EM Sovereign Rating Model for Q4 2015

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We have produced the following Emerging Markets (EM) ratings model to assess relative sovereign risk.  An EM country’s score directly reflects its creditworthiness and underlying ability to service its external debt obligations.  Each score is determined by a weighted compilation of fifteen economic and political indicators, which include external debt/GDP, short-term debt/reserves, import cover, current account/GDP, GDP growth, and budget balance.  These scores translate into a BBH implied rating that is meant to reflect the accepted rating methodology used by the major agencies.  We find that our model is very useful in predicting rating changes by the major agencies.  The total number of Emerging Market countries covered by our model stands at 30.

EMERGING MARKETS RATINGS SUMMARY

There have been 7 EM rating actions since our last update in July.  All but 3 have been negative moves on Brazil.  S&P moved the outlook on Brazil’s BBB- rating from stable to negative in July, and then followed up with a one notch cut to sub-investment grade BB+ last month with negative outlook.  Moody’s cut Brazil’s rating a notch to Baa3 but inexplicably moved the outlook to stable, while Fitch cut Brazil one notch to BBB- but kept the negative outlook.  Elsewhere, S&P downgraded Ecuador by one notch to B with a stable outlook.

Fitch was responsible for one of the positive rating actions, moving the outlook on the Philippines’ Baa2 rating from stable to positive.  S&P provided the other, upgrading Korea one notch to AA- with a stable outlook.

So far this year, there have been 20 actions recorded; 8 were positive and 12 were negative.  However, we note that virtually all of the negative actions have been on Brazil (5), Russia (4), and Venezuela (2).  Netting out those three countries, then all but one of the EM rating actions this year have been positive.

EMERGING MARKETS RATINGS OUTLOOK

Many of the stronger EM credits (mostly in Asia) saw their scores improve or remain steady, and for the most part maintained their positions this round.  On the other hand, many of the weaker credits saw their scores deteriorate, underscoring what we view as growing divergences within EM.  Most of those seeing deterioration are commodity exporters, as the ongoing drop in prices is weighing on fundamentals.  Our model suggests some noteworthy misalignments remain in place across EM.

In Latin America, most scores worsened this round.  This was largely due to the commodity-centric nature of the region.
Brazil’s implied rating fell two notches to BB-/Ba3/BB-, and its actual BB+/Baa3/BBB- ratings are subject to continued downgrade risk.  Further deterioration in the fiscal numbers and/or another rumored cut in the primary surplus target for this year could be the trigger for another round of downgrades.  Before S&P moved it to BB+ in September, Brazil had been rated investment grade by all three agencies since 2009.

Mexico and Colombia both saw their scores worsen, but only the latter was by enough to change its implied rating a notch to BBB/Baa2/BBB.  Colombia no longer has any upgrade potential, and appears correctly rated at BBB/Baa2/BBB.  With its implied rating steady at BBB+/Baa1/BBB+, Mexico appears correctly rated by S&P and Fitch at BBB+.  However, Moody’s seems to have been premature in upgrading it to A3 back in February 2014.

Peru saw a modest improvement in its score, but not by enough to change the implied rating of BBB+/Baa1/BBB+.  Moody’s seems to have been premature in upgrading it to A3 back in July 2014, while S&P and Fitch are on target at BBB+.  Ecuador also saw a slight improvement in its score, but its implied rating was steady at B+/B1/B+.
Chile’s score worsened, but its implied rating of A/A2/A remained steady.  However, there are still significant downgrade risks for Chile, which we think is rated too highly at AA-/Aa3/A+.

Scores and implied ratings for Panama, Venezuela, and Uruguay deteriorated.  Panama’s implied rating fell a notch to BBB/Baa2/BBB, erasing any upgrade potential.  Venezuela’s implied rating fell two notches to CCC-/Caa3/CCC-, highlighting downgrade risks to the CCC ratings from both S&P and Fitch.  Lastly, Uruguay’s implied rating fell a notch to BBB-/Baa3/BBB-, and highlights downgrade risk from S&P (BBB) and Moody’s (Baa2).

In Asia, India continues to see reduced downgrade risk.  Its score worsened slightly, but remains firmly in BBB-/Baa3/BBB- territory.  This is right at India’s actual ratings.  If the new government can deliver deeper fiscal reforms, we believe that it could move into BBB/Baa2/BBB territory over the next year or so.

Malaysia’s score worsened and moved deeper into BBB+/Baa1/BBB+ territory.  This suggests ongoing downgrade risks to actual ratings of A-/A3/A-.  Indeed, we disagreed with Fitch’s decision this year to move the outlook on its A- rating from negative to stable.

Thailand’s implied rating improved a notch to BBB+/Baa1/BBB+, and no longer faces significant downgrade risks to actual ratings of BBB+/Baa1/BBB+.  Political uncertainty is likely to continue weighing on the economy, however, and so we do not think Thailand is fully out of the woods yet.

Singapore, Hong Kong, and Taiwan all saw steady scores, while China’s worsened marginally.  Indonesia’s score worsened modestly.  All of these countries appear to be more or less correctly rated.  Korea’s implied rating improved one notch to AA/Aa2/AA, suggesting upgrade potential for actual ratings of AA-/Aa3/AA-.  The Philippines’ implied rating also improved a notch to A/A2/A and still appears to be vastly underrated with actual ratings of BBB/Baa2/BBB-.

In EMEA, Russia’s score worsened but its implied rating was steady at BB-/Ba3/BB-.  We thus see downgrade risks to actual ratings of BB+/Ba1/BBB- that should push it deeper into sub-investment grade territory.   Fitch’s investment grade BBB- rating is clearly too high.  Low oil prices and ongoing sanctions continue to hurt the economy.

Turkey’s score worsened but its implied rating was steady at BB/Ba2/BB.  It continues to face strong downgrade risks to its BB+/Baa3/BBB- ratings.  The investment grade ratings given by Moody’s and Fitch seem premature now, but even S&P’s BB+ rating is subject to downgrade risk.

South Africa’s score improved slightly but its implied rating was steady at BB/Ba2/BB.  We believe actual ratings of BBB-/Baa2/BBB are still subject to strong downgrade risk, and loss of investment grade is a real possibility in the coming year as the fiscal outlook deteriorates.

Hungary’s implied rating was steady at BB/Ba2/BB.  It remains right on the cusp of moving into BB+/Ba1/BB+ territory and so we see only slight downgrade risk to Hungary.  The Czech Republic saw its score improved but its implied rating was steady at A+/A1/A+, and appears correctly rated for now.

Poland’s score worsened and its implied rating fell a notch to BBB/Baa2/BBB.  While our model still suggests downgrade risks to actual ratings of A-/A2/A-, we feel that the rating agencies are unlikely to move until the October elections are completed and the new government signals its policy intentions.

UAE’s implied rating fell a notch to A-/A3/A-, and faces even stronger downgrade risk to its Aa2 rating from Moody’s.  Elsewhere, Qatar’s score worsened too.  While its implied rating of AA-/Aa3/AA- was steady, the nation is right on the cusp of falling into A+/A1/A+ territory.  Israel’s implied rating moved up one notch to AA-/Aa3/AA-, but is barely in this higher category.  As such, upgrades to actual ratings of A+/A1/A are unlikely to be imminent.

CONCLUSIONS

Downgrades concentrated in Brazil, Russia, and Venezuela so far this year suggests that there are still some idiosyncratic negative risks within EM.  Lower commodity prices are also likely to continue having a negative impact on the commodity exporting countries, while benefiting the importing countries.  As such, we continue to warn investors that EM fundamentals will still diverge across countries.  The investment climate remains challenging, with fundamentals remaining the most important factor for global investors to consider.