The outlook for sovereign ratings in 2023 is challenging, reflecting the effects of Russia’s protracted war in Ukraine, high inflation and monetary tightening.
A sharp economic slowdown, challenging fiscal dynamics, inflation and rising official rates will underpin divergence of sovereign ratings next year.
More sovereign borrowers evaluated by Scope Ratings have faced downward than upward rating actions since the escalation of Russia’s war in Ukraine in February.
The overall sovereign outlook for 2023 is negative, indicating a higher likelihood of ratings downgrades next year than ratings upgrades. More than 20% of Scope Ratings’ publicly rated sovereigns are currently on ‘negative outlook’ – indicating a minimum one-in-three probability for downgrade, compared with 11% on ‘positive outlook’.
The world is entering a period where the ‘new normal’ is one of more volatile economic growth. Global output will slow next year to 2.6% – below its potential rate of 2.9% – down from an estimated 3.3% in 2022.
Scope Ratings’ 2023 global projections assume near-stagnation of the euro area (0.7%), slow growth in the US (1.1%), a contraction in the UK (minus 0.6%) and below potential growth of 4.3% for China. There are downside and upside risks for global projections.
Technical recessions are probable in many economies in 2022-23, although they will prove shallow in most such cases. Risks partly reflect potential energy shortages during the European winters in 2022/23 and 2023/24 as Russia reduces gas supplies. Meanwhile, China’s improved economic performance with the gradual relaxation of its zero Covid policy will support growth.
The baseline economic scenario assumes no severe global or euro area recession nor a global financial crisis next year although the possibility of continued interest rate rises and an inverted yield curve represent risks for 2023 and beyond – threatening an early end of the post-Covid global economic recovery.
Like the supply-side inflationary crises of the 1970s, inflation will run higher for longer even as it recedes from peaks. Amid the belated central bank response to the surge in inflation, prices have been rising for sufficiently long that they have become partially self-sustaining. Broadening price pressures risk resulting in further delays in the decline of inflation rates towards central bank objectives.
For major economies, annual average inflation for 2023 is coming close to or falling below central banks’ inflation objectives in Switzerland (2.2%), Japan (1.4%) and China (2.3%). Euro area inflation should average a still-high 6.1% next year before 2.4% in 2024, after 8.5% this year.
Rapid price rises lower the real value of the stock of existing debt – which supports sovereign credit ratings – but the benefit erodes with time as interest payments rise and central banks’ room for manoeuvre is curtailed.
Many central banks – most importantly, the Federal Reserve – may have reached ‘peak hawkishness’. The speed of rate rises is seen slowing moving ahead after front-loaded hikes from Covid-19 record lows.
Still, there appears to be limited scope for easing monetary policy next year for most central banks even if terminal rates are reached in the first half of 2023. Central banks will be compelled by markets to retain tight monetary stances as inflation stays high. Otherwise, they risk currency devaluation or rises of bond yields, which might endanger price- or financial-stability objectives, if not both.
Any further upside surprises in inflation might lead to more drawn-out rate rise cycles than under baseline assumptions – particularly if the Federal Reserve and/or European Central Bank were resigned to more prolonged phases of tightening rates.
The combination of monetary policy constraints and challenging fiscal dynamics place pressure on sovereign ratings – for emerging as well as advanced economies.
Slow economic growth and higher borrowing costs make it harder for sovereigns to return to pre-pandemic debt levels, while interest payments are due to rise after years of decline. However, a proposed new EU fiscal architecture should help consolidation of some member states.
Credit risks are most elevated for emerging economies with inadequate foreign currency reserves and significant financing requirements next year.
However, if the interest cycle peaks by 2023, this could provide a degree of much-needed relief for developing countries confronted with capital outflows and exchange-rate depreciation. This could support ratings next year for some emerging-market sovereigns during an otherwise challenging year ahead.
Dennis Shen is Director of Sovereign and Public Sector Ratings at Scope Ratings.