Greece: Strong Growth, Reinforced ECB Support Bolster Ratings Outlook Despite High Inflation

Greece (BB+/Stable) has staged a strong recovery from the Covid-19 crisis. Last month, we revised up our 2022 growth forecast to 4.9% from an 4.6% estimate at the start of the year – the economy grew 8.3% last year – though we revised down our 2023 forecast to 2.1% from 2.5%.

The robust rebound in tourism in Europe this summer, which led to better-than-expected Q2 growth in Spain and Italy, might also ensure Greece’s Q2 GDP comes in higher than a 0.25% quarter-on-quarter increase we assume. Conversely, any correction of recent significant inventory build-up would present downside risk. Greece is due to release Q2 GDP figures on 7 September.

Political stability under Prime Minister Kyriakos Mitsotakis’ New Democracy and strong monetary and fiscal assistance are furthermore underpinning the economy.

Figure 1. Better-than-anticipated debt trajectory

Greece general government debt, % GDP

Source: IMF World Economic Outlook, Scope Ratings forecasts.

Non-investment Grade Rating Status No Longer Rules Out Eurosystem Support

ECB support has stabilised Greek debt markets. Together with the first line of defence of the central bank’s Pandemic Emergency Purchase Programme (PEPP) reinvestments, the new Transmission Protection Instrument (TPI) helps Greek creditworthiness in three important ways.

First, there is Greece’s very inclusion in the TPI despite non-investment grade credit ratings. Secondly, there is programme capacity for unlimited purchasing of Greek bonds, even as purchases are sterilised so as to avoid conflict with forward guidance for tighter monetary policy. Thirdly, the ECB will purchase bonds considering euro area countries’ specific circumstances rather than be bound by the capital key.

Furthermore, eligibility criteria requiring fiscal and macroeconomic sustainability ought to, to a degree, incentivise responsible policy setting – especially crucial with the end of the Greek Enhanced Surveillance programme this month and associated post-programme policy uncertainty.

However, the vague activation criteria for TPI – leaving significant discretion to the ECB Governing Council about which bonds are bought and when – leave unclear how the ECB would define what an “unwarranted” rise of yields is, which could constrain use and effectiveness of the facility. In addition, the lack of definition leaves the programme vulnerable to future legal challenges.

TPI Presents Potentially Durable Monetary Backstop for Greek Bonds

In our September 2021 rating announcement, we referred to the reinforcement of Eurosystem support for Greece after the Covid-19 crisis as crucial for any further ratings upside from a BB+ credit rating. Recent Eurosystem announcements such as i) reinforcement of PEPP reinvestment; ii) extension of a Greek waiver under the ECB repo framework to around end-2024; and, crucially, iii) announcement of the TPI are steps in the right direction.

More generally, central bank action since 2020 has marked a sharp pivot from Greece’s pre-pandemic exclusion from ECB monetary operations due to speculative grade credit ratings. Specifically, the TPI presents potentially provision of a permanent programme backing Greek markets, which we stated as crucial for the future ratings trajectory during our September 2021 ratings upgrade.

The TPI provides a permanent ECB purchase facility for Greece that does not include elevated activation hurdle(s) of Outright Monetary Transactions. Such a durable Eurosystem backstop for periphery markets is especially relevant as there remains meaningful risk of a regional debt crisis as the ECB raises rates with possibility of a winter energy crisis.

Debt-to-GDP Could Decline Below 150% by 2027

Greece’s 10-year government bond yields rose to 4.0% at time of writing – more than double an estimated 1.5% weighted average cost of debt for 2022.

We expect a headline budget deficit of only 3.5% of GDP and primary deficit of 0.75% this year, better than government objectives of 4.4% and 2% respectively, before a balanced primary account is reached over 2023-27, with a headline deficit of around 2.7% of GDP in those years.

The aggregate debt ratio is seen declining much faster than previously expected, supported by elevated inflation of 12.1% YoY in June, above-potential real GDP growth and fiscal consolidation. Debt-to-GDP will fall from a 206.3% peak in 2020 to 171.3% by end-2022, dropping below the 180.7% recorded pre-crisis in 2019, before potentially further moderating to 146.5% by 2027 (Figure 1).

For a look at all of today’s economic events, check out our economic calendar.

Dennis Shen is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH. Alessandra Poli, Associate Analyst at Scope Ratings, contributed to writing this commentary.

Mid-Year Sovereign Outlook: Slowdown, Inflation, Rising Rates Create Divergent Rating Risks

Download Scope’s 2022 Sovereign Mid-Year Outlook.

Explainer video: Scope Ratings introduces the 2022 Mid-Year Global Economic Outlook

Figure 1. Scope’s global economic outlook, summary, as of 18 July 2022

*Changes compared with December 2021’s 2022 Sovereign Outlook forecasts. Negative growth rates presented in parentheses. Source: Scope Ratings forecasts, regional and national statistical offices, IMF.

We are forecasting weaker global growth for 2022 but our forecast remains consistent with an economic baseline entering this year, of above-potential for the calendar year but uneven economic growth. While there is significant likelihood of technical recession over 2022-23 in certain countries, such recessions are likely to be mostly shallow with annual growth rates probably remaining moderately positive.

Annual growth for 2023 will display further slowdown or normalisation across many economies, although China is a crucial exception here, as high prices restrict purchasing power while post-Covid rebounds fade in force.

One legacy of the Covid-19 crisis has been a government debt overhang. In this respect, high inflation can be credit positive near term for sovereign credit ratings via the trimming of debt ratios. However, inflation derails real economic growth and, with time, increasingly constrains central banks’ room for manoeuvre should price-stability mandates be compromised.

As such, if persistent inflation restricts lender-of-last-resort functions of a central bank to intervene during market failures, current conditions lean towards being negative for sovereign ratings.

Stagflationary conditions present divergent positive and negative effects for sovereign risk

Stagflationary conditions hold divergent positive and negative effects for sovereign credit ratings, with more borrowers seeing downside rating actions than upside actions since the escalation of the Russia-Ukraine war. Since 24 February 2022, Scope Ratings has revised three countries’ ratings lower: Russia (WD), Ukraine (CCC/Negative), Turkey (B-/Negative), changed three rating Outlooks to Negative: Japan (A), China (A+), Czech Republic (AA) and revised only three countries’ ratings/Outlooks to an upside: Croatia (BBB+/Stable), Portugal (BBB+/Positive), Cyprus (BBB-/Positive). Russia has defaulted while Ukraine contemplates debt restructuring.

Further significant market instability is likely, although global financial crisis not anticipated

Impediments to global growth include elevated energy and commodity prices, weakened economic sentiment and a slowdown of economic trading partners. Inflation remains elevated even with tighter monetary policies. Even when inflation peaks and starts to moderate over the coming quarters, significant market instability and correction are likely, although we do not anticipate a global financial crisis.

Economic slowdown and the gradual easing of elevated inflation will cause front-loaded central bank tightening to decelerate, halt or even reverse in many cases by 2023. Currency depreciation is seen forcing tightening by more dovish central banks such as the ECB or they risk importing further inflation.

We have cut GDP growth forecasts for this year (Figure 1), to 2.8% for the euro area, 3.5% for the UK, 1.7% for the US, 3.6% for China, and 1.8% for Japan. Next year, continued moderation of annual rates of growth is seen for the euro area: 1.8%, UK: 1.0%, Japan: 1.7%; the US sees 2% growth next year, with China recovering to 5.1%. The Russian economy is expected to contract by more than 10% this year. We marked up Turkish growth amid credit-fuelled recovery.

A central risk to Scope’s economic baseline scenario is further tightening of financial conditions

A central risk to our mid-year global economic baseline is further significant tightening of financial conditions in the form of higher long-term bond yields, a further correction in global equity markets and/or appreciation of the US dollar. This could be the result of current very high inflation further surprising to the upside and/or behind-the-curve central banks tightening faster than currently communicated.

Faster policy tightening cuts the risk of inflation becoming more deeply engrained but also raises risk of policy mistakes exacerbating financial instability. Alongside significant Federal Reserve and Bank of England hikes and quantitative tightening, we expect the ECB to start raising rates for an initial time this cycle later this week while introducing near term a novel ‘anti-fragmentation’ programme against rises of periphery spreads.

Register for Scope’s webinar presentation: Global economy in slowdown: inflation, war, Europe’s energy crisis darken the outlook (Tuesday, 26 July 2022, 15:30 CEST)

For a look at all of today’s economic events, check out our economic calendar.

Dennis Shen is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH and lead author of the rating agency’s Sovereign Outlook. Giacomo Barisone, Managing Director of Sovereign and Public Sector ratings at Scope Ratings, contributed to writing this commentary.

Ukraine: War-torn Economy to Shrink 40% in 2022; Daunting Financing, Reconstruction Task Ahead

Uncertainty around the state of the Ukrainian economy is huge, but we assume output will partially rebound by around a fifth in 2023 as activity recovers in regions where the conflict eases. Output next year would potentially remain 30% below 2021 levels, speaking to the scale of the reconstruction task at hand.

The severe decline of output places enormous strain on debt sustainability. We see debt-to-GDP gradually climbing to above 90% by 2027, from 48.9% end-2021. However, Ukraine’s debt outlook would be far bleaker were it not for government measures and significant international financial assistance.

Compared with the sharp rise in debt during the 2014-15 Crimea crisis, the government has this time supported debt dynamics through administrative controls while the National Bank of Ukraine (NBU) has fixed the exchange rate. The move has limited hryvnia depreciation to 5% against the euro since November 2021 although unofficial rates are circa 20% below official ones at this stage. As the NBU has sold foreign currency, reserves have declined, however, to USD 24.0bn in April from USD 29.4bn in December 2021.

Official-sector support has been vital for bridging Ukraine’s funding gap

Ukraine’s funding gap is in the range of USD 5-7bn a month. Official-sector support has been vital for bridging this gulf. The US has finalised military and humanitarian aid of USD 40bn. The EU has proposed bond issuance guaranteed by member states to assist Ukraine with EUR 9bn of emergency loans alongside a ‘RebuildUkraine’ programme of non-repayable grants and loans modelled on its Covid-19 recovery fund. The IMF’s and World Bank’s establishment of multi-donor administered accounts have packaged grants and loans from varying international multilateral and bilateral benefactors.

Nevertheless, Ukraine faces the daunting cost of rebuilding the economy, which the government estimates at USD 560bn for repairing destroyed infrastructure and physical capital. The government’s budget deficit will rise to 15% of GDP this year from 4% in 2021. Over 2023-25, the deficit will remain above 10% of GDP a year.

Longer run, US and European policy makers have contemplated co-opting around USD 300bn of frozen Russian reserves and even the liquidation of seized Russian oligarch assets to pay or serve as collateral for reconstruction funding. One precedent is the US seizure of Afghan reserves after 9/11. Such action would be helpful for Ukraine’s credit ratings although there are valid questions over whether this undermines due process and whether reserves might serve better as bargaining chips in talks to end the conflict.

Domestic funding is more limited, even though Kyiv has sold more than USD 2bn of war bonds since March – mostly in hryvnia, with support from the temporary monetary financing activities of the NBU.

Debt relief is a complementary option to addressing liquidity and debt-sustainability risk

Debt relief is a complementary option. The IMF regards Ukrainian debt as sustainable under current projections. However, this can change. After Russia’s invasion of Ukraine in 2014, Ukrainian debt rose to 99% of GDP by February 2015 – up from 40% in January in 2014 – prior to a restructuring of debt late in 2015. Debt levels are seen reapproaching such levels.

Ukraine’s Finance Ministry has dismissed external debt restructuring at this stage, seeking foreign market participants to re-engage and support funding of the war and recovery via initiatives such as the “peace bond”.

Given international goodwill toward Ukraine amid calls for the equivalent of a new Marshall Plan, official-sector debt relief is expected, such as a potential suspension of debt service nearer term and/or possible longer-run debt cancellation. Whether foreign bondholders support debt relief hinges on how long the war endures, its ultimate cost and the degree to which international multilateral and bilateral assistance alone can prevent Ukraine’s debt burden from becoming an impediment to sustainable recovery.

We downgraded the sovereign credit rating of Ukraine to CCC early March, from B/Negative before the full invasion, and placed ratings under review for a developing outcome.

For a look at all of today’s economic events, check out our economic calendar.

Dennis Shen is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH.

Turkey: Deterioration of Credit Profile, Unsustainable Governance Raise Likelihood of Deeper Crisis

The outcome of elections due in 2023 will be decisive for Turkey’s credit outlook.

Scope Ratings expects growth in Turkey of only 2.3% in 2022 before 2.4% in 2023, amid risk of sudden economic reversal, after 11% in 2021. Inflation, meanwhile, has risen to highs of 61.1% in March, and is seen staying elevated.

Structurally loose monetary policy, high inflation, negative net foreign-currency reserves as well as elevated and rising sovereign FX exposure increase the risks facing the long-run capacity of the government to repay debt especially during sudden future depreciations of the lira.

The risk of more severe crisis is high in view of testy market conditions and the economy’s external vulnerabilities

The risk of more severe crisis is high in an emerging-market economy with external vulnerabilities like Turkey’s given the spill-over effects on financial markets from Russia’s war in Ukraine. In addition, normalisation of monetary policy by G4 central banks amplifies capital outflow from developing countries.

Turkey’s capacity to repay sovereign debt is, furthermore, intertwined with the likelihood of domestic instability during a forthcoming phase surrounding presidential and legislative elections scheduled mid-2023.

The deterioration of the country’s credit profile underscored our decision of 11 March to downgrade Turkey’s long-term foreign-currency ratings to B- and maintain a Negative Outlook.

The resilience of the domestic banking system is critical to assessing how deep crisis might run

The resilience of the domestic banking system is critical to assessing how deep the economic crisis might run. The sovereign-banking nexus has tightened – with the government dependent at this stage on domestic banks for funding in domestic and in foreign currency.

The banks have been one of the country’s core credit strengths and so long as the banks stand, the sovereign stands. Nevertheless, economic mismanagement and associated credit risks will likely weaken Turkish bank balance sheets, and thus raise the possibility of greater vulnerabilities over the medium run.

A core vulnerability is the value of lira

A core vulnerability is the value of the lira. Periods of significant depreciation impair bank capital adequacy, forcing the government’s recent recapitalisation of several state-owned banks, not to mention raising inflation and compromising sovereign debt sustainability due to FX denomination of the state debt. The government has sought to stabilise the value of lira with policies that artificially ease sell-off pressure. They include protecting lira deposits against FX loss and requiring exchange of 25% of exporter FX revenue to lira.

Unfortunately, such policies are unlikely over the long run to prove sustainable or prevent another severe currency crisis. Instead, the lira savings scheme sacrifices a crucial credit strength of Turkey, namely, the health of the sovereign balance sheet. After TRY 10bn of payments in one week of maturing accounts – equivalent to 0.1% of GDP – the programme was recently expanded to include foreign companies and individuals, with payments expected to increase with time.

We assume general government deficits will average 5.9% of GDP during 2022-26 – more elevated than before the Covid-19 crisis – with government debt increasing to 65.0% of GDP by 2026 from 27.4% at its 2015 low, driven by currency depreciation of an assumed 24% a year over 2022-26, creating debt-servicing stress for a 67% share of central-government debt in foreign currency.

Central bank reserves adjusted for swaps represents a net liability of USD 58.7bn in February. The economy’s current account weakening this year to a deficit of around 8% of GDP – due to elevated global energy and commodity prices, and reliance on wheat import from Russia and Ukraine – represents a further challenge with respect to reserves.

Scheduled 2023 elections could prove to be a make-or-break moment

The current economic trajectory is unsustainable. Scheduled 2023 elections could prove one make-or-break moment. Should President Recep Tayyip Erdoğan hold to power after 2023, economic mismanagement is likely to endure. Alternatively, were opinion polls to prove right, and Erdoğan be defeated, a resetting of the policy framework of Turkey might ensue – fundamentally altering the country’s credit outlook.

For a look at all of today’s economic events, check out our economic calendar.

Dennis Shen is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH.

 

Further Russian Conflict Escalation Could Pressure Ukraine Sovereign Credit Rating

On 28 January 2022, we published B first-time sovereign credit ratings of Ukraine, with a Negative credit Outlook – reflecting potential for escalation of conflict.

A deepening of a long-standing conflict between Russia and Ukraine is likely after Russia’s recognition of self-declared ‘republics’ in the Donbas region. Russian forces entering eastern Ukraine places them closer to direct confrontation with Ukrainian forces – potentially creating grounds and pretext for more expansive conflict over time.

Russia may seek to pressure Ukraine and the West to force a moratorium of Ukraine’s NATO accession objective as well as diplomatic concessions from the West if not coerce a change in the pro-Western government of Ukraine.

Further escalation that undermines an outlook for Ukraine’s macro-economic stability could pose severe credit implications for the nation. A scenario of hryvnia loss if reserves were depleted, an acceleration of capital outflows, higher inflationary pressure as well as growth decline and/or wider budget deficits are possible outcomes.

In our January credit rating announcement, we noted that under an adverse scenario of equivalent severity to a 2014-15 geopolitical crisis, Ukrainian government debt could rise to 92.2% of GDP by 2024 (from circa 50% as of end-2021), before moderating to 80.6% by 2026.

Scope Ratings’ assessment of Ukraine reflects substantive efforts made by authorities to bolster economic resilience

Our B credit rating of Ukraine reflects the substantive efforts made by authorities to bolster economic resilience since the 2014-15 crisis. Nevertheless, existing buffers remain inadequate under a more severe or prolonged crisis given ultimately modest reserve coverage of 56% of short-term external debt.

The Ukrainian state debt portfolio remains highly exposed to currency risk: foreign-currency-denominated public debt accounts for 65% of the aggregate portfolio. This is broadly unchanged from an outstanding composition prior to the 2015 Eurobond restructuring and represents a central vulnerability. This means any scenario under which the hryvnia drops severely represents a core risk to the sovereign’s creditworthiness.

The hryvnia has weakened by a manageable 9% against the euro since November 2021, although the central bank has been selling foreign exchange to ease currency volatility.

Ukraine has rebuilt foreign-exchange buffers in recent years – with reserves of a bolstered USD 27.7bn as of January 2022, although trimmed USD 1.7bn since Dec-2021’s post-2012 peak. The US government has made available USD 1bn of loan guarantees, and the European Council has approved EUR 1.2bn of additional macro-financial assistance. Ukraine has an IMF programme until (at least) June 2022 that has USD 2.2bn in undisbursed funding. The government is likely to seek further IMF assistance alongside an extraordinary vehicle of transfer of Special Drawing Rights.

Western economic support has come as Ukraine lost international market access

Western economic support has come as Ukraine momentarily lost international financial-market access. Ukraine’s five-year dollar bond has of recent traded near 1,000bps over US treasuries, from around 400bps in September 2021.

There is still a number of available scenarios, including those observing de-escalation as long as negotiations continue. However, such scenarios have narrowed in view of Russia’s most recent actions.

Whatever occurs over the coming months, the return of a more prolonged confrontation between the West and Moscow looks likely.

For a look at all of today’s economic events, check out our economic calendar.

Dennis Shen is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH.

Poland’s Rule-of-law Dispute With the EU Challenges Long-run Credit Outlook

Long-standing weakening of Poland’s independent judiciary and tensions between the government and the EU are clouding an otherwise robust outlook for economic growth and put at risk fiscal consolidation. The rule-of-law dispute also casts doubt over government receipt of critical EU funding, particularly after the European Court of Justice (ECJ) this week dismissed legal challenges of Poland and Hungary to EU rules. The EU can now go ahead and withhold funding from member states in cases of rule-of-law violation.

The dispute also raises question marks over whether Poland would receive EU support such as balance of payments assistance in an event of a future economic shock. These are relevant concerns for the country’s sovereign credit ratings.

Such setbacks in EU-Poland relations are especially pertinent today considering how Poland’s public finances have weakened compared with prior to the Covid-19 crisis. The increase of public debt since the crisis is unlikely to be fully reversed over a foreseeable future – seen remaining above 50% of GDP in coming years (Figure 1) – despite strong recovery (4.7% growth estimated this year and 4.1% in 2023). Built-in rigidities in welfare expenditure are one reason. Another is a prospect of modest fiscal slippage ahead of parliamentary elections scheduled for 2023.

Figure 1: General government debt-to-GDP and real growth, %

Source: IMFWEO, Scope Ratings GmbH forecasts.

This was the context underlying our decision of 14 January to revise Poland’s Outlook to Negative from Stable on its A+ sovereign ratings.

There have been some signs of a more constructive approach in Warsaw to meeting EU concerns

There have been some recent signs of a more constructive approach in Poland to meeting EU concerns. Polish President Andrzej Duda proposed a bill to replace the controversial Disciplinary Chamber of the Supreme Court. Parliament subsequently made a separate proposal for changing the chamber with an aim of preventing judges from being disciplined for the content of their rulings. Nevertheless, it remains unclear whether such proposals will pass. Any final bill needs, moreover, to satisfy EU requirements.

Furthermore, there are indications of other contentious issues. In December, the European Commission opened infringement proceedings associated with a separate breach of the primacy of EU law after a 2021 Polish Constitutional Tribunal decision. The longevity of such disputes surrounding judicial independence and the rule of law suggests that there is no obvious middle ground for the two sides even if the Polish government were to compromise on some issues.

EU measures to bolster the rule of law among member states have intensified in recent years

EU measures to bolster the rule of law among member states have intensified in recent years – notably after 2021 inception of ‘Rule of Law Conditionality’ – which could have multi-billion-euro consequences for Poland. Poland’s post-Covid Recovery and Resilience Plan has not yet been approved, delaying reception of EUR 36bn in EU recovery funding, equivalent to 5.3% of average 2022-26 annual GDP.

The European Commission could furthermore suspend payments to Poland under the 2021-27 multiannual budget if it thought violations of the rule of law “affect or seriously risk affecting” management of EU financing. The EU budget earmarked for Poland is worth EUR 110.1bn, by far the largest nominal sum for a member state and equivalent to 15.8% of average estimated 2021-27 GDP.

A scenario of a Poland exit from the EU or even a loss of EU voting rights – likely to be vetoed via Hungary – remain unlikely, however institutional disagreements undermine an investment outlook premised in part on EU financing. In addition, extra costs incurred from monetary penalties, comparatively less buoyant long-run growth and resulting wider budget deficits add up with time, especially were government to replace delayed EU funding with national funding.

For a look at all of today’s economic events, check out our economic calendar.

Dennis Shen is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH. Matthew Curtin, Senior Editor at Scope Ratings, contributed to writing this commentary.

Draghi’s Continued Premiership Prolongs Political Stability, but Risks Remain After 2023 Elections

However, uncertainty looms after the 2023 elections – representing one core challenge to the economic outlook.

A continuation of Draghi’s national unity government to at least 2023 – as we have assumed – is expected to further advancement of crucial reform regarding public procurement and competition law, underpinning economic recovery and ensuring a continued inflow of vital funding from the EU’s Recovery and Resilience Facility.

Italy front loaded reforms, upon which receipt of funding from the 2021-26 EU Recovery Fund is conditional, to 2021 and 2022 – Draghi’s assumed window as prime minister. This includes overhaul of public administration, the judiciary, budgeting and pensions.

Draghi’s space for significant reform is finite, given 2023 elections

Nevertheless, Draghi’s space for significant reform is finite, given the support he requires in parliament to govern might weaken as parties step up electoral campaigns before 2023 elections, although he possesses a possible trump card of threatening to pull the plug on government should parliament become gridlocked.

Even so, the credit rating relevance for Italy and the EU more broadly of even a single additional year of Draghi as prime minister ought not be understated. Draghi could leave a lasting mark upon European economic governance by adding his respected voice to EU deliberations around changes of the Stability and Growth Pact and regional budgetary rules.

Still, the re-election of Sergio Mattarella as president in the absence of any other candidate with a majority backing of electors did illustrate how difficult consensus-building remains in Italy, which might foreshadow possible complications in formation of a government after elections of 2023.

Coming elections are one risk due to possibility of a skew to the political right

The forthcoming 2023 election remains, moreover, a risk due to possibility of a skew to the political right after the election – were Italy to elect a (first) far-right prime minister (of the post-war era). This said, especially under an alternative scenario in which the right were to come up short, we also do not rule out possibility of Draghi being called on to prolong a prime ministership under scenario of a hung parliament.

For now, the Draghi administration has been responsible for comparatively stable and prudent policy, boosting domestic economic sentiment, anchoring a recovery that has as well benefitted from pent-up demand and raised public- and private-sector investment.

An official estimate of 2021 economic growth at an above-consensus 6.5%

An official estimate with respect to 2021 economic growth was printed of an above-consensus 6.5% – near Scope’s December estimate for 6.6% for last year. In 2022, Scope expects growth of a robust 4.5%, prior to 2.1% during 2023.

Prudent policy making is especially significant given the recent increase in yields on Italian government bonds to a nevertheless still accommodative 1.4% – equivalent to 134bps spread to Germany – from a low of around 0.5% last August. Minimising unnecessary sovereign risk premia associated with domestic politics is crucial for the state’s long-run debt sustainability, as the ECB pulls back on support in debt capital markets amid a sharp pick-up of inflation.

An upward government debt trajectory over the long haul

We assess Italy’s debt trajectory as remaining on an upward trend over the long run (factoring in rises during future crises).

Enhanced stability of the national government and momentum behind a robust programme of reform supported our announcement of a revision of an Outlook concerning Italy’s BBB+ sovereign credit ratings to Stable, from Negative, in August of 2021.

For a look at all of today’s economic events, check out our economic calendar.

Dennis Shen is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH. Giulia Branz, Analyst at Scope Ratings, contributed to writing this commentary.

 

Turkey Nears Tipping Point: Capital Controls, Use of Reserves Unlikely to Prevent Lira Depreciation

The government in Ankara has few options available so long as President Recep Tayyip Erdoğan remains committed to lowering borrowing rates to accelerate economic growth and raise exports even under conditions of inflation running above 20% – eroding ordinary citizens’ disposable income.

Either the currency crisis gets bad enough for President Erdoğan’s advisors to say “enough is enough”, at which stage the central bank changes personnel and belatedly hikes rates – even if temporarily – to ease current selling pressure on lira and check inflation.

Or, as an alternative, the central bank resorts to “de-globalising” the currency – reintroducing capital controls, limiting access to foreign currency within the economy, seeking foreign currency from domestic banks and foreign allies, and going through reserves in defence of the currency – in line with what occurred between 2018 and 2020 when Erdoğan’s son-in-law Berat Albayrak ran economic policy.

The government’s exchange-rate pain threshold appears higher than in the past

Any decision to cut rates again, even as global central banks are generally tightening, at the monetary policy committee of 16 December could place even further pressure on lira, already having lost around half its value since February.

Inflation rose to 21.3% YoY in November, sending real policy rates to -5.2%, among the lowest in emerging markets.

Stemming this lira slump is critical but the government’s exchange-rate pain threshold appears higher than it was in 2018 or late 2020 when the central bank last hiked rates sharply to circuit break a currency rout.

Erdoğan has significantly consolidated his influence over economic decision-making by this stage, including monetary policy. The president appears much more “dug in” during this crisis with loyalists running the central bank and treasury and repeated mantra of how falling interest rates support growth and employment. In addition, the political stakes are much higher ahead of centenary elections due by 2023. Erdoğan and his Justice and Development Party are trailing in polling, so any public admission of failure on the economy such as vis-à-vis a rates reversal is likely to be seen by Erdoğan as damaging to credibility.

Observing steps of use of forex reserves and capital controls in slowing lira losses

We are already observing the government pursuing a “de-globalisation” strategy in using forex reserves to intervene in exchange-rate markets – after having previously committed not to do so – and adopting specific forms of capital controls to discourage depositing in foreign currency and selling of lira, to allow for lower rates while slowing currency losses. The catch is that defending lira via such a strategy is unsustainable long run.

The policy is expensive, and only buys time. Turkey racked up foreign-exchange reserve losses of over USD 100bn over 2018-20. Net reserves ex-swaps, standing at negative USD 42.3bn as of October, represent a lasting testament to consequences of this policy framework, which would be risky to attempt again with the domestic sector losing confidence in value of lira, precipitating further capital outflows.

Risk of political crisis with elections looming, on top of economic and lira crises

Instead of helping Erdoğan’s political cause, a lower interest rate policy to engineer higher economic growth appears to be aggravating his likelihood of re-election. The weak currency is instead exacerbating high inflation and loss of consumer purchasing power, which are central causes of popular discontent. Moreover, rate cuts are resulting in much higher long-end rates, tightening monetary conditions and exacerbating economic instability – hitting the poorest the hardest.

Should Erdoğan not alter course and electoral defeat were to appear inevitable, political tensions are likely to grow over 2022 and 2023 if the president turns to less democratic routes to hold to power. Risk of a political crisis, in addition to economic and lira crises, represents a vulnerability with bearing on B/Negative Outlook foreign-currency credit ratings we assign to Turkey.

For a look at all of today’s economic events, check out our economic calendar.

Dennis Shen is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH.

 

African Nations’ Shock Resistance, Debt Sustainability Varies Widely Despite Shared Vulnerabilities

Explainer video: Scope Ratings introduces its 2021 external vulnerabilities and resilience report

Our annual external risk-ranking report reflected this year 12, mostly larger African economies, comprising those with sufficiently transparent data for metrics assessed under the report, although 2021 findings attest to the continent’s mixed economic performance through the Covid-19 crisis.

Algeria, Botswana and South Africa stand out for comparatively stronger resilience in the region

Botswana stands out with respect to external-sector resilience, supported by stronger public finances and a comparatively stable crawling-band exchange-rate policy. Neighbouring South Africa’s recovering economy has shock absorbers during external crises in a long average maturity of government debt of around 12 years of which a lesser proportion (10%) is denominated in foreign currency, plus a flexible exchange rate.

Algeria owes its external-sector resilience to adequate holdings of official reserves and limited outstanding foreign currency debt or debt held by foreign creditors, reflecting longer-standing government reluctance to borrow internationally. These factors partially compensate for persistently wide current-account deficits.

Zambia, Angola and Gabon are Africa’s three riskiest economies under 2021’s ranking

On the other hand, features common to Africa’s more fragile economies include net capital outflows, volatile, less-globally traded domestic currencies, large net international liability positions, inadequate reserves and high foreign ownership and foreign-currency-denomination of their government debt – this being most significantly true as regards Zambia, Angola and Gabon.

Zambia, Angola and Gabon compose the Africa region’s “risky-3” under this year’s Scope ranking, which embeds a special concentration on Africa.

Zambia and Angola are participating in the G20 debt service suspension initiative (DSSI). Zambia has sought more comprehensive debt restructuring under an associated G20 Common Framework for Debt Treatments beyond the DSSI, after defaulting on debt late in 2020.

G20 debt-relief programmes risk not going far enough in addressing Africa’s solvency crisis

The G20 Common Framework’s continued concentration upon extension of debt maturity and, only where applicable, debt reduction on NPV terms, risks achieving overly little in improving debt sustainability as regards many heavily indebted sovereign states. The DSSI and the Common Framework also target low-income countries, leaving many middle-income countries vulnerable to debt crisis.

Many African governments are poorly placed in dealing with their heavier medium-run debt servicing requirements due to DSSI payment postponements. Half of all sub-Saharan African sovereigns were at high risk of or in debt distress already prior to the Covid-19 crisis.

A more comprehensive debt restructuring involving debt forgiveness could enhance credit profiles of many poorer countries of the Africa region significantly after restructuring. We have titled such a framework more comprehensively embedding debt forgiveness: DSSI+.

Instead, by postponing today’s problems to tomorrow under DSSI, interest and principal payments may come due during periods when there is less international support for multilateral debt relief than there is today.

Zambia’s default has elevated concern around African debt owed to China

Zambia’s 2020 default has elevated concern surrounding repayment risk associated with other highly indebted countries with borrowing from China, such as Angola or Uganda, as the latter furthermore seeks amendment of loan clauses.

Among other African markets, Nigeria’s comparatively lesser dependence upon financing in foreign currency plus liquid domestic debt markets support external resilience. However, persistent high inflation has resulted in overvaluation of the naira.

Meanwhile, Kenya’s outstanding external risks are mitigated by IMF extended arrangements as well as relief provided via DSSI, which Kenya made a U-turn concerning and participates under this year.

Our annual external vulnerability and resilience rankings evaluate nations on 1) underlying vulnerabilities to a potential balance of payment crisis; and 2) economies’ degree of underlying resilience when exposed to such external crisis. This year’s ranking expanded the Africa sample to 12 nations of the region, from two in 2020.

Download the 2021 external vulnerabilities and resilience report and rankings (pages 11-15 for Africa).

For a look at all of today’s economic events, check out our economic calendar.

Dennis Shen is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH. Levon Kameryan, Senior Analyst at Scope Ratings and co-author of the report, co-wrote this article.

 

Poland: row with the EU could have negative impact on outlooks for growth, public finances

Investment premised on future EU funding will prove essential for determining the potential for long-run growth in Poland (rated A+/Stable). The government would have limited room for fiscal manoeuvre should EU financing continue to be withheld considering the nation’s sizeable allocation under the EU Recovery and Resilience Facility of EUR 58.7bn. The funding is made up of EUR 23.9bn in grants and EUR 34.8bn in loans – together equivalent to more than 10% of 2021 GDP – though Poland does not plan on making full use of available loans.

The row between Warsaw and Brussels follows the recently introduced ‘Rule of Law Conditionality Regulation’, which allows the EU to suspend payments to member states where violations of the rule of law “affect or seriously risk affecting” the management of EU funds. The European Commission has delayed approval of national recovery and resilience plans of Hungary and Poland over concerns around the rule of law and judicial independence.

Tensions between Poland and the EU are unlikely to subside soon

Tensions between Poland and the EU surrounding rule of law are unlikely to subside soon, and a recent ruling of Poland’s Constitutional Tribunal has only deepened divisions.

On 7 October 2021, Poland’s Constitutional Tribunal ruled some areas of EU treaties as being incompatible with the Polish Constitution, challenging the primacy of EU law. A group of 26 former judges of the Tribunal, including some former presidents, have criticised the ruling under a joint statement.

The ruling leaves the EU between a rock and a hard place. The strategic importance of Poland in the central and eastern Europe region and pressure on the EU to accelerate sustainability-linked financing in transport and energy sectors underscore a determination to punish Poland for transgressions but without pushing the point overly far. However, it is hard to see at this stage what room there is for compromise given the Tribunal’s ruling and another unresolved conflict around the independence of the Polish Supreme Court.

The European Court of Justice ruled last week that Poland will be required to forfeit EUR 1m per day until the government suspends a disciplinary chamber of the Supreme Court. Poland has responded it will not pay this fine.

The risk is that disagreements result in more prolonged suspension of EU funding for Poland

The government’s want to update fundamental provisions of EU law – on the basis of the Tribunal’s assessment of incompatibility with the Polish Constitution – is not realistic. Meanwhile, an exit of the European Union – ‘Polexit’ – remains highly unlikely. According to recent opinion polling, 9 of every 10 Poles support Poland’s membership of the EU.

Aside from added monetary penalties and an escalating row with the EU potentially adversely impacting foreign direct investment, the risk Poland faces is that current disagreements result in a more significant and prolonged suspension of EU funding. This could adversely impact the growth and public-finance outlook, the latter especially should the government use own resources to compensate for suspended EU financing.

For now, Poland’s economy remains resilient, weathering the Covid-19 crisis comparatively robustly. The government’s budgetary and monetary response has complemented unprecedented EU support in response to the crisis. Poland’s output will grow by around 5.6% in 2021, having returned to pre-crisis levels of output in Q2, and 4.6% next year.

For a look at all of today’s economic events, check out our economic calendar.

Dennis Shen is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH. Levon Kameryan, Senior Analyst at Scope Ratings, contributed to writing this commentary.

Greece: High Government Debt, Sovereign-Bank Nexus, Weak Growth Potential Remain Economic Challenges

Greece (rated BB+/Stable)’s government debt ratio is second only to that of Japan (A/Stable) among 36 nations whose debt is rated publicly by Scope. While we anticipate general government debt of Greece to moderate to 199.1% of GDP by end-2021, from a 205.6% peak last year, this remains significantly above a pre-crisis 180.5% level in 2019.

The high stock of Greece’s debt leaves the government vulnerable to any reappraisal in markets after this crisis concerning sustainability of government debt and deficits accrued in crisis, especially as ECB support is gradually scaled back. This vulnerability to market correction remains a core sovereign credit rating constraint.

After 2021, Greece’s public debt ratio is foreseen declining to around 186% of GDP by 2026 as growth stays above potential and budget deficits narrow, assuming no interruption to the economic recovery.

Sustained recovery remains contingent upon addressing structural bottlenecks

Nevertheless, sustained economic recovery remains contingent upon Athens addressing residual structural economic bottlenecks, such as the continued reduction of non-performing loans (NPLs) on domestic bank balance sheets, even recognising recent significant progress achieved in this area. Elevated NPLs (21.3% of total loans as of June but reduced from 40% as of end-2019) affect banking-system profitability and capacity to finance recovery. Piraeus Bank, Alpha Bank and the National Bank of Greece have taken on capital-enhancing actions to cover cost of forthcoming non-performing loan securitisations and the gradual phasing out of transitional prudential arrangements.

System-wide tier 1 capital ratios dropped to 13.0% of risk-weighted assets in Q2 2021 from 16.4% in Q4 2019, a reflection of poor profitability and asset quality. In this respect, under an adverse scenario of the European Banking Authority’s 2021 stress examination, core capital ratios of three of the four systemic banks observed decline to 8% or under – speaking to remaining vulnerabilities in the financial system.

Sovereign-bank nexus represents an increasing risk under adverse scenarios for the financial system

Crucially, a high share of deferred tax credits in bank capital, banks’ increasing domestic government bond holdings, state equity stakes in Greek banks and guarantees under the Hercules scheme infer a stronger sovereign-bank nexus – increasing risk for the sovereign borrower under contingent scenarios impacting banking-system resilience.

The government has focused upon addressing outstanding challenges

The government has focused on addressing outstanding bottlenecks in the real economy such as rigidities in the labour market, low investment and elevated private-sector arrears. Unemployment remains high, of 14.2% as of July, although having sharply been reduced from 17.2% in April. Tax compliance remains a weakness, although having similarly been improved, while spending on pensions and public-sector wages is above a euro-area average, limiting fiscal space for growth-enhancing expenditure.

Further progress required to enhance confidence in Greece’s long-run growth potential

Progress is important on some aforementioned areas to enhance confidence in Greece’s long-run growth potential, which remains among the lowest of the euro area, as well as to raise confidence in stability of the Greek economy under future crisis scenarios.

Scope upgraded Greece’s long-term sovereign ratings one notch to BB+, from BB, on 10 September.

For a look at all of today’s economic events, check out our economic calendar.

Dennis Shen is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH and primary analyst for Greece’s sovereign credit rating.

Debt Ceiling Crisis Serves as Reminder Why the United States No Longer Has a AAA Credit Rating

Each debt-ceiling crisis imposes costs and damages the US’ reputation as a ‘risk-free’ borrower.

On Monday, a vote on a stopgap spending measure, packaged together with suspension of the debt ceiling, was blocked in the Senate. So, the US enters a critical phase of debt repayment risk entering October as the federal government’s cash resources diminish, and with federal deficits significantly higher than normal in 2021. Wider deficits curtail the time the US Treasury has for emergency action in meeting government spending obligations. Treasury’s cash balance stood at USD 0.3trn on 20 September, down from USD 1.6trn in February.

Expectation debt ceiling to be raised or suspended under party-line vote at the last moment

We expect the US government to raise or suspend the debt ceiling under a party-line vote in the end, thereby avoiding a sovereign credit default.

Nevertheless, the last-minute nature of any legislation sidestepping temporary default would remind investors of the significant, recurring risk to the willingness and capacity of the US to meet its debt obligations due to the debt ceiling.

Scope does not rate the United States as a AAA, risk-free sovereign issuer

Not only does Scope Ratings – the European rating agency I represent – not rate the US as a AAA, risk-free sovereign borrower, but the debt ceiling represents the most relevant near- to medium-run downside risk to current AA credit ratings we assign.

To resolve the latest debt-ceiling crisis, congressional Democrats could first seek to delink the debt ceiling and pass a separate continuing resolution for the US government to be open (confronting a potential government shutdown on 1 October). Thereafter, the Democratic Party, holding a technical majority in both houses of Congress, could consider budget reconciliation as final recourse to delay the debt ceiling until after 2022 midterm elections – although the complex reconciliation process similarly presents a set of risks due to nearly two weeks’ time this may demand.

Should not assume debt-ceiling political stand-offs are inevitably resolved just in nick of time

This latest episode is a fresh reminder that debt-ceiling crises of 2011 or 2013 are anything but things of the past.

We ought, moreover, not simply assume debt-ceiling political stand-offs are inevitably resolved in the nick of time. After all, the only technical US government debt default of the post-war era occurred in 1979 precisely due to partisan use of the debt ceiling.

The frequency of such US debt-ceiling stand-offs and recurring possibility of temporary non-repayment – even if driven by a so-called ‘accidental’ credit event – weigh on the US credit ratings. No other sovereign rated AA by Scope experiences such frequent crises during which default is a real scenario, barring last-minute legislative action, or has experienced a post-war credit event.

Each debt-ceiling crisis brings avoidable market instability, damage to Treasury market

Alongside risk of technical default, each debt-ceiling crisis brings otherwise avoidable financial-market instability, raising operational expenses for markets and resulting in some degree of damage to the market for US debt. This is even accounting for likelihood the debt ceiling has some impact in limiting ambition of incumbent governments’ spending policies.

According to the Government Accountability Office, delays in raising the debt ceiling in 2011 raised funding rates, hiking borrowing costs by USD 1.3bn over the fiscal year. The Bipartisan Policy Center estimated that the 2011 crisis, over a lengthier 10-year period, raised borrowing costs an aggregate USD 18.9bn.

Even a ‘temporary’ default on treasury bills – similar to that of 1979 – could result in structural damage to treasuries’ status as the global benchmark ‘risk-free asset’. The reputation of the US may require time to recover from any credit-event scenario, even if extra interest costs incurred might ultimately prove manageable.

Debt-ceiling crises occur as status of the US as issuer of the global benchmark safe asset is attenuating

US debt-ceiling crises are also taking place while the status of the US as issuer of the global reserve currency and benchmark risk-free asset is slowly attenuating. Avoiding debt crises is crucial to avoid any acceleration of this process.

This is leaving aside short-run repercussions of any credit-event scenario as regards undermining economic sentiment and growth – the latter which we estimate at a robust 6.2% for 2021 before 4.8% for 2022.

Debt-ceiling risks could further increase after 2022 midterm congressional elections

Risk associating with the debt ceiling could, furthermore, further elevate over the future, such as after midterm elections – should Democrats lose control of Congress. The experiences of 2011 and 2013 debt-ceiling crises demonstrate that risks were near heights when a Democrat President faced instead a divided Congress – and was, as such, absent recourse to a party-line congressional vote to raise (the debt ceiling), instead requiring a fraught bipartisan solution.

For a look at all of today’s economic events, check out our economic calendar.

Dennis Shen is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH.

 

Poland: Minority PiS Government Restricts Capacity for Reform, Raises Early Election Risk

We expect Poland to help lead the economic recovery in central and eastern Europe this year. Polish output should grow 5.6% in 2021 – revised up from a 4.9% forecast Scope Ratings held as of June – before 4.6% growth next year, having reached pre-crisis output levels by Q2 2021.

However, the governing Law and Justice (PiS) party’s loss of one of its junior coalition partners represents, nevertheless, an increase in policy and economic uncertainty, not least by raising likelihood of early elections before the autumn 2023 deadline.

Institutional erosion has increased political instability and tested Poland’s institutional relationships

PiS’s loss of its slim majority in the lower house (Sejm) shows the consequences of institutional erosion since PiS entered government in 2015 – a factor that has weighed on Poland’s A+ sovereign credit ratings. The recent bill introduced in Parliament seeking to bar companies outside the European Economic Area from holding majority stakes in Polish media firms has brought government instability after the coalition partner’s exit while potentially further testing Poland’s institutional relationship with the EU and the United States.

The bill under question is seen as a manner to compel US media group Discovery to sell a controlling stake in TVN, Poland’s main independent broadcaster, which has been critical of the government. At this stage, it remains unclear whether the bill will be signed into law.

A silver lining to Law and Justice losing its governing majority

There’s a silver lining, however, to PiS’s loss of its governing majority, which, while making the passage of important reforms such as those required for critical EU funding more difficult, may also bring a more balanced near-term legislative agenda, reducing the risk of further weakening of judicial independence and the free media. The government may temper certain policy objectives in return for support of smaller parliamentary groupings and independent MPs to pass legislation.

Over recent weeks, the government has passed a bill reducing the room for property restitution claims and was forced by the European Court of Justice into an about-face over a disciplinary chamber for Supreme Court judges. Since PiS entered government, other actions that have buffeted democratic norms include politicisation of the Constitutional Tribunal, attempted removal of Supreme Court judges, and limitations of media freedoms.

Checks and balances prevail restraining pace of institutional weakening

Checks and balances restricting pace of institutional backsliding still hold, including the government’s lack of a Sejm majority at this stage and opposition control of the Senate. More importantly, Poland’s dependence on EUR 58.1bn in EU monies, equivalent to more than 10% of 2021 GDP as part of the Recovery and Resilience Facility, alongside on further 2021-27 EU multiannual budget financing, constrain the government’s room for manoeuvre.

Dependence on EU funds encourages PiS observation of ECJ rulings and EU decisions on the rule of law ultimately, after frequently a phase of acrimonious back and forth talks.

A minority government may be difficult to sustain

Looking ahead, the PiS party will be eager to put off elections for as long as possible, although a current minority government may be difficult to sustain. Should PiS lose a parliamentary vote of confidence, an early election scenario could raise possibility of a hung parliament and associated heightened political uncertainty, but, moreover, might bring change of government favouring centrist groups.

Delays of fiscal consolidation and impediments to economic programme

This aside, the minority PiS government may seek to delay stringent fiscal consolidation reform over the coming period, with looser spending policies driven by political considerations. A recent outsized 60% pay hike for legislators – which goes into effect on 1 September – is only one example of how this may look. The lack of a governing majority may, moreover, impede the government’s capacity to fully implement its economic programme – even the flagship Polish New Deal in the existing form.

For a look at all of today’s economic events, check out our economic calendar.

Dennis Shen is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH. Levon Kameryan, Senior Analyst at Scope Ratings, contributed to writing this commentary.

Italy: Strong Rebound is Underway; EU Funds to Help Raise Medium-Run Growth Potential

We forecast a robust Italian rebound this year and next, with the rating agency I represent raising a 2021 growth estimate to 6.1% from an already above-consensus estimate of 5.6% we had forecasted previously since December 2020, while we kept for the present an estimate of growth in 2022 of 3.8%. The Italian economy shrank by 8.9% in 2020.

However, the medium-run growth potential of Italy as the EU’s third biggest economy remains modest given domestic bottlenecks in part relating to an ageing population, tepid productivity growth alongside risk that sizeable EU funding is absorbed only incompletely or ineffectively.

Here, we see after 2022 a gentle moderation of Italy’s annual growth in direction of a potential rate of around 0.8%, the latter revised modestly up from an estimate of the economy’s medium-run growth potential of 0.7% we had held prior to the Covid-19 crisis.

Public investment and economic adaptation to the virus support economic growth potential

The expected growth-enhancing effects of extra public investment post-crisis and economic adaptation to coexisting with the SARS-CoV-2 virus, curtailing some associated longer-term economic scarring effects, support the more optimistic assessment of the economy’s medium-run potential.

But any more significant increase in Italy’s growth potential might hinge upon Prime Minister Mario Draghi maintaining current momentum in deep-rooted structural reforms – in competition policies, enhancing fiscal and social safety nets, labour market reform, after a first set of judicial reform was achieved. Maintaining the cohesion of this government of national unity remains crucial after such actions had for decades eluded policy makers amid frequent changes in government.

Continued robust growth expected over the second half of this year although risks have settled on the horizon

We should see continued robust growth over the second half of this year if Italian households continue spending some of the forced savings accrued during successive lockdowns, further progress is achieved with vaccination of residents and investment stimulus from the Next Generation EU recovery programme begins flowing in over coming months.

However, we also acknowledge that there are downside risks to the economic outlook moving ahead as Covid-19 cases have climbed due to transmission of the Delta variant, potentially restricting some economic activities, plus the possibility of a harsher winter flu season.

Nonetheless, Italy’s Q2 GDP came in at double consensus estimates at an elevated 2.7% on quarter, largely in line, however, with our estimate for the quarter.

A large beneficiary of EU funds

For the medium-run outlook, Italy is one the largest beneficiaries from the Next Generation EU plan, particularly important given low levels of investment since the global financial crisis.

Inflation is another factor. Italy’s inflation rate, at 0.9% YoY in July, is running well under the euro area’s (2.2%) and is likely to continue underperformance even though we might consider much of current low inflation of Italy to associate with transitory factors and Italy’s inflation medium run is likely to rest above a 0.7% pre-crisis rate.

Higher but still comparatively modest levels of medium-run nominal growth

Higher real and nominal growth for Italy is anticipated as compared with rates from before the Covid-19 crisis, but the nominal medium-term trend will nonetheless remain comparatively modest at around 2%, representing an ongoing constraint for debt sustainability.

After all, real growth averaged only 0.3% over a 2010-19 decade (with nominal growth of 1.3% on average over this period), while an expected 0.5% annual decline in the working-age population over 2021-26 remains a significant economic headwind.

Italy’s 10-year yield level trades currently near its historic lows, at below 0.6%, helped by ECB support, despite the significant increase in the country’s government debt by the equivalent of nearly 25% of GDP since the crisis started.

The next review of Scope Ratings’ BBB+/Negative Outlook sovereign ratings of Italy is on 20 August.

For a look at all of today’s economic events, check out our economic calendar.

Dennis Shen is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH. Giulia Branz, Analyst at Scope Ratings, contributed to writing this commentary.

US Recovery Plan Will Support Recovery and Raise Long-Run Economic Growth Potential From 1.9%

Since the USD 1.9trn American Rescue Plan was signed into law in March, the Biden administration is pursuing two complementary pillars of its three-pillar “Build Back Better” agenda: i) the American Jobs Plan (with an earlier bipartisan compromise around a curtailed USD 1.2trn over eight years before recent setbacks), and ii) the American Families Plan (proposed USD 1.8trn).

The American Jobs Plan channels public funding towards enhancing physical and digital infrastructure, investing in research and development, shoring up supply chains and strengthening care systems. The American Families Plan aims to significantly raise federal spending in priority areas such as childcare, paid leave, pre-kindergarten, community college and healthcare.

The recovery plan is important not only for economic recovery but also for addressing structural bottlenecks

The administration’s programme is critical not only to provide near-term support for the economic recovery but also to address long-standing structural bottlenecks in the US economy. By enhancing the economy’s productive capacity, supporting domestic demand and tackling infrastructure deficits as well as structural weaknesses with respect to the social safety net, the programme supports a more inclusive and sustainable economic rebound and raises economic growth potential.

In our June 2021 Sovereign Interim Outlook, Scope Ratings projected the US economy to recover robustly, with 6.2% growth in 2021 (raised 2.2pps from our December 2020 projections) before 4.8% in 2022. After the 3.5% economic contraction of 2020, GDP is expected to have exceeded pre-crisis output as of Q2 2021, well ahead of the pace of recoveries in most European economies, including that of France and the United Kingdom. On the basis of the public investment programme, there is upside risk to our department’s prevailing US growth potential estimate of 1.9% – with potential output growth having otherwise seen secular decline since the turn of the century.

The spending programme comes at significant fiscal cost

The spending programme comes at a significant fiscal cost, however. The Committee for a Responsible Federal Budget estimates that the comprehensive package may amount to an aggregate of USD 6.7trn over 10 years. The US government has proposed offsetting measures such as an increase in the corporate income tax rate from 21% to 28%, enhanced tax enforcement and higher taxation of high-income households. These measures might generate savings of USD 3.3trn, leaving USD 3.5trn of unfunded costs, absent further revenue-raising measures.

In addition, mandatory expenditure linked to the healthcare system is likely to increase given the increase in federal spending on Medicaid and Medicare due to the Covid-19 health crisis and as more Americans seek benefits under programmes, barring reforms of the system.

US public debt to rise further, but accommodative financing conditions manage costs of borrowing

Presently, we expect US public debt to rise to above 135% of GDP in forthcoming years, from 108% in 2019 and only 65% as of 2007, exacerbating public finance weaknesses and stressing the United States’ AA credit ratings. Gross government financing requirements are estimated to stay around or above an elevated 40% of GDP per year through 2026. At the same time, prevailing accommodative financing conditions mitigate costs of borrowing, with 10-year government yields having backtracked to around 1.2% amid concern of a slowdown in the global recovery, from March highs of nearly 1.8%.

While benefits of a well-tailored investment programme at this stage are high and the cost of debt is low, it is critical that additional debt incurred nonetheless translates to tangible improvements of growth potential and addresses structural bottlenecks such as rising social inequality and problems of social mobility.

A return to a more balanced budget position remains crucial to ensuring benign funding costs and as the debt ceiling looms

While the United States still has meaningful fiscal space due to the dollar-based global financial system and the unparalleled status of US treasuries as the international risk-free asset, a return to a more balanced budget position after this crisis and reduction of contingent liabilities are nonetheless crucial to ensuring continued benign funding costs, especially as the Federal Reserve considers its exit strategies from crisis policies and as elevated deficits present risks after coming reinstatement of the US debt ceiling.

For a look at all of today’s economic events, check out our economic calendar.

Dennis Shen is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH. Thibault Vasse, Senior Analyst at Scope Ratings, contributed to writing this commentary.

China’s Economic Outlook Stabilises as Beijing Addresses Financial Risks to Enhance Resilience

The Chinese state’s commitment to reining in credit growth, deflating asset bubbles, and cutting off state support for unproductive firms while also encouraging the development of Chinese financial markets and opening the capital account support the sustainability of China’s growth model.

Reduced financial-stability risk is partially a function of a noticeably reduced concentration of the state on meeting inflated ‘hard’ growth objectives. The latest Five-Year Plan target of doubling the size of the economy between 2020 and 2035 implies a more manageable average annual growth of 4.5% over 2022-35 assuming growth in GDP of 8.6% (our updated forecast) this year.

Such structural reforms ease still significant economy-wide debt risks and increase likelihood of a ‘soft’ rather than ‘hard’ landing after the significant private- and public-sector debt accumulated since the global financial crisis. As economic growth recovered slightly to 1.3% Q/Q in the second quarter, we expect Chinese authorities to balance management of financial stability risk with a parallel need to support recovery over the second half of this year.

Trend growth of China’s economy still compares favorably with that of most economies

Even as growth cooled since the initial rebound from Q1 2020 troughs, trend growth of China’s large and diversified economy remains very high compared with that of most economies around the world even if the former moderates towards a 5% rate over the medium run.

The Agency I represent affirmed China’s long-term local- and foreign-currency issuer and senior unsecured debt ratings at A+ on 9 July and revised the Outlooks to Stable from Negative. We also affirmed China’s short-term issuer ratings at S-1+ in local- and foreign-currency and revised the Outlooks to Stable from Negative.

Extensive financial-stability reform and progress of renminbi as reserve currency underscore improved outlook

Extensive supervisory and regulatory changes have intensified since the Covid-19 economic crisis with the People’s Bank of China laying out defined priorities in the period to 2025 that include improvement of the macro-prudential assessment framework and strengthening supervision of systemically important institutions, businesses and infrastructure.

Further anchoring China’s improved outlook is gradual progress in establishing the renminbi as a global reserve currency, which in turn reinforces the country’s economic resilience on top of existing external-sector buffers relating to high foreign-exchange reserves and low external debt.

Budget deficits and rising public debt remain credit challenges

Structural public-sector fiscal deficits as well as an increasing public-sector debt stock over the long run remain prevailing credit challenges, exacerbated by the fiscal and monetary easing adopted to cushion China’s economy against repeated macroeconomic shocks.

China’s general government deficit increased to 11.4% of GDP in 2020 despite relatively moderate pandemic-related fiscal stimulus, from 6.3% in 2019 and only 0.9% of GDP in 2014. The general government deficit will remain a sizeable 9.5% of GDP this year before narrowing to 8.6% next year.

High and rising levels of total non-financial sector debt since 2008 remain a core credit challenge, although authorities have taken important steps to easing this trajectory of rising debt.

For a look at all of today’s economic events, check out our economic calendar.

Dennis Shen is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH.

US: Debt Ceiling Deadline Highlights Risks to Sovereign Ratings, Need to Reform Fiscal Framework

The debt limit is a drag on the US ratings without a better-designed alternative instrument enforcing budget discipline.

Scope Ratings says the US debt ceiling is the most relevant near- to medium-term risk to the US sovereign credit ratings (of AA/Stable Outlook) – one that is likely to increase after the 2022 midterm elections if they should lead to a divided or Republican-controlled Congress.

The only technical US government debt default of the post-war era took place in 1979 in a crisis related to the debt ceiling, a reminder that one should not simply assume debt-related political standoffs are inevitably resolved.

The debt ceiling today increases rather than decreases the likelihood of a US credit event.

Risk of another technical default remain a relevant consideration for the US credit ratings

In the period since 1979, while another debt ceiling-related default has been prevented – risks of another technical default remain a rating-relevant consideration when the US government gets so close to severe payment difficulty every year or few years. Risks relating to the debt ceiling have also increased since 1979 due to the intensification of domestic political brinkmanship, including the use of the debt limit in partisan grandstanding.

In today’s political context in Washington, we expect the most likely compromise will be for the Joseph R. Biden administration and Democrat-controlled Congress to again raise the debt ceiling or, alternatively, suspend the ceiling once more later on in the year, sidestepping debt default.

Such a move will become even less straight-forward, however, in the future should Democrats lose control of Congress in 2022 if the experiences of the 2011 and 2013 debt-ceiling crises are anything to go by when President Barack Obama faced a divided Congress.

Scope’s AA credit assessment of the US recognises risks associated with the debt limit and impact on the likelihood of a credit event, even an ‘accidental’ one such as in 1979. No other sovereign credit rated AA by Scope either experiences such frequent crises during which default is a real scenario barring last-minute legislative action or has experienced a post-war credit event.

Higher US budget deficits reduce room for manoeuvre during debt-ceiling crises

We see pressures building seeking resolution of the debt ceiling before Congress’s recess in August.

For one, federal deficits are now much higher – meaning the fiscal largess of past and present US administrations is presenting shorter-run credit risk via curtailing the duration during which Treasury can mobilise extraordinary measures to meet spending obligations after debt ceilings are reinstated.

The Congressional Budget Office projects a federal deficit of USD 2.3trn in 2021, the second largest since 1945 and USD 1.3trn more than the deficit the US recorded when it last suspended the debt limit. Treasury faces growing pressures to slash T-bill supply ahead of the coming debt deadline. Any credit event affecting US treasury bonds impacts the US and global financial systems given treasuries are the global risk-free asset of choice and vital for inter-bank liquidity as collateral.

Treasury warnings are exaggerated, but government has likely only until the autumn prior to acute payment stress

Treasury’s warnings about the US running out of available funds by August are likely exaggerated, partially designed to focus minds in Congress. Nevertheless, the US government likely has until the autumn for the debt limit to be resolved before it encounters acute debt payment problems.

The expected resolution over the coming period of the debt ceiling could come via packaging a debt-limit suspension within the infrastructure spending legislation or the American Families Plan or alongside stopgap funding to avert a partial government shutdown after the fiscal year ends on 30 September – bills with more substantive congressional backing. If this does not work, Democrats, currently controlling technical majorities in both houses of Congress, could hold the option, at this stage, of using budget reconciliation to push back the limit – although there’s a view among experts that the reconciliation process may require raising the ceiling rather than suspending.

Acrimonious negotiations could serve as reminder of a longer-standing crisis of governance

Even assuming the debt ceiling issue is resolved in the end this go around, the likely acrimonious negotiations surrounding any agreement will be a reminder of a crisis of governance in the US’s divided political and social landscape. Governance risk has not disappeared with the new US administration. Republican members of Congress, mindful of primary challengers in 2022, will be under pressure to extract concessions from a Democrat-controlled White House and Congress and push for deep budget cuts.

Frequent debt crises underscore the need to reform the US’s fiscal framework

Frequent debt crises in the United States underscore deficiencies of the fiscal framework in the world’s largest economy, with the debt limit requiring reform in an age of political obstructionism.

Here, the US credit outlook would benefit from the replacement of the debt limit with an alternative credible and better-designed fiscal instrument that more effectively enforces budgetary discipline, particularly given the US government’s otherwise unparalleled capacity to raise funds and refinance debt.

On 2 July 2021, Scope took no rating action on the US but noted the debt ceiling as a credit constraint.

For a look at all of today’s economic events, check out our economic calendar.

Dennis Shen is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH. Thibault Vasse, Senior Analyst at Scope Ratings, contributed to writing this commentary.

 

UK Outlook: Brexit Drag On Sovereign Rating Eases; Risks to City, Trade Balance Remain

We have consistently argued through the Brexit period that “no deal” was the least likely outcome. In this respect, the entering into force of the Trade and Cooperation Agreement with the EU in May 2021 was a crucial development behind an improved credit outlook for the United Kingdom.

The reduction of ‘no-deal’ adverse Brexit risk has significantly curtailed contingent downside risks that affect economic, fiscal, external-sector and institutional outlooks relevant for the UK’s sovereign credit ratings.

While the important UK services sector was mostly excluded from the trade deal, the additional Memorandum of Understanding agreed by the two sides in March represents a further important step for any more substantive access rights granted to the UK financial industry medium run, contingent on equivalence rulings.

Scope revised the UK’s sovereign rating Outlook to Stable on 25 June

The rating agency I represent revised the United Kingdom’s rating Outlook to Stable from Negative, affirming the ratings at AA on 25 June. In part, this Outlook change also reflected an exhibited resilience since the referendum in sterling’s status as a reserve currency.

The diminished risk of severe no-deal complications from Brexit has coincided with comparative resilience of the British economy through both a tense phase of domestic politics and frequently fraught relations with the EU after the June 2016 referendum and the Covid-19 crisis.

Sharp contraction in UK output in 2020, but strong recovery expected over 2021-22

UK economic output contracted sharply by 9.8% in 2020 with strict sequential lockdowns and heavy disruption of the domestic economy as the government struggled to contain the SARS-CoV-2 virus.

However, supported by large-scale fiscal and monetary stimulus, we expect a strong, but uneven, economic rebound of 6.6% this year and 5.4% next. In the medium term, we anticipate the UK’s growth potential to remain around 1.5%, capped by soft estimated productivity growth of just 0.6% a year.

True, that is below our 2% potential growth estimate should the UK have stayed in the EU, but it is nonetheless still comparable to that of similarly-AA rated countries such as the US, at 1.9%, and France, at 1.4%.

Revision of UK credit Outlook does not imply Brexit risks have passed

The revision of the UK rating Outlook does not imply Brexit risk and associated economic and institutional consequences have passed. The City of London is facing permanent damage in awaiting definitive agreements with the EU on financial services. UK-based businesses may continue to relocate some activities to the continent. Domestic politics remain volatile, from the growing pressure for a second referendum on independence for Scotland and the fall-out in Northern Ireland from the new UK-EU trading arrangements.

The external sector represents one constant credit challenge. The current account deficit amounted to 3.5% of GDP in 2020, slightly up from 3.1% of GDP in 2019 although significantly below a 6.1% of GDP peak in the four quarters to Q3 2016. The UK ultimately secured an EU deal for trade in goods where it has a trading deficit with the EU, but not one as comprehensive in services where it stands to see a diminished trading surplus. This holds longer-term adverse consequences for the UK’s current account balance.

For a look at all of today’s economic events, check out our economic calendar.

Dennis Shen is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH. Eiko Sievert, Director at Scope Ratings, contributed to writing this commentary.

G7 Corporate Tax-reform Poses a Moderate Risk to Ireland’s High-growth Economic Model

The G7 agreement to clamp down on global tax avoidance by multinational corporations (MNCs) aims to ensure that a larger share of corporation taxation is paid in countries where they operate. This included G7 backing for a global minimum corporation tax rate of at least 15%. This agreement may form the basis for a global deal.

The 15% minimum rate is nearer Ireland’s prevailing 12.5% rate than an original US proposal of 21% was, but still represents a gap.

However, the tax rate is only one factor that investors consider when deciding where to put their money. Ireland is no exception.

Ireland has multiple attractions for international businesses

Ireland holds multiple factors attractive to international business, among them the English language, a well-educated workforce, membership of the EU single market and favourable business conditions. As long as the tax ‘top-up’ does not widen significantly beyond current expectations, it is unlikely that most MNCs opt out of Ireland. The G7 agreement is only the starting point for future discussion at the G20 before any final deal is struck, likely to contain exemptions to ensure as many countries sign up as possible.

The full domestic impact of global tax reform will also hinge upon Ireland’s policy response, which may involve new measures to attract foreign capital and support local businesses. This could include advancing innovation backing such as campus incubators that abet firms with access to venture capital.

Any corporate tax increase is important, given MNCs’ role in Irish economy

Any increase of the tax rate is nonetheless important, considering Ireland’s dependence on pharmaceutical, computer services and other MNCs sectors, visible in the economy’s resilience amid the Covid-19 crisis.

Ireland’s 3.4% GDP growth was the highest in the EU in 2020 as MNCs benefitted from pandemic-associated trends such as more remote working and demand for immunological drugs. However, Ireland’s underlying economy – measured by real modified domestic demand – contracted 5.4% amid comparatively stringent lockdown, more akin to a 6.7% aggregate drop of euro-area aggregate GDP. The pharmaceutical and technology MNCs’ performance during this crisis may also carry into a post-Covid age, with these companies potentially benefitting longer term from structural economic changes.

Putting some of the government’s tax take at risk

Changes in global tax rules could put some of the government’s tax take at risk, ranging from 0.6-1% of GDP, or 1.1-1.8% of modified GNI in 2018, according to the IMF. The Irish government estimates that it might lose EUR 2bn (0.9% of estimated 2021 modified GNI) of corporation tax receipts longer term due to OECD proposals related to changes in the geographical domicile of corporate taxation.

Ireland’s small, open economy and the size and complexity of its financial and corporate sectors leave it vulnerable to shifts in international regulation around cross-border trade and investment.

Upgraded credit rating; 2021 growth forecast revised higher

Scope upgraded Ireland’s credit ratings one notch to AA- on 21 May, with the Outlook revised to Stable. Scope expects GDP growth of 9% in 2021 (revised sharply up from 5%) – supported by pent-up demand, strong monetary and fiscal policy support, and recoveries in Ireland’s main trading partners – followed by 4% growth in 2022.

For a look at all of today’s economic events, check out our economic calendar.

Dennis Shen is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH.

Ireland’s Debt Ratio Could Fall to Pre-covid Levels After 2026 on Deficit Reduction, Strong Growth

The consolidation in Irish public debt when measured as a percentage of modified gross national income (GNI*) – an indicator of the underlying output of Ireland’s globalised economy – will be slower than that in debt-to-nominal GDP, the latter metric set to fall to pre-crisis levels by 2025 absent significant adverse shock. The GNI* benchmark excludes the economic contribution of multinational pharmaceutical, technology and other companies with operations in Ireland that have performed strongly amid the crisis and may benefit longer term from structural economic changes owing to the pandemic.

Ireland is among the euro area member states with the greatest capacity to reverse the significant debt build-up from the crisis.

Comparatively resilient economic performance

Ireland’s comparatively resilient economic performance, with 3.4% growth in 2020 followed by an elevated 7.8% QoQ over the first quarter of 2021, plus robust growth expected after the crisis, gives the government substantive room to consolidate excess budget deficits. We upgraded Ireland’s sovereign credit ratings to AA- on 21 May, with the Outlook revised to Stable.

The Irish government’s significant fiscal response to the Covid-19 global crisis – equivalent to EUR 38bn or 18% of GNI* in 2020 and 2021 – will nonetheless see a budget deficit of around 9% of GNI* this year, approximately the same as last year’s deficit. The correction in Ireland’s budget is seen starting thereafter more significantly from 2022 on.

A further modest increase in the public debt ratio in 2021, before reductions medium term

Scope expects a further modest increase in the public debt ratio to 110% of GNI* (62% of GDP) this year as government support for business and households remains in place during the early stages of economic recovery. Public debt rose to nearly 106% of GNI* (60% of GDP) in 2020 from 95% in 2019 (57% of GDP).

As recovery takes hold, our expectation of robust growth underpins a forecast of post-crisis reductions of government debt: we estimate Ireland’s potential annual growth at 4% under real GDP terms and at 3% under a real modified domestic demand definition. Output growth should accelerate this year, with growth of 5% under GDP terms and 3% in respect to the underlying economy.

Brexit has had a mixed impact on the Irish economy. The consequences of greater friction in UK-Ireland trade after Great Britain’s exit from the single market contrasts with Brexit’s boon for foreign direct investment in Ireland, the latter which supports real growth.

An improving profile of the outstanding government debt

A constructive element is an improving profile of Ireland’s general government debt. The official sector holds an increased share of government debt. Official sector loans represented 19% of the Irish debt stock at end-2020, including bailout loans from 2011-13. An additional near 30% of the debt stock will likely be held on the Eurosystem balance sheet, after ECB asset purchases, by the end of this year, further reducing the outstanding proportion of rateable Irish debt owned by the private sector. Debt-service costs have moderated, with 10-year financing rates of 0.2%.

Ireland’s National Treasury Management Agency has taken advantage of benign borrowing conditions to extend the maturity of debt instruments to a weighted average of 11.2 years at end-March, comparing favourably with an advanced-economy average of 7.1 years. Year-to-date issuance in 2021 has averaged a lengthier 14.6-year maturity. Ireland has raised EUR 6.1bn in sovereign green bonds since 2018.

Economy retains significant inherent vulnerabilities

Irish fiscal dynamics will improve over time after the crisis, but we need to bear in mind that the economy retains significant inherent vulnerabilities to external and/or domestic shocks, given the prominence of multinational corporations in the private sector, a very open economic structure, high public and private debt stocks, and a considerable size of the financial system as compared with the size of the real economy. Forthcoming shifts in international corporation tax policy represent a relevant risk to Ireland’s economic comparative advantages.

For a look at all of today’s economic events, check out our economic calendar.

Dennis Shen is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH.