Hotspots for sovereign credit risk: Fitch report

What Greece needs is a thunderbolt from Zeus, not a bailout from Frankfurt.  Source:
What Greece needs is a thunderbolt from Zeus, not a bailout from Frankfurt. Source:


Like a thunderbolt from Zeus, financial markets are struck by the perils of a sovereign debt default.  In financial crises, markets and policy makers fight the last war.  In the Great Depression, countries made the mistake of balancing budgets instead of offering a Keynesian stimulus; in today’s crisis, they are spending like crazy by issuing debt (like crazy).  Sovereign balance sheets are in a woeful state. 

Fitch Ratings explains what is going on in Greece, what countries like the US must do to keep their AAA ratings, and what Latin America’s outlook is.  Fitch delivered its annual Sovereign Hot Spots seminar, which I used to run in New York.  Read the summary below and access the powerpoint presentations and the video of the conference to bone up on sovereign credit risk, which preoccupies global markets these days, as it well should.

Fitch belatedly downgraded Mexico, which lacks a dynamic economy and resists reforms to the oil sector and taxes that could improve creditworthiness.  These factors have long been at play in Mexico.  In addition, Fitch highlights Mexico’s dependence on the US market, as opposed to peer countries such as Brazil that export increasingly to China.  This factor is discussed as a weakness for Mexico these days, whereas for years it was alluded to as a strength.  (Who better to export to than the US, went the argument.) On the other hand, Brazil’s ratings are being held down because of its woeful fiscal accounts, in spite of its strong external balance sheet (which Mexico lacks).  I won’t quibble with the importance of public finances to sovereign creditworthiness; I will just point out that time and time again, analysts have let sovereigns off the hook that had strong public finances and weak external finances (e.g. Asia crisis countries and some countries today in Eastern Europe).  This has caused lots of Wall Street analysts to get it badly wrong in the past. (Did they call the 1998 Asia crisis or the problems Eastern Europe is currently having? No.)  Brazil has the reverse profile — strong fx reserves and weakening (though not fragile) public finances.  By penalizing Brazil too much for Lula’s loosening of the fiscal purse, analysts may miss the boat on Brazil (or may already have).

Finally, it might not be enough to say, as Fitch does, that AAA countries remain AAA because of their financial flexibility, but must find an “exit strategy” from all the rising debt over the medium term, as the US and others sure need to do.  This is ratings stickiness again, folks.  Rating agencies have a difficult time adjusting their ratings because it suggests their analysts might be wrong.  Maybe some AAA countries should have already lost their stellar ratings.  Economists are always good at finding powerful intellectual arguments to explain their current positions — remember Alan Greenspan before Congress on low interest rates.  Have a read of the Fitch summary below — it is chock full of good sovereign credit analysis. 

From Fitch:

“Sovereign Hotspots: Diverging Trends” began Tuesday, 2 March, with a conference in New York discussing the divergence of fiscal prospects between high-grade advanced economies and emerging markets. The conference focused on recent credit pressures and bond market volatility in Europe, as well as credit trends in Latin America. Additionally, Fitch distributed a press release commenting on Chile’s sovereign ratings following the country’s catastrophic earthquake and aftershocks. The event concluded with an analyst panel providing more details on specific countries in Latin America and an investor panel debating recent developments and prospects for the global economy and emerging markets in particular.

Below are some highlights of the conference, followed by links to each presentation. If you would like to hear a replay of the event, please click here. For information on next week’s events in London, Frankfurt and Paris, which will include presentations on Emerging Europe, the Middle East and North Africa, please click on or contact Katie Donnelly at 1-212-908-0828.
New York Conference Highlights:
High Grade and Euro Area Sovereign Risk      
Diverging Trends – ‘Advanced’ and ‘Emerging Market’ Sovereigns

Emerging markets (EM) have weathered the global economic and financial crisis relatively well due to their generally strong balance sheets.  Foreign exchange reserves for EM excluding China have shown a strong recovery since February 2009 and are now near pre-crisis levels.  In addition, lower public debt ratios, combined with less sensitive tax bases have led to more solid fiscal positions in EM relative to developed markets (DM).  Over the next two years, Fitch foresees a continued divergence in public debt paths, with government debt/GDP declining in EM and increasing in DM.
High Grade Sovereigns and the Meaning of ‘AAA’

Countries with high financing flexibility are better positioned to withstand economic/financial shocks than countries that are less flexible in terms of funding, with financing flexibility largely depending on the size of the economy (i.e., the amount of real & financial assets to absorb sovereign liabilities) and the depth of demand for a country’s currency (reserve currency status implies strong underlying demand for assets in that currency).  However, while high-grade sovereigns have the capacity to maintain solvency and the cost of debt service is still below mid-1990s levels, Fitch views these sovereigns’ fiscal exit strategies as key to their ratings outlook, with the urgency among the larger AAA-rated countries being greatest for the UK, Spain and France. 
Greece and the Euro Area

With Greece’s greatest problem being its non-credible statistics and poor track-record, Greece needs to bolster credibility and investor confidence in the long-term solvency of the state in order to gain market access at an ‘affordable’ price. At present, the EU is playing a game of “constructive ambiguity” aimed at stabilizing markets and reducing liquidity risk while putting additional pressure on Greece to restore fiscal discipline.  However, it should be noted that at this stage it is not clear that contagion risk is that severe, as so far spread widening has been ‘rational’, focusing on large deficit countries.
View full presentation
Latin America Overview

Although the average rating continues to be higher for Emerging Europe than for Latin America, the change in the average regional rating has been much better for the latter, with five positive rating actions taking place since July 2009.   Thus, while Latin America has been a mixed bag, with the number of negative rating actions exceeding the number of positive rating actions since the onset of the crisis, the region has generally been quite resilient to the global economic storm.  After an estimated 3% decline in GDP in 2009, Fitch anticipates overall GDP to grow by 4% in 2010, aided by supportive monetary and fiscal policies, a renewed credit cycle and stronger domestic demand (particularly in Brazil, Chile, Panama and Peru), as unemployment rates (which rose only modestly during the crisis) are declining, real wages are recovering and consumer confidence is increasing across the board.  In addition, both domestic and foreign direct investments are expected to rebound, general government debt is anticipated to stabilize and current accounts to remain resilient in 2010, with further accumulation of international reserves taking place.

Nonetheless, Latin America still faces important challenges as it copes with a sluggish global economic recovery as well as significant budgetary rigidity, which may hinder fiscal consolidation.  Additional challenges for the region include sustaining prudent policies through a sluggish recovery and avoiding election-related market uncertainty as presidential elections approach in Colombia (May 2010), Brazil (Oct 2010), Peru (Apr 2011), Guatemala (Aug 2011) and Argentina (Oct 2011).  Thus, while Latin America’s economy will rebound in 2010, the pace of the recovery will differ across countries and growth will still be below the rates observed in 2006-2007.  Since Fitch is currently not seeing a strong reform momentum throughout the region, sovereign creditworthiness trends are likely to remain stable to slightly positive.
Mexico: Explaining the Downgrade

Mexico was downgraded to ‘BBB’ with Stable Outlook in November 2009 primarily for structural reasons, including its low non-oil tax base and high oil dependence, combined with uncertain oil prospects (in fact, oil production has been declining in recent years despite an increase in capex, indicating the need for further reforms at Pemex).  In addition, the 2009 tax package, while in the right direction was insufficient, demonstrating the reluctance of political parties to come together to implement major fiscal reforms to improve tax revenues.  Other factors that led to the downgrade include a relatively modest fiscal buffer (the commodity stabilization fund is small compared with Chile’s, Russia’s and Kazakhstan’s), a limited external cushion (i.e., a weak international liquidity ratio compared with ‘BBB’ peers) and Mexico’s historical growth performance, which has been lagging that of its peers.  While Peru, Chile and Brazil have increased their trade links with China and reduced their ties with the US, Mexico still exports over 70% of its products to its North American neighbor.  As a result, the sluggish rebound of the US economy will continue to constrain Mexico’s growth in 2010.  Factors that led Fitch to change its Outlook on Mexico from Negative to Stable include the country’s well capitalized banking system and low balance of payment risk, as well as its track record of disciplined macroeconomic policies, its smooth external debt profile and its demonstrated ability to tap international markets under difficult external conditions.
Brazil: Beyond the Economic Resilience

Investor confidence towards Brazil is supported by the country’s strong external balance sheet, its robust external solvency ratios (Brazil has long been a net external creditor) and the healthy economic rebound anticipated for 2010, with the expected 5.5% growth in GDP being the strongest in Latin America and only behind India’s and China’s.  However, Fitch has not taken a positive rating action as the agency considers that Brazil’s resilience is already captured in its current ratings to a certain degree and that its stronger external balance sheet has been at a fiscal cost.  In fact, the deterioration in public finances and high government debt burden due to double-digit current spending and significant budget rigidity are dampening the country’s upward credit trajectory.  Moreover, Brazil’s domestic debt composition needs to improve further, as a large proportion of its debt is still contracted at floating rates and 2010 maturities are on the higher side when compared to those of its peers.  Finally, with 2010 being an election year, needed reforms are likely to stall until the next administration takes over.  Fitch will observe how the next administration will handle challenges such as the realization of expenditure reforms, the definition of BNDES’ role and the simplification of the tax system, as well as the management of oil sector development given recent discoveries, among other things.
View full presentation 
The presentations will be available free of charge for three months. If you have problems accessing these presentations or for more information, please email Frank Laurents at, or telephone +1 212-908-9127.

Additional information can be found on the Fitch Ratings website,

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Image: What Greece needs is a thunderbolt from Zeus, not a bailout from Frankfurt. Source:

(from a blog post of March 5, 2010.)

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