Brazil’s downgrade to junk status last week by Standard & Poor’s, the credit rating agency, is not only a severe blow to investors, policymakers and citizens in Brazil, but it also opens the prospect of a wave of further downgrades across emerging markets, as credit spreads widen and investors become increasingly gloomy about a global economic slowdown.
“We are entering a different phase,” says Bhanu Baweja, emerging market strategist at UBS in London. “For the longest time we have thought that even if EM growth is weak, EM balance sheets, or their ability to service their debts, have been broadly OK. But now things are getting more serious.”
Analysts say the three main global rating agencies — S&P, Moody’s and Fitch Ratings — are increasingly basing their ratings decisions on broad macroeconomic criteria rather than on a country’s narrow ability to service its foreign currency sovereign debts, traditionally the agencies’ main focus.
Brazil, indeed, has relatively little foreign currency sovereign debt.
However, it does have a lot of government debt denominated in local currency, as well as a lot of foreign currency bonds issued by companies —Petrobras, the crisis-stricken oil company, being a prime example.
Increasingly, the ability to service those debts is being seen as a function of more than the size of a country’s foreign exchange reserves or its budget balance, although both are still important.
“There is such a wide variety of metrics and [gauging ability to pay] has become so complex that it is very hard for the agencies to allocate a weight to specific factors in a matrix,” says Simon Quijano-Evans, EM strategist at Commerzbank in London.
Rating agencies, he says, are looking at structural issues such as the business environment and levels of corruption.
In particular, he says, they are concerned about the path of structural reform and whether, in the case of commodity-dependent emerging markets, there has been progress in diversifying the economy into other areas.
“In places like Brazil, Russia, South Africa and now China, things have been going on a downward spiral,” he says. “Policymakers have had time to get on the reform path and it hasn’t happened.”
Even if investors think a sovereign’s ability to service its foreign debts is not at risk, a downgrade from investment grade to junk matters because it pushes up borrowing costs across an economy. On financial markets, it may result in forced selling of bonds, as many asset managers can only buy investment grade-rated assets.
