereas China, Philippines, and Angola appear on the strong end of the spectrum. The results also indicate that the popular moniker of the so-called "fragile five" (Turkey, South Africa, Indonesia, India, and Brazil) actually masks significant differences between these emerging economies. Indeed, while Turkey and South

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Policy Risks, Not Tapering, Are Key To Emerging Market Sovereign Ratings

Africa do appear in the top 10 of vulnerable economies, Brazil is actually in the bottom one (mostly thanks to its low stock of short-term external debt), while India and Indonesia occupy the middle ground.

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Policy Risks, Not Tapering, Are Key To Emerging Market Sovereign Ratings

The three measures applied correlate positively (from a correlation coefficient of 0.90 for the first two to 0.42 for the last two) even though they measure different facets of potential exposure to a fall in global liquidity. Depending on which measure one chooses, the conclusions may differ. For example, while Hungary appears to be strong on the twin-deficit measure, falling into the bottom 10, the country appears more exposed by the second measure, falling into the top-10 vulnerable sovereigns. Similar patterns are observable for Venezuela and Kazakhstan, the latter having taken recourse to a surprise devaluation of the tenge of around 20% on Feb. 11, 2014.

Why Sovereign Ratings Have So Far Been Unaffected By Capital Flow Reversals
Standard & Poor's has kept its EM sovereign ratings broadly steady since last June's tapering announcement. Among the highlighted sovereigns at the top-end of the vulnerability scale, we lowered the rating on Ukraine twice to 'CCC', as its external funding challenges were greatly exacerbated by the collapse of political cohesion in the country. We also revised the outlook on our 'BB+' foreign currency rating on Turkey to negative in early 2014. Overall, though, our ratings have incorporated tolerance against some erosion of market-confidence. Chart 2 juxtaposes our fundamental view on EM sovereign creditworthiness (unweighted average rating on 14 EM sovereigns, blue line) with the implicit default assessment of financial markets, or what we refer to as "market-derived signals" (red line). The red line is a result of transforming probabilities of default implicit in market prices into "ratings", by matching implicit default rates with empirical default rates associated with Standard & Poor's ratings. We find that not only has the market shown much more volatility in its "ratings", but it has also been much more optimistic during the period of ample global liquidity. Investors "rated" EM sovereigns between one and two notches higher than Standard & Poor's. Following the tapering announcement, this gap collapsed as prices for EM sovereign bonds dropped and by mid-2013 the market-derived signal had converged toward, and has since remained close to, the credit view embedded in our ratings. This is not to say that downside risks to EM sovereign ratings are negligible. While we have two positive outlooks (Ecuador and Romania) on sovereigns in the list of 17 governments included in the JP Morgan EMBI+ index, seven ratings carry a negative outlook (Argentina, Brazil, Hungary, South Africa, Turkey, Ukraine, and Venezuela). The two EM sovereigns with a positive outlook account for only 2% of the estimated debt outstanding from all sovereigns included in the index. The debt share of the seven EM sovereigns with negative outlooks, on the other hand, accounts for a very large 61% of the total (see “Emerging Markets Sovereign Debt Report 2014: Borrowing To Remain Broadly Unchanged This Year,” Feb. 27, 2014). This important outlook imbalance does suggest a negative tendency in the likely direction of EM ratings this year. Nevertheless, in all seven cases the key risk to the rating as expressed in our corresponding outlook statements is not the possible effect of tapering. Instead, we stress what we consider to be mounting downside risks to domestic policy choices and implementation. Furthermore, apart from Argentina and Venezuela, the other five sovereigns with a negative outlook are facing key legislative or presidential elections in 2014. These are, in our view, further reducing visibility about policy choices and, at least temporarily, raising the risks of imprudent policymaking further.

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Policy Risks, Not Tapering, Are Key To Emerging Market Sovereign Ratings

This assessment focusing on domestic policymaking is not in contradiction with the fact that six outlooks on the ratings of the 10 most vulnerable sovereigns listed in table 1 have a negative outlook (Ukraine, Ghana, Turkey, Bulgaria, Morocco, and South Africa). In contrast, among the 10 least vulnerable sovereigns, only one (Brazil) has a negative outlook. None of the sovereigns in either set have a positive outlook. We think vulnerability and suboptimal policy choices can reinforce each other. Inadequate policies, such as running unsustainably expansionary macro policies, will before long lead to increased vulnerability to external shocks. At the same time, once a degree of vulnerability has built up, the room for policy mistakes will have shrunk and policy uncertainties will weigh more heavily on our ratings. In times of growing uncertainty about external liquidity provisions, prudent economic policies become more important than ever to protect sovereign creditworthiness.
Chart 2

Notes
Standard & Poor's rating outlooks are intended to indicate our view of the potential direction of a long-term credit rating, typically over six months to two years for investment-grade ratings ('BBB-' and higher) and six months to one year for speculative-grade ratings ('BB+' and lower). A positive or negative outlook is intended to designate at least a one-in-three likelihood of a rating change in the indicated direction. Standard & Poor's Ratings Services has found that its outlooks on sovereign ratings have been useful indicators of future rating actions. Since we began assigning outlooks to our ratings in 1989, we have never lowered a sovereign rating with a positive outlook. On the other hand,

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Policy Risks, Not Tapering, Are Key To Emerging Market Sovereign Ratings

we have raised 173 out of 242 sovereign ratings with positive outlooks. Similarly, we have raised only one sovereign rating with a negative outlook, and we have lowered 181 out of 317 sovereign ratings with negative outlooks. See: “Outlooks: The Sovereign Credit Weathervane, Year-End 2013 Update,” Feb. 4, 2014

Under Standard & Poor's policies, only a Rating Committee can determine a Credit Rating Action (including a Credit Rating change, affirmation or withdrawal, Rating Outlook change, or CreditWatch action). This commentary and its subject matter have not been the subject of Rating Committee action and should not be interpreted as a change to, or affirmation of, a Credit Rating or Rating Outlook.

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