Brexit has a cost, but so far it appears to be more modest than many analysts had feared.
The U.K.’s creditworthiness tumbles 3.1 points, to 85.8 on a scale of 0 to 100, in Institutional Investor’s semiannual Country Credit survey. The fall, a significant one for a major advanced economy, comes in the wake of the June referendum in which British voters stunned the political establishment and opted to take the country out of the European Union. The decline drops the U.K. two places, to 15th, in the survey.
Yet many analysts say it’s far too early to determine what the long-term impact of Brexit will be. The new prime minister, Theresa May, has only just begun consulting with political leaders inside the U.K. about what kind of future relationship the country should pursue with the EU, and she’s a long way from invoking Article 50 of the EU treaties, which will start a two-year exit process. “It all depends on the negotiations,” says François Faure, head of country risk at BNP Paribas in Paris.
Although some political commentators have warned that Brexit could ultimately lead to a breakup of the EU, sovereign risk analysts don’t seem to regard that as much of a threat for now. The average rating for Western European countries slips just 0.1 point in the latest survey and is up 0.7 point from a year earlier. Ireland rises 2.5 points since six months ago, continuing its impressive economic and financial recovery. The country’s rating now stands at 74.6, up from 49.0 five years ago when it sought a bailout from the EU and the International Monetary Fund. Belgium (+1.8), Finland (+1.0) and France (+1.0) tally notable gains in the latest six months as well, but in a sign that worries persist about the periphery, Italy and Spain fall 2.2 and 1.6 points, respectively, while Greece (–0.8) and Portugal (–0.5) also retreat.
Asked about the odds of recession in major economies over the next 12 months, survey respondents put the U.K. at the top of the list, with a 55.5 probability of a downturn, followed by the euro area (30.8 percent) and the U.S. (19.3 percent). They see a 16.9 percent risk of a global recession.
Overall the survey paints a stable picture. The average global creditworthiness rating stands at 44.2, down 0.5 point from March but up 0.1 point from a year ago. That continues the pattern of the past four years, which has seen the global average hover in a very narrow range even as certain countries — such as Argentina on the upside or Brazil and Venezuela on the downside — make significant moves.
Analysts see plenty of risks on the horizon. Global growth forecasts “are constantly being revised downward,” says BNP Paribas’s Faure. Economists fret that the U.S. is not growing fast enough to pull many others along, that China’s glory days of double-digit growth rates are long gone and that the EU remains vulnerable to a relapse.
Those developments are weighing on the credit quality of many emerging-markets economies. In the first half of 2016, Standard & Poor’s downgraded 16 sovereign borrowers, Fitch Ratings trimmed 14 and Moody’s Investors Service lowered 24. Nearly a third of all emerging-markets issuers are at risk of being downgraded, according to S&P Global Ratings.
Yet money has been pouring into stock and bond markets across the EM world this year. Net inflows to emerging-markets bond funds reached a record high of $4.9 billion in the week ended July 20, reports Bank of America Corp. According to the Institute of International Finance in Washington, global bond funds raised their EM allocation to 10.6 percent in August from 9.8 percent in February. A July paper from BlackRock urged investors to join “the great migration” to EM investments.
How to explain this seeming paradox of deteriorating credit quality and rising investment? Many investors “are clearly chasing yield,” says Karen Territt, head of country credit at AIB Bank in Dublin. In short, it’s better to take a chance on Ecuador than earn nothing in Japan or Switzerland.
Which is just what many investors did. The country, which has defaulted eight times since 1832, went to the market in July to sell $1 billion of five-year notes at a yield of 10.75 percent. Investors snapped up the issue.
Faure sounds a note of caution about the EM trend. “There are many more downgrades than upgrades,” he says. “The risk premiums may not be enough to compensate for the economic risks.”
Argentina is the EM star of the latest survey. Its creditworthiness rate shoots up 7.4 points in the past six months, and has gained 11.0 points in the past 12 months, because of the investor-friendly stance of the administration of President Mauricio Macri. But politics have been decidedly troublesome in Malaysia (–2.3), Turkey (–1.6 points) and Venezuela (–3.1).
One year after China’s equity market meltdown and unexpected currency depreciation, a Goldman Sachs analysis found that mutual funds were underweight China by more than 3 percentage points vis-à-vis global benchmarks, the biggest underweighting in a decade. Respondents judge the country’s creditworthiness to be virtually unchanged, though. Its rating dips a negligible 0.1 point, to 75.9, good for 27th place in the ranking, just ahead of a fast-climbing Ireland.
The consensus seems to be that the mainland economy is not going to crater, but Chinese leaders are struggling to turn their exporting powerhouse into a consumption-led economy. Meanwhile, some other Asian countries that are eating China’s lunch as low-cost manufacturing centers post gains, led by Vietnam (+3.8) and Bangladesh (+2.4).
China isn’t the only source of uncertainty. The U.S. presents two big question marks. One is the November presidential election. Foreigners, not to say many Americans, are bewildered by the phenomenon of Donald Trump’s campaign, and worried as well. “If Trump gets in, who knows what will happen,” says Paul Papadopoulos, managing director of Politicon Consultants, a sovereign risk consultancy in Athens.
The other big U.S. unknown is Federal Reserve policy. The central bank’s march toward higher interest rates got sidetracked after an initial 25-basis-point hike in December, but chair Janet Yellen and her deputy, Stanley Fischer, have said the Fed is near its goal of full employment and stable inflation, indicating that additional rate increases are in the cards. A hike could produce a stronger dollar, which “would have a significant impact on a number of countries,” AIB’s Territt says.
When respondents are asked which countries are most likely to have a higher credit rating in six months, Argentina tops the list, with 65.5 percent expecting its rating to rise, while 50.0 percent say Cuba, 60.0 percent cite Iran, and 29.4 percent say India. By contrast, 67.6 percent predict the U.K. will present a greater credit risk in six months, compared with 87.5 percent for Venezuela, 75.8 percent for Turkey, 50.0 percent for Brazil and 45.9 percent for China.
Richard Jerram, chief economist at Bank of Singapore, suggests concerns about emerging markets may be overblown. “If anything, the signs of downside risk across the emerging-market countries have probably diminished,” he says. “Commodity prices have stabilized, so the stress on commodity exporters should be less in three to six months. And the growth prospects for some of the big emerging-market countries have also stabilized.”
The problem, he says, is that “it’s hard to see much change in the developed world.”
