Soaring inflation and slowing growth have hit the outlook for emerging sovereign credit ratings, and investors are bracing for a series of downgrades which could dent confidence in emerging markets. Improving local finances and domestic growth helped trigger a string of sovereign upgrades in emerging markets in recent years, with Brazil assigned the coveted investment grade by two of the three major ratings agencies in the past few months. But from here on, ratings agencies say, the outlook is likely to be more gloomy. Ratings agency Fitch says that the balance of positive to negative outlooks for emerging market sovereigns is at zero, for the first time since August 2003. This means that the next ratings move for emerging market sovereigns is as likely to be a downgrade as an upgrade. Deutsche Bank research based on data from the three major ratings agencies - Moody's, Standard and Poor's and Fitch - shows that in the last three months there were more emerging sovereign downgrades than upgrades for the first time in five years. The increased number of downgrades and negative outlooks has already fed into weaker emerging markets, analysts say. “The market has probably gone a bit ahead of the ratings agencies in some cases,” said Marc Balston, emerging debt strategist at Deutsche Bank. “When there is a cut in outlook, markets tend to price in more than one downgrade.” In South Africa, which had its outlook cut to stable by Fitch last month, credit default swaps (used to insure against restructuring or default of debt) are pricing in a downgrade of more than 2-1/2 notches, Balston said. This would take the country's rating to the threshold of investment grade. Investors rely heavily on the view of the ratings agencies when making investment decisions, with some funds only able to invest in investment grade assets - those assigned a BBB- rating by Fitch and S&P, or Baa3 by Moody's. Borrowers also worry about their ratings levels, as countries with a lower rating have to offer a higher yield on their debt to attract investment. Ahead of the onset of the global credit crunch a year ago, emerging market debt could do no wrong, with several sovereigns poised for upgrade and yield spreads of hard currency debt at record narrow levels over US Treasuries. But rising food and energy costs have hit emerging markets hard, in some cases leading to greater political instability. “In the last couple of months, emerging markets have seen problems with inflation, with budgets, there are political difficulties,” said Oliver Kastner, fixed income portfolio manager at Deka Investments in Frankfurt. “The picture is a little bit more difficult compared with two to three years ago. It's not really a one-way street, as a lot of people were thinking it was.” Ken Orchard, senior analyst for sovereign risk at Moody's, said inflation had been a direct factor behind the ratings agency's decision last month to cut its outlook to negative for Egypt and Vietnam. “Inflation is a global issue, but some countries are better able to deal with higher inflation than others,” he said. Brian Coulton, managing director of sovereign ratings at Fitch, said inflation risks prompted its ratings downgrade of Sri Lanka and its lowering of Ukraine's debt outlook. Emerging markets took longer than developed markets to react to the global credit crisis, with the local banking sector seen protected by its lack of exposure to US subprime mortgages. But ratings agencies say there is no immunity from the credit crunch. “It would be slightly delusional to say that emerging markets are a safe haven,” said Moritz Kraemer, managing director for EMEA sovereign ratings at Standard & Poor's. “When you have a squeeze in liquidity and increase in risk premium, it tends to affect those countries which have liquid securities and currencies like South Africa and Turkey. You have to see what you can unload, the most liquid instruments are in the front line.” But Brazil is not the only sovereign to buck the trend by gaining an upgrade in recent weeks. Russia, Saudi Arabia and Slovakia have also been upgraded, with the high oil price helping Russia and Saudi Arabia's debt positions and Slovakia poised to adopt the euro. Brazil is also a commodity producer, and ratings agencies as well as investors are noting greater differentiation between emerging market sovereigns than in the past. Those emerging sovereigns with better trade positions are less likely to suffer a ratings downgrade. “Generally the commodity producers are performing very well, those that import are starting to suffer,” said Moody's Orchard. “That will continue for the future.”
