Scope Ratings Sees Inflation Moderating by 2022 but to Somewhat Higher Trend Rates Versus Pre-Crisis

Current high levels of inflation largely reflect transitory factors as associated with surges in commodity prices and the release of pent-up demand as economies have re-opened. Demand is being further amplified as stimulus and economic support policies continue, accentuating pandemic-associated supply-demand mismatches. Monthly YoY US CPI was 5.4%, 2.5% in the UK, and 1.9% in the euro area according to latest June data.

In this respect, we foresee elevated inflation easing by 2022 as economic conditions normalise. But only after inflation jumps higher in specific markets, such as in the UK or the euro area, in the second half of 2021.

In the long run, multiple factors hinder sustained elevated rates of inflation

With regard to long-term consumer price inflation, there remain multiple critical factors that hinder sustained elevated price increases, such as the forces of globalisation, technological innovation, automation, even social dynamics such as the disinflationary effects of ageing populations and rising inequality.

Normalisation of consumer-price inflation expected, but to somewhat higher trend rates

Nonetheless, there is a distinct possibility that consumer-price inflation will normalise from current highs but settle at somewhat more elevated trend rates post-crisis versus pre-crisis. This in part reflects the effects of structurally looser monetary and fiscal policies after this crisis.

All else being equal, changes in policy making orthodoxy over this past decade mean the policy reaction function may favour comparatively more accommodative global monetary policy setting and higher rates of public investment and consumption post-Covid compared with policy norms after the global financial crisis.

This includes more dovish G4 central banking exemplified via the outcome of the ECB’s strategic review. Dovish policy has been exemplified in the secular decline of rates to the lower bound, the introduction of negative rates, the fact that central-bank balance-sheet expansion has now become conventional, and recent transitions to symmetrical inflation objectives tolerating higher rates of inflation. These policy accommodations could anchor favourable private investment conditions, growth in commodity prices, and slightly higher market-based inflation expectations and wage & pensions growth. In addition, lower-for-longer policies pressure higher rent costs as housing prices continue hitting records.

Freer-spending post-crisis budget conventions are also seen presenting more durable inflation outcomes, at least as compared with the disinflationary austerity, internal devaluation and deleveraging orientation after the 2008-09 crisis.

Inflation rates averaged 1.8% in the United States over the 2010-19 decade, 2.2% in the UK but only 1.4% in the euro area and 0.5% in Japan, with these averages possibly seeing upside over the 2021-30 decade as inflation objectives are similarly revised up.

The sovereign ratings impact of prevailing inflation risk includes positive and negative components

The sovereign ratings impact of prevailing inflation risk includes both positive and negative components. On one hand, somewhat higher trend-rate inflation leads to higher nominal growth, supporting the trajectory of debt-to-GDP ratios provided there is not an outsized response in government bond markets to higher rates of inflation. This is credit positive.

On the other hand, increases in government bond yields and in corresponding weighted average costs of the public debt portfolio might exceed the increase in inflation should inflation prove more durable, with markets demanding higher real yields to offset greater uncertainty surrounding the outlook for price rises and with central banks more limited in capacities to intervene in markets should inflation persistently be testing a 2% objective. This could hold more adverse implications for sovereign credit outlooks.

More pronounced or persistent inflation remains a central risk to the economic outlook

In the end, as highlighted in our June 2021 Sovereign Outlook, a sharper spike in or a more prolonged bout of inflation than currently anticipated remains a prime risk to the economic outlook. The Agency’s stressed economic scenario sees inflation risks triggering a “taper tantrum” and a rush to safe-haven assets. Here, given the effects of easy money policies in inflating global asset prices much more than they have driven consumer prices higher, any lagged adjustment of monetary policies and sudden tightening of global financial conditions could put financial stability and recoveries at risk.

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

Giacomo Barisone is Managing Director of Sovereign and Public Sector ratings at Scope Ratings GmbH. Dennis Shen, Director at Scope Ratings, contributed to writing this commentary.

Global Economic Outlook: Global Gdp to Rise 6% in 2021, 4.4% in 2022 Amid Debt, Variant & Inflation Risks

Download Scope Ratings’ June 2021 interim global outlook.

The legacy of this Covid-19 crisis includes much higher government debt and structurally wider budget deficits, reflecting the shift in fiscal orthodoxy as governments have turned their backs on austerity, which was the default policy paradigm to differing degrees after the Global Financial Crisis.

Structurally weakened government balance sheets are credit negative, but still highly accommodative monetary policy – particularly from the Federal Reserve, ECB, Bank of England and Bank of Japan – has been compensating by ensuring continued low rates. The G4 central banks have enhanced roles as lenders of last resort.

In Europe, important institutional reforms with the agreement on the EU Recovery Fund and joint EU debt issuance is another credit positive development brought about in response to the pandemic.

More sovereign issuers on Negative Outlook than Positive; greater crisis effect on emerging countries

Since the Covid-19 crisis started, Scope has downgraded two sovereign issuers of the 36 credits it evaluates (Turkey, Belgium), while upgrading two (Lithuania, Ireland). Eight countries globally are presently evaluated by our agency on Negative credit Outlook (three EU member states, five non-EU) with one on Positive Outlook (Greece).

In emerging economies, the crisis has held greater net negative consequences for sovereign credit risk as governments’ balance sheets have weakened without domestic central banks being able to provide commensurate monetary support.

The global economy has fresh momentum, but recovery is likely to stay uneven and subject to setbacks

The good news is that the global economy has renewed momentum, supported by vaccination programmes, which have accelerated across many countries. However, vaccines are not equally available everywhere, so the economic recovery does not look as sustainable in emerging economies as it may in advanced ones.

However, full economic normalization remains vulnerable even in advanced economies to setbacks as segments of populations are yet to be vaccinated, virus variants present latent health-care risks and the withdrawal of extraordinary economic stimulus potentially lays bare higher unemployment and corporate insolvencies.

Governments may have to re-introduce some restrictions to deal with possible future increases in coronavirus cases, though we do not expect a repeat of the economic disruption of 2020 as vaccinations continue and countries adapt to new ways of doing business.

Upside revision of 2021 global growth driven by stronger US growth; monetary policy to remain accommodative over immediate future

The slight upward revision to our 2021 global GDP forecast stems mostly from a revised outlook for the US (+2.2pps to 6.2%) compared with six months ago. In contrast, we have revised down our forecast for euro area growth by 0.9pps to 4.7% and revised down China’s by 0.6pps to 9.3%, with forecasts for the UK and Japan unchanged from December projections at 6.6% and 3.0%. The impact of the pandemic on labour markets remains comparatively benign due to government interventions, with unemployment rates averaging 8.3% in the euro area this year, 5.7% in the US and 4.6% in the UK.

Monetary policy will remain accommodative over the immediate future, even as scale-back of net asset purchases is contemplated. We expect policy rates in the US, euro area and Japan to remain on hold at least through 2022. The UK will likely increase its base rate to 0.25% by end-2022, with the People’s Bank of China raising its loan prime rate 10bps in 2021 and in 2022.

Further tightening of global financial conditions represents a central risk to the economic baseline

A central risk to the Agency’s economic baseline is a further tightening of global financial conditions, in the form of higher long-term treasury yields, a significant correction in bubbly global equity markets and/or depreciation of exchange rates. This could be a result of a more significant “taper tantrum” in which inflation returns more dramatically or for longer than currently foreseen by global central banks, forcing behind-the-curve adjustments of policy setting and signalling. This risk is evidenced as central banks start advancing projections for interest rate increases.

Such an adverse scenario could test economies, particularly in emerging markets, which have accrued debt and are grappling with fragile recoveries.

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

Giacomo Barisone is Managing Director of Sovereign and Public Sector ratings at Scope Ratings GmbH.

Italy’s Debt: ECB Creates Room for Budget Expansion but Fiscal Space Still has Limits – Interview

An interview with Giacomo Barisone, head of sovereign and public sector ratings at Scope Ratings, about Italy’s sovereign debt dynamics.

Italy (rated BBB+/Negative Outlook by Scope) needs the public investment and structural economic reforms proposed by Draghi to increase near- and long-term growth, but the part financed by national resources comes at cost of wider budget deficits. Can Italy easily take on this new debt?

According to the government’s current debt projections, public debt increases to around 160% of GDP this year from 156% in 2020 before declining, under a constructive scenario to 135.5% of GDP by 2032, near the 134.6% level of 2019. We consider this government scenario optimistic – and instead expect Italy’s debt ratio to remain on a structurally increasing trajectory longer term.

However, the goalposts for interpreting public debt sustainability are shifting. A general government debt ratio of 160% or 180% of GDP in the euro area does mean something different today from what it might have 10 years ago. In 2010, such a debt ratio would surely have resulted in lost market confidence and materially exacerbated Italy’s debt crisis. What has changed are the actions of the European Central Bank, anchoring ultra-low sovereign borrowing rates today, and doing so with scale and flexibility.

Has this monetary-policy shift benefitted countries such as Italy especially?

Yes, it has – the innovation during this crisis has been the flexibility of ECB purchases across jurisdictions, time and asset classes. The central bank has stabilised especially financing conditions of member states with greater propensity for market stress such as Italy by not strictly purchasing assets proportionally to a country’s population & economic size during this crisis. In the process, nearly 30% of Italian general government debt has shifted to the joint Eurosystem balance sheet. As sovereign ratings are assigned on debt due to be paid to the private sector, shifting debt to the official sector balance sheet is credit positive, curtailing the outstanding segment of rated debt owned by the private sector.

The ECB programmes have also given an extended window of opportunity for Italy as well as other sovereign borrowers to improve their debt profile. In addition to changes in the ownership of Italy’s sovereign debt, the weighted average interest cost of outstanding debt has declined to 2% this year from 4% in 2012. We anticipate further declines with Italy refinancing its maturing debt at 10-year BTP rates of (only) 0.9%. The average life of Italian debt has also increased to seven years due to the actions of the Italian Treasury, taking advantage of the flatter yield curve. This supports greater resilience against a higher stock of debt.

So, given ECB support and still favourable rates conditions, how much fiscal space does Italy have?

Even with greater tolerance for increased debt given ECB intervention, Italy’s fiscal space in 2021 still has bounds. True, it is the accommodative monetary policy that is creating fiscal space, and the ECB – as a credible, reserve-currency central bank – does have flexibility with its balance sheet to create further fiscal space for euro area member countries. Yet the ECB’s room for manoeuvre is not without its own checks and balances. The central bank has an inflation mandate, and overly assertive action could result in higher inflation. The central bank’s actions also exacerbate pre-existing financial-system imbalances and could bring more substantive depreciation of the euro especially after this crisis if such balance-sheet expansion were pursued asymmetrically rather than in aggregate during crisis across all major central banks.

Such depreciation would undermine the euro’s growing global reserve-currency status. As the ECB plans exit strategies from the crisis – scaling back pandemic programmes – it is unclear how conventional QE via the Public Sector Purchase Programme, with associated issuer and issue limits, may constrain monetary space after the crisis, or whether such self-imposed QE limits may be further adjusted. There are also legal constraints on the ECB – and thus on the sovereigns relying on the ECB to extend fiscal space.

As Italy does not have an independent monetary policy, any Italy-specific crisis, such as one akin to the 2018 crisis, may not necessarily result in the same scale of ECB intervention as we are currently seeing when all euro area countries face an aggregate shock.

How does Scope weigh up the need for Draghi to kick start the economy with these concerns?

The 25pp increase in Italy’s debt-to-GDP ratio since the start of the crisis is a key credit concern. At the same time, there is no public debt level that by itself implies a lowering in the rating from the current BBB+ investment-grade assignment. Changes in ECB policy and progress toward closer European fiscal union, via ECB policies as well as via forthcoming EU joint-debt issuance, have offset to an extent pressure on the ratings. Nevertheless, Italy’s fiscal space has limits and a higher debt stock increases the sovereign’s vulnerabilities after this crisis is over under conditions of any market reappraisal of sovereign risk or withdrawal of monetary accommodation in the future. The Draghi government should keep fiscal sustainability in mind even as it rightly makes growth-enhancing policies the main priority.

Despite the ECB and EU support, what are the longer-term risks to Italy’s ratings?

Risks to Italy’s longer-term credit outlook are several. They include: (i) lower long-run output due to prolongation of lockdowns and permanent structural damage to economic potential stemming from Covid-19 impairment; (ii) implementation risks surrounding recovery funds and pro-growth structural reform, in recognising Italy’s record of low absorption rates of EU funds and recurrent changes in government interrupting reform momentum; and (iii) the risk of crystallisation of high contingent liabilities on the country’s balance sheet from stress in the private sector.

Italy has sharply increased public guarantee schemes amounting to 13% of GDP, which have been extended until end-2021. If the private sector were to require further extraordinary support in the form of bailout monies, this could push up public debt beyond existing expectations, which could result in downward pressure on ratings.

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

Giacomo Barisone is Managing Director of Sovereign and Public Sector ratings at Scope Ratings GmbH. Dennis Shen, Director at Scope, contributed to writing this interview.

Euro-Area Economic Outlook: Taking Stock of a Sluggish Rebound, ECB Stimulus and Public Debt

Scope Ratings sovereign analysts Giacomo Barisone and Dennis Shen discuss five pressing questions for policymakers and investors:

1) The euro area’s near-term outlook for recovery remains challenging given renewed increases in Covid-19 cases and the slow vaccine rollout. What is Scope’s outlook on growth?

Giacomo Barisone: We continue to expect the recovery to gain a firmer footing by early spring 2021 as pandemic-related restrictions are slowly relaxed. However, amid the sluggish vaccination rollout in the European Union due to supply constraints and rising numbers of Covid-19, the recovery will remain uneven and subject to setback. The scale of the recession last year was also less severe than anticipated in the euro area – especially in countries such as France – as Europeans adapted to lockdown conditions by the fourth quarter of 2020. This reduces some of the upside to 2021 growth. We do see downside risks to our December forecast for 5.6% euro-area growth in 2021.

2) Euro-area core inflation increased sharply in January, reaching 1.4% – its highest level since 2015. Will underlying inflation pressures rise significantly in the euro area?

Dennis Shen: There is plenty of inflation globally – but this inflation is mostly in asset prices rather than in consumer prices. As noted in our 2021 Outlook, there is downside risk to the global recovery from any correction in inflated property, equity and bond markets, which could tighten global financial conditions. We are seeing such a correction in real time in debt markets, but EUR 5.6trn of euro-area government debt was still negative yielding as of end-February. Consumer-price inflation will rise near term from February’s 0.9% headline rate in the euro area – but this increase is linked in significant part to temporary factors such as higher energy prices as well as one-offs like the reversal of the German VAT reduction. Longer term, we see continued structural limits to sustained higher consumer price inflation. Indeed, ECB forecasts this week indicated average annual HICP inflation does not exceed 1.5% in any of the next three years. As the ECB considers a symmetrical inflation objective – implying somewhat greater future tolerance of more elevated inflation – we expect monetary policy to remain highly accommodative even as inflation rises.

3) Higher inflation expectations have caused bond yields to increase globally and triggered ECB action Thursday. What is the outlook for monetary policy moving ahead?

DS: The increase in global yields, while led by reflation concerns in US markets, has certainly made euro-area financial conditions less accommodating. Nevertheless, the sell-off has remained more moderate in the euro area: 10-year Bunds at time of writing are yielding around -0.3% compared with -0.6% at the start of this year.

The ECB has sought to ease or reverse this increase on the long end of the curve – talking down markets and backing words up with a pledge on Thursday to (temporarily) “significantly” speed up asset purchases over the coming quarter. There is still nearly EUR 1tn of unused ammunition under the Pandemic Emergency Purchase Programme (PEPP)’s EUR 1.85tn remit as of end-February, so no immediate need to increase the aggregate size of the programme. The ECB could, however, extend in the future the suggested earliest end-date of PEPP purchases of March 2022 and/or the earliest end-date for reinvestment of expiring bond proceeds should this be needed to re-emphasise its “lower for longer” message.

4) The recovery hinges on the already-sizeable fiscal stimulus to continue being extended. What is the outlook for euro-area public finances?

GB: The outlook for government finances is challenging. The aggregate general government deficit of the euro area widened to 8.8% of GDP last year from 0.5% in 2019 and the aggregate public-debt ratio rose to 101.7% of GDP from 85.9% in 2019 with large differences across member states. The EU’s fiscal framework will remain suspended until at least 2023 to support a sustained rebound over coming years, as governments still need fiscal support in anchoring recovery.

Still, once recovery gains traction, fiscal consolidation, particularly among highly indebted sovereign borrowers, will be critical. Here, a revision of the EU’s overly complex fiscal rules, replacing, as an example, unobservable structural targets with measurable expenditure rules, could be a credible route to facilitating the required adjustment.

We expect governments will selectively and gradually phase out emergency budget measures introduced in 2020, particularly as they are set to benefit from windfall tax receipts as growth recovers. Even so, for many countries of the euro area – such as Italy, Spain and France – public-debt ratios are structurally on an upward trajectory looking through the cycle.

5) Does the sharp rise in public-debt ratios across euro-area countries come with debt sustainability risks, in Italy or Spain as an example?

GB: We believe EU institutional reform – including steps taken toward more significant fiscal union via the Recovery and Resilience Fund – and the highly accommodative stance of the ECB will ensure debt sustainability risks are manageable at least near term. Political wrangling around the management of the Fund has been resolved for the moment in Spain’s case and, more recently in Italy, with a more constructive reform and strategic framework since the appointment of Mario Draghi as Prime Minister. Nevertheless, longer-term debt sustainability risks remain a significant concern.

Read more on Scope’s views about the 2021 recovery and ECB policy in the Sovereign Outlook 2021 (published 9 December 2020).

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

Giacomo Barisone is Managing Director of Sovereign and Public Sector ratings at Scope Ratings GmbH. Dennis Shen is a Director of Sovereign and Public Sector ratings.

Sovereign ESG Financing: Italy’s First Green Bond Gets Warm Reception, Helping Ease Funding Risk

Last week’s debut green bond of the Italian Treasury – a EUR 8.5bn note maturing in April 2045 – came shortly after finalisation of Italy’s framework for the issuance of sovereign green debt, aligned with ICMA Green Bond Principles and the EU’s Sustainable Finance Taxonomy. The government has outlined categories of public expenditure eligible for green funding, as well as the tracking and reporting procedures to ensure proceeds are allocated appropriately.

Improving Italy’s debt profile and funding flexibility

The long maturity of this issue supports the extension of the average maturity of Italian government debt, which stood at seven years last December – around the median for advanced economies. Any hypothetical extension over time of this average maturity of public debt would be considered credit positive for Italy’s BBB+/Negative ratings from Scope, given the significant relevance of spacing out redemptions in view of Italy’s significant debt load.

Debt-maturity extension supported by the green bond framework is set to be maintained as the government expects to top up this long-dated 2045 bond.

In addition, the issuance diversifies Italy’s investor pool – not only in respect to longer-term groups of investors but also with an increasing body of environmental, social and governance (ESG) investors. As foreign investors purchased 74% of this debut green bond – this expands the investor pool as well by geography, though we recognise that a core historical credit strength of the Italian sovereign has been a strong domestic investor base – with foreign investors more prone to capital flight in periods of risk-off sentiment.

The fact that the issue received over EUR 80bn in demand is important for the government’s funding flexibility amid the recent sharp increase in global sovereign yields – and as the ECB contemplates longer term an eventual exit strategy from presently elevated net asset purchases.

Better programming of green government expenditure

The establishment of the sovereign green bond framework signals Italian authorities’ commitment to addressing climate change and environmental risk and could support better programming of green government expenditure. Reporting requirements with respect to the use of proceeds, together with heightened market scrutiny, support better environmental policies.

We see Italian authorities maintaining a fiscal stance supportive of gradual economic recovery in the coming years – including investment in combating climate change. However, associated excess deficits as the Covid-19 crisis wanes, together with a still challenging longer-term growth outlook, leave concerns hanging over the longer-term trajectory of public debt, with debt-to-GDP likely exceeding 160% by if not before the next global or regional crisis.

Low borrowing rates vital for Italian debt sustainability

In this context, it is critical that low borrowing rates anchor Italian debt sustainability. Locking in a 1.5% coupon for this period of above 20 years with the green bond helps reduce stepwise Italy’s vulnerability to bouts of capital-market volatility particularly if interest rates increase.

Italian yields reached historic lows over recent weeks, of under 0.5% for the 10-year bond, and trades at time of writing around 0.75% – nonetheless highly accommodative.

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

Giacomo Barisone is Managing Director of Sovereign and Public Sector ratings at Scope Ratings GmbH. Dennis Shen, Director, and Giulia Branz, Associate Analyst, contributed to writing this commentary.

Italy’s Government Crisis adds Risk to Outlook for Economic Recovery and Public Finances

The collapse of Prime Minister Giuseppe Conte’s coalition after the withdrawal of junior party Italia Viva, led by former prime minister Matteo Renzi, brings three risks to the fore for Italy.

First, prolonged political uncertainty could impede effective decision making if Conte struggles to reconstitute a robust ruling coalition. Secondly, fresh parliamentary elections, even if unlikely at this stage, could result in victory for Italy’s right-wing anti-EU political parties according to the latest polls.

The third risk is potential damage to Italy’s relations with Europe: effective management of the pandemic response and successful deployment of EU budget funds to stabilise and kick start Italian growth are in the interests of Italy’s regional neighbours – interests undermined by internal policy disagreements among Italian political groupings.

Political impasse might sour relations with other EU members

European institutions may be concerned that Italy’s political parties are embroiled in domestic power disputes rather than focusing on tackling the pandemic and putting to good use the large amount of resources that European partners have entrusted the country with. Italy had a credibility gap at the onset of the pandemic, with an uneven record in fully and efficiently absorbing EU funds. The country is one of the primary beneficiaries of the Next Generation EU recovery fund with allocated loans and grants of about EUR 209bn.

So far, political tensions have had no significant impact on investor confidence, however, unlike in earlier Italian political crises, due to the ECB’s supportive monetary policies. The spread between 10-year Italian government bond yields and that of German bunds rose to around 120bps before declining to around 113bps at the moment, leaving Italy able to borrow at near record low rates.

Italy’s large budget deficit is a concern without a robust economic rebound

The pandemic is still spreading fast. The government has extended a state of emergency to end-April as vaccination scales up.

Pandemic-related government spending – including an additional EUR 32bn (1.8% of GDP) support package announced last week – and a wider fiscal deficit continue to adversely affect the outlook for Italy’s public finances. We forecast a budget deficit of around 9% of GDP this year, after an estimated 11.5% in 2020, with public debt increasing to nearly 160% of GDP and continuing to rise thereafter, underlining the urgency of addressing the public-health crisis promptly.

Conte’s government has agreed on measures to solve structural economic bottlenecks within its national recovery and resilience plan (PNRR). The integration of NGEU and national fiscal stimulus would result in EUR 311bn allocated to six strategic missions over 2021-26, including accelerating digitalisation and the green transition, encouraging innovation and addressing social inclusion. The government has identified accompanying judicial, civil service and tax reform, without, for the moment, providing details.

Rome is counting on fiscal stimulus, ambitious reforms to generate faster growth

The government is counting on the PNRR to boost the economy by 0.5% of GDP in 2021, with the cumulative impact on output equivalent to more than 3pp by 2026, which, together with high forecasted primary surpluses, could return Italy’s public-debt ratio to pre-crisis levels by 2031.

This upbeat scenario from the Italian authorities relies on accelerating reforms to ensure the Italian economy sustainably grows faster – hence the danger of any prolonged political impasse in Rome that stymies decisive economic and fiscal policy making.

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

Giacomo Barisone is Managing Director of Sovereign and Public Sector ratings at Scope Ratings GmbH. Dennis Shen, Director, and Giulia Branz, Associate Analyst, contributed to writing this commentary.

Global Economic Outlook 2021: Global Growth Recovers amid High Debt; Changing Fiscal, Monetary Frameworks

Download Scope Ratings’ 2021 Sovereign Outlook.

 

Explainer video: Scope Ratings presents its 2021 Global Outlook

The pace of 2021’s recovery will be asymmetric across countries. China, where coronavirus first struck last December, will lead the global recovery with strong 9.9% growth next year – accounting for more than a third of global growth – with other leading global economies recording turnarounds: 4% in the US, 5.6% in the euro area, 3% in Japan and 6.6% in the UK.

We continue to expect recovery to gain a firmer foothold by the early spring of 2021 as vaccines are made available to at-risk segments of the population, better weather slows virus transmission and governments ease social and economic restrictions.

Full economic normalisation in 2021 and beyond will remain vulnerable to setbacks, however – partly from the risk of another wave of infection in countries that ease restrictions too speedily – such as in advance of the coming holidays.

There are both upside and downside risks to the 2021 global outlook, compared with our assessment of a downside skew to risk in entering 2020.

Debt is high and rising, although central banks mitigate immediate liquidity risks

Global government debt is close to a record 100% of GDP, while public debt trajectories are unlikely to reverse significantly post-crisis in the cases of some government borrowers. This represents a constraint for sovereign rating outlooks for countries such as France and Spain.

Rising household and corporate debt levels, in addition, hold implications for financial stability. Non-performing loans and defaults could rise as extraordinary support provided to protect households, jobs and business tapers as the crisis moderates next year.

Central banks have mitigated immediate sovereign liquidity risks in advanced economies. Due to central bank action, financing rates for governments in advanced economies have fallen compared with pre-crisis levels despite much higher debt. However, any normalisation steps of central bank policies could lead to a repricing of risk. In emerging economies, financing constraints are more significant as increased debt has escalated currency and debt crises.

Budget strategies transitioning to pro-growth orientation rather than austerity

The budgetary strategies of governments post-crisis will concentrate on maintaining pro-growth policies to achieve fiscal consolidation rather than relying on austerity as they did after the global financial crisis.

However, this carries its own long-term risks. If sustainably higher growth does not materialise after investment spending over the coming years, large deficits could translate to unsustainable debt dynamics, forcing more permanent central bank interventions.

Accommodative monetary policy and rising euro to support euro area borrowers?

Monetary policy will remain highly accommodative. Revisions to central banks’ policies in the context of asset purchases and ambitions to support green transitions could transform global central banking in the years ahead.

Meanwhile, the dollar remains the dominant global currency, with the euro still far behind entering 2021. Still, recent developments – notably the enlarged pool of euro area safe assets as the European Union issues debt to finance recovery – could enhance the euro’s global reserve currency role to challenge the dollar’s dominance longer term, with positive rating implications for euro area sovereign issuers over time.

EU issuance to finance the Recovery Fund as well as ECB asset purchases mark a fundamental transition in EU fiscal and monetary frameworks towards closer implicit fiscal and monetary union. This is positive for EU borrowers even though the landing zone for an EU architecture post-crisis remains unclear.

Environmental risks as a growingly significant thematic

We also expect governments, regulators and investors to pay increasing attention to environmental, social and governance risks, partly from the disruption caused by Covid-19.

Scope’s sovereign rating methodology now explicitly accounts for environmental credit risks via three factors: i) the transition risks to lower-carbon economies, ii) natural disaster risk and iii) ecological wealth.

2021 rating actions to hinge upon impact of crisis, policy response and credit profile

Scope currently rates 10 sovereign governments of a portfolio of 36 rated countries with a Negative Outlook, including the UK and Japan, while Ireland, Greece and Lithuania hold Positive Outlooks. Rating actions in 2021 will depend on the impact of the crisis and expected speed of recovery; the efficacy of monetary and fiscal policy responses; as well as the sovereign’s credit profile at a given rating level.

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

Giacomo Barisone is Managing Director of Sovereign and Public Sector ratings at Scope Ratings GmbH.

Global Economic Outlook: Gradual, Uneven Recovery Runs into Virus-Containment Challenge in Q4

Scope Ratings presents its updated economic forecasts

 

Download Scope Ratings’ Q4 macroeconomic update.

Scope Ratings’ baseline forecast is for a contraction in the global economy of around 4% in 2020, compared with its July forecast of a 4.5% slump, with growth rebounding by 6% in 2021, compared with a previous forecast of 5.8%. The 2020 forecast represents the sharpest global contraction of the post-war era.

However, under a stressed scenario, Scope expects a deeper global contraction of 6.5% this year and only 4.8% growth in 2021 assuming that, in the months ahead, governments reimpose lockdowns on a similar scale to those in early 2020 under this alternative scenario.

We have expected that the economic recovery would become more uneven and subject to interruption by this stage in 2020 after the sharp recoveries mid-year when governments ended lockdowns in Europe and North America. The re-imposition of restrictions to contain the resurgence in Covid-19 will inevitably have an impact in curtailing economic activity.

While the trajectory of Covid-19 remains uncertain, our baseline scenario remains for a severe contraction in output in 2020 even though, as governments and public health sectors are better prepared than in March and April, we don’t generally expect a return in the coming months to the same scale of drastic restrictions of earlier this year.

However, under any scenario, the return to more normal levels of economic activity will take time and there will be setbacks as we are now experiencing.

Second coronavirus wave has slowed or even temporarily reversed national recoveries

Second waves of Covid-19 have slowed or even temporarily reversed national economic recoveries. The latest measures to contain the pandemic will slow down the recovery particularly in more hard-hit countries such as the US, the UK, Spain and France. After moderate interruptions to economic recoveries in Q4, including outright contractions in Q4 GDP expected in multiple cases, recovery should regain momentum by the spring of 2021.

An important possible exception to significant renewed economic restrictions in Q4 is China, with a sustained recovery since the first quarter as authorities have mostly contained the transmission of Covid-19 over recent months. We forecast growth in China of 1.3% this year – the weakest since 1976 – accelerating to 9% in 2021 (revised upward 2.6pps from July forecasts). The revision to 2021 China growth expectations drives a higher 2021 baseline global growth forecast.

Emergency financial measures to protect households, workers, and businesses – including around EUR 700bn in fiscal stimulus in the euro area – amid the lockdowns and other healthcare-related restrictions have led to rapidly rising government borrowing. Higher debt ratios weaken general government balance sheets. In addition, putting fiscal consolidation on hold as central banks ensure easy financing conditions creates moral hazard. These are credit concerns – though ratings implications will vary country by country.

Forceful policy responses have placed a floor beneath economies, protected jobs market

At the same time, the forceful monetary and fiscal policy responses to this crisis have moderated the degree of deterioration in sovereign creditworthiness near term. Countermeasures have put a floor beneath the economy, maintained low interest rates for many public sector borrowers and transferred significant sovereign debt from private sector balance sheets to central banks, in addition to forestalling sovereign liquidity crises. This explains the only modest downward rating actions we have taken so far in this crisis.

In the euro area, we have revised the Outlook on ratings for Italy (BBB+), Slovakia (A+) and Spain (A-) to Negative. Turkey lost its BB- ratings in July, when it was downgraded to B+.

The modest upward revision to Scope’s 2020 global baseline forecast to -4% mostly reflects somewhat more optimistic assessments of activity in the US (+1.5pps to -6%) and the euro area (+0.6pps to -8.5). Spain (-12%), France (-10.1%) and Italy (-9%) will nonetheless experience deep recessions this year, compared with a less drastic slump in Germany (-5.6%). Euro area unemployment has, however, not increased in line with the depth of output losses due to the exceptional policy action undertaken.

Outside the EU, the UK faces among the world’s deepest recessions with a contraction of 10.8% in 2020, including continued anticipation of a quarter-on-quarter contraction in Q4, though the UK could also see one of the sharpest recoveries next year, with growth of 8%. Scope expects milder recessions in Turkey (-1.4%) and Russia (-5.5%) this year than previously forecast.

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

Giacomo Barisone is Managing Director of Sovereign and Public Sector ratings at Scope Ratings GmbH.

Global Economic Outlook 2020 Update: Gradual and Uneven Global Recovery; Significant Risks Still on Horizon

Download Scope’s Q3 2020 Sovereign Update (report)

Scope Ratings’ latest baseline scenario embeds a renewed increase in Covid-19 infections in the second half of 2020 in advanced economies, but one that is “manageable” in most such nations. Renewed virus transmission does not halt economic recovery but forces it onto a more gradual and uneven trajectory.

Only a selective second round of economic restrictions is imposed; more intensive in countries such as the United States or the United Kingdom. This scenario is similar to a check mark- or wing-shaped global recovery with a decelerating recovery slope after the speedy pick-up in activity of recent months.

“The implications of this crisis more broadly for the creditworthiness of sovereign states link significantly to the activation of monetary and fiscal policy responses,” said Dr Giacomo Barisone, head of sovereign ratings at Scope Ratings. “These raise debt ratios longer term, could increase moral hazard and weaken government balance sheets. Higher unemployment, non-performing loan ratios and private sector default instances weaken private and banking sector resiliencies – especially under our stressed scenario.”

“However, central bank actions continue to transfer a significant share of new public debt to monetary authorities – momentarily at least easing the scale of sovereign liquidity or solvency risk from the standpoint of private sector creditors,” Barisone says. “Weakened reserve coverage ratios and FX instability are additional risks to emerging market issuers.”

Sharp 2020 contractions globally; 2021 recovery speeds vary

Under the rating agency’s baseline economic scenario, the euro area (EA) economy contracts sharply – by 9.1% in 2020, led by deep recessions in Spain (-12.5%), France (-11.0%) and Italy (-10.0%), with a more moderate growth decline in Germany (-5.5%). Of the four largest euro area member economies, expected 2021 recoveries range from 3.2% in Germany to 7.5% with Italy.

The UK, the US and Japan also see significant contractions in activity in 2020 (-10.4%, -7.5% and -6.0%, respectively), with recoveries of 8.8%, 6.0% and 3.0% in 2021. China sees its weakest economic growth since 1976 of 1.3% in 2020, while Russia’s and Turkey’s economies contract by 6.8% and 4.2% respectively.

A stressed scenario assumes fresh lockdown in H2 2020

In a stressed scenario, there is a second round of coronavirus cases and non-essential economic activity in Europe and the US by Q3 or Q4 2020, forcing countries to reimpose highly disruptive full or partial lockdowns – leading to a double-dip economic contraction extending into prolonged economic weaknesses in 2021.

This stressed case is akin to a W-shaped recovery with, on top, severely weakened economic conditions in 2021. The stressed scenario sees global growth contract by 7.3%, with the EA seeing growth decline by 12.7% and the US by 12%. China experiences near zero growth. Under the stressed scenario, 2021 economic recoveries are more moderate.

“There is both upside and downside risk to Scope’s economic baseline, however,” said Barisone. “A more robust-than-anticipated release of pent-up demand supported by extraordinary fiscal and monetary stimulus and/or better than anticipated Q2 2020 GDP could present upside growth potential. Conversely, downside growth risks include those under the stressed case or any reversal in inflated global asset markets, crystallisation of corporate debt risks or intensification of global trade tensions.”

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

Giacomo Barisone is Managing Director in Public Finance at Scope Ratings GmbH.

Central and Eastern Europe: Covid-19 Shock Triggers Deep Recession

Scope Ratings says that, with the euro area economy set to contract by about -6.5% in 2020 under a baseline scenario (and -11.5% in a severe scenario), EU-member CEE countries will also slide into deep recession this year. In the rest of the emerging Europe region, Russia faces the additional impact from lower-for-longer oil prices.

Turkey is vulnerable to the present global financial market turmoil. This relates to high volatility in FX and bond markets, which is likely to remain so over the duration of Covid-19 lockdowns, reflecting crisis impacts on global risk aversion. CDS and bond yield spreads in CEE widened markedly in mid-March before narrowing again in some cases more recently.

Varying magnitudes of economic contraction and sovereign ratings implications

The magnitude of this year’s contraction will vary from country to country, but the economic impact of the pandemic alongside higher spending needs will sharply widen budget deficits and push levels of public debt back towards 2014 levels for most CEE governments.

How severe the impact turns out to depend on how quickly and durably lockdowns in CEE economies as well as in western Europe can be relaxed, how effective the monetary and fiscal response to the crisis proves, and how fast an economic recovery takes hold later on in Q2 and through the second half of the year.

“The current situation is exceptional for CEE countries on four fronts,” says Giacomo Barisone, head of sovereign ratings at Scope. “The countries face: i) an unprecedented supply and demand shock to services sectors; ii) the adverse impact of global supply-chain disruptions and temporary suspensions of critical regional car industries; iii) renewed volatility in capital and currency markets; and iv) a collapse in oil prices, meaningful especially for Russia,” Barisone says.

Cyclical implications of the crisis relate to risks linked to rising unemployment, corporate defaults, borrowing rates, and FX and banking sector risks. Structural implications correspond to monetary and fiscal policy responses being deployed – which raise debt ratios longer-term and weaken the private sector and government balance sheets.

Sharp economic contractions in EU member states of CEE

In Scope’s baseline scenario, output in Poland and Hungary will contract by around 4% in 2020. In Poland, an important factor is the high share of temporary employment and self-employed, each around 17% of total employment, with these agents usually having limited cash buffers and are thus more exposed in times of economic distress. In contrast, Hungary has one of the highest exposures to global value chains among CEE countries, which constitutes a key risk in times of global economic turmoil.

Under the baseline scenario, Scope forecasts that output will contract by around 5.5% in the Czech Republic and Slovakia, given reliance on car industries, which account for 10% and 13% of their GDP, respectively, and by almost 7% in Slovenia, which has high goods trade with a severely weakened Italian economy. Romania’s economy will contract by around 4.3%, with limited room for fiscal stimulus, given the country’s already elevated budget deficits.

Bulgaria’s output will shrink by 4.6% this year. Croatia’s economy will be heavily hit – with a projected contraction of almost 7.5% in 2020 – given its dependence on travel and tourism, which contribute around a quarter of GDP (indirect activities linked to the sectors included). The small, open economies of the Baltic states will shrink by over 6% each.

Deep contractions in the rest of emerging Europe

For Russia, Scope has revised a baseline growth projection to around -5% in 2020, accounting for the recent oil price collapse, with Brent crude oil prices now trading around USD 20 a barrel at time of writing even after OPEC+’s 10m barrels a day output cut decision.

Scope anticipates a GDP contraction of 5% in 2020 in Turkey, revised down from an earlier estimate of about -1% in 2020. Turkey’s external sector weakness, including significant FX debt exposure and high external debt outstanding, increases its sensitivity to any extended period of global economic weakness and/or “risk-off” market conditions. Lastly, Georgia’s externally-exposed economy may contract over 3% in 2020.

Risks to baseline assumptions remain skewed to the downside as growth in CEE could be weaker if the economic shock from the Covid-19 crisis endures longer.

Read more in the rating agency’s Q2 2020 CEE Sovereign Update.

Giacomo Barisone is Managing Director in Public Finance at Scope Ratings GmbH.

Covid-19 Pandemic Creates High Risks, Triggers Deep Global Recession

2020’s global recession will be deeper than even that seen in the global financial crisis trough of 2009 when world output contracted by 0.1%, says Scope Ratings. For more detail, see Scope’s Q2 2020 Sovereign Update: Covid-19 pandemic’s economic impact: significant risk as the world economy falls into recession.

None of the world’s largest economies will escape the pandemic’s macro-economic and financial-sector impact. We forecast an economic contraction of around 6.5% for the euro area in 2020, with the steepest declines in Spain (around 8%) and Italy (around 7.5%) with Germany’s economy shrinking 5.2% and France’s by 6.3%. China grows only 4%, while the United States contracts around 3.5% and Japan’s GDP recedes 4%.

Double impact on sovereign ratings

“The pandemic-linked recession will have a double impact on sovereign credit ratings,” says Giacomo Barisone, head of public finance at Scope.

“The cyclical implications of this crisis relate to the severity and duration of the downturn in the near-term with risks linked to rising non-performing loans, unemployment and corporate defaults,” Barisone says.

“Structural implications correspond to the extraordinary mobilisation of monetary and fiscal policies to respond to the economic impact of the health crisis, which will raise debt ratios longer-term and structurally weaken private sector as well as government balance sheets,” he says.

Higher borrowing rates and currency depreciation are further rating-relevant risks.

Countries most exposed include: China (rated A+/Negative), Japan (A+/Stable), Italy (BBB+/Stable), Spain (A-/Stable), and Turkey (BB-/Negative).

Assumptions in baseline forecasts

“We have made several assumptions, including the prospect that, in China, the outbreak stays fairly contained after end-March, while in Europe and the US, there is momentary but marked slowing of infections by end-Q2,” Barisone says. Scope assumes an associated gradual lifting of containment measures during Q2 and entering Q3.

“Our baseline forecasts reflect, moreover, the assumption that economic output among most developed economies declines sharply over Q1 and Q2 and gradually recovers starting in Q3, with the strength and durability of this recovery subject to risk in the second half of the year and depending on the country,” Barisone says.

Thirdly, the recovery in China, where the coronavirus outbreak started, and the country that plays such a crucial role in global supply chains, will precede those in the US and Europe, with the latter economies beginning to recover after a delay.

“The recovery, when it does take place, will reflect the pandemic’s longer-lasting impact on supply chains and sentiment and the impact of potential further waves of coronavirus infection, which is why we see neither a dramatic V-shaped turnaround nor a prolonged L-shaped slump,” says Barisone.

Risks to baseline outlook

“That said, we cannot ignore downside risks to our economic baseline,” Barisone says.

In one stress case scenario, assuming lockdowns and quarantine policies are extended significantly in western economies to the end of Q3 2020, global growth would contract an unprecedented 3.5%, with a 11.5% decline in the euro area and 8.0% drop in the US economy. China would experience its slowest growth since 1976 of about 2%.

Giacomo Barisone is Managing Director in Public Finance at Scope Ratings GmbH.

Exceptional Circumstances Demand Exceptional Action: Scope on Europe’s Covid-19 Crisis Response

Below is an interview with Giacomo Barisone, managing director in sovereign ratings at Scope Ratings.

Are European governments’ responses to the coronavirus crisis the right ones?

Governments in Europe have realised the gravity of the circumstances and are enacting two types of policies: i) containment measures to respond to and mitigate the public health crisis and ii) policies to reduce the economic impact of the crisis.

Tough containment measures are negative for near-term growth, but assuming that they achieve desired ends of slowing transmission – as they have in parts of the world like China and Taiwan – they support prospects of gradually “flattening the curve” of infection rates: that is, ensuring a slower rate of transmission and thus, lowering the strain on hospital capacity and fatalities.

Assuming the containment measures slow the coronavirus’ transmission in the coming months in the northern hemisphere, a focus by governments on alleviating the impact of the crisis on businesses and households is key.

In this context, action by national governments and the European Commission, including liquidity guarantees and targeted support to groups most likely to suffer from the effects of the pandemic – such as the self-employed and small businesses – are what is needed at this stage.

Banks are unlikely to extend loans to businesses that have now become riskier owing to limited cash flows. Tough containment and economic- and liquidity-support measures could abet a very gradual recovery, hopefully starting in H2 2020. However, risks of continued transmission of the virus and/or a new wave in the fall or winter could still have an impact in H2 2020.

What do you think of the ECB’s announcements so far including the ECB’s new emergency package?

The ECB delivered last week a well-designed package of emergency measures to counter the shock, including attractively priced liquidity to the banking system and additional asset purchases to ease significant market anxiety.

The new Pandemic Emergency Purchase Programme (PEPP) of EUR 750bn of new purchases of public- and private-sector securities extending to at least the end of 2020 implies cumulative new asset purchases of almost EUR 1trn when combined with the package announced earlier in March.

Importantly, the ECB is giving itself more room for manoeuvre by conducting securities purchases under this programme with greater flexibility with regards to time and across asset classes and jurisdictions, including a waiver that allows for the purchase of Greek securities.

In addition, the ECB Banking Supervision agreed to temporary capital and operational relief for euro area banks, which should mitigate pro-cyclical, unintended consequences.

This ECB decision also allows for consideration of public-sector issuer limit changes and de facto activation of Outright Monetary Transactions without conditionality via facilitation of the front-loading of purchases for certain countries. The action also underscores authorities’ commitments to avoid the Covid-19 economic shock deepening the existing financial crisis, which could, if left unchecked, exacerbate the overall economic dislocation caused by the pandemic.

What is the impact on Europe’s economic outlook?

We expect a strong downward revision to growth in H1 2020.

Prior to the outbreak of the COVID-19 crisis, we expected moderate euro area growth of just above 1% for 2020. Now, depending on the duration of the lockdowns, the economic impact will be severe. On average, in line with a recent ECB update, we assume for now a 1.5 to 2.0pp decline in growth for each month a country is in lockdown, which for the euro area implies deeply negative growth for 2020.

Will the containment, fiscal and monetary policy response be enough?

This is too soon to tell.

The key for overcoming this crisis is to slow the transmission of the virus until ultimately immunisation treatment is available for public use (hopefully by 2021). The earlier containment measures work, the sooner they can be relaxed in gradual phases, bringing businesses and households back towards normality. In this context, the national and European policy responses are now accelerating and in the right direction.

Will countries breach the European fiscal rules?

No. The Stability and Growth Pact allows for deviations from the 3% fiscal deficit rule under exceptional circumstances and the European Commission has indicated leniency in this regard at least for the year 2020.

Therefore, even if countries’ 2020 deficit figures break beyond 3%, which may be the case for Italy (BBB+/Stable), France (AA/Stable) and Spain (A-/Stable) among others, member states would still be compliant with budget rules as these have been suspended under a “general escape clause” for 2020.

Does this crisis put sovereign ratings for countries at risk?

Our focus in the current environment will be on assessing whether temporary and urgent fiscal measures enacted by governments to counter the public health emergency will have implications that persist over the medium-run as well.

At this stage, the prospect of one-off 2020 fiscal deficits closer to or above 3% of GDP in 2020 is not in and of itself a reason to downgrade a sovereign’s credit ratings. The size and potential longevity of the current simultaneous demand and supply shock induced by the crisis warrant a significant fiscal effort to mitigate the economic impact.

The pandemic is an external shock that will ultimately hit most countries of the world, albeit to varying degrees depending on the effectiveness of containment actions, hospital capacity, policy responses as well as economic structures and fiscal resilience.

COVID-19 is exacerbating risks especially for countries already experiencing low growth and/or those with elevated debt ratios, external vulnerabilities and/or financial system fragilities. Countries whose sovereign ratings might be more likely to be affected include China (A+/Negative), Japan (A+/Stable), Italy (BBB+/Stable) and Turkey (BB-/Negative).

Giacomo Barisone is Managing Director in Public Finance at Scope Ratings GmbH.