Oil Price Shock on Top of Coronavirus Compounding Sovereign Credit Risks

As if the fallout from a rapid spread of the novel coronavirus wasn’t bad enough, now an oil price war has just knocked the bottom out of the already-weak financial markets. This is going to have a compounding effect that may hurt sovereign credit. Fitch Ratings has warned that the dual shocks will put pressure on some sovereign credit fundamentals and potentially on their ratings.

As for developed markets, Fitch sees the key drivers as the effect on growth, if the current situation persists and the responses on fiscal and monetary measures. Emerging markets are shown to face additional risks related to commodity export receipts, capital flows and exchange-rate pressures.

After seeing the biggest one-day drop in the price of oil in nearly three decades, there is a reference to how low oil prices weighed on ratings of major exporters in 2014 to 2016. Fitch warns that this will happen again if the oil price war between Saudi Arabia and Russia leads to sustained lower prices. After the collapse in oil prices in 2014, numerous emerging market sovereign downgrades were seen and many of the oil-exporting sovereigns are said to be still struggling to adjust to that shock. Breakeven oil prices are now well above the current market rates.

Nations that are higher-rated exporters are said to have large buffers, mainly in the form of sovereign wealth funds. That said, Fitch sees the impact of these low oil prices may be worse than the economic impact of the coronavirus. Sovereigns with large direct and indirect contributions to gross domestic product from tourism include Macau, Thailand, Maldives, Croatia, Iceland, the Seychelles and several Caribbean islands. The Fitch report said:

The economic effects of an oil shock maybe longer lasting that those from COVID-19. Indeed, the impact of cyclical economic downturns on sovereign credit profiles is typically temporary as countercyclical policies and automatic stabilizers are usually reversed during subsequent recoveries. Nevertheless, some of the economic effects of COVID-19 are likely to linger, especially in sectors such as travel and tourism.

More warnings on top of a weaker economic outlook come in the form of lower tax revenues and increasing demands on government. The report added:

Several international institutions are encouraging national authorities to enact fiscal support measures. The IMF, for example, points to an urgent need for sufficient frontline health-related spending along with initiatives to confront supply and demand shocks. Political pressures for direct support to affected industries and workers will intensify.

A number of sovereigns already have announced fiscal or pending actions. These include China, Japan, Korea, Singapore and Malaysia in Asia, where COVID-19 spread initially, and Italy, which has been most affected in Europe. A G7 statement pledged “fiscal measures where appropriate”, following a call among finance ministers and central bank governors on the virus and its economic implications.

Perhaps a larger worry about existing sovereign pressure, Fitch now expects the list of sovereigns engaged in fiscal expansion to grow much longer. It also recognizes that timely and targeted policies can help to reduce the risk of a permanent loss of output. Rather than using the low interest-rate environment to undertake fiscal consolidation, most G7 governments have increased non-interest spending, effectively preserving historically high levels of public debt. Fitch added:

A global monetary easing cycle is underway, most notably with the recent 50bp cut by the Federal Reserve. From a sovereign rating perspective, the focus will be on the extent to which lower rates or additional liquidity contributes to further debt accumulation by the public and private sectors in countries with prior concerns about the implications of high debt for macroeconomic stability or the integrity of the financial system. China is a notable example, though there is still no sign the central bank is deviating meaningfully from its de-risking campaign or that a large-scale monetary and credit policy loosening is forthcoming.

Emerging market sovereigns face risks associated with changes in global investor sentiment that may harm external funding conditions, lower commodity prices or diminished trade volumes that would weaken the balance of payments. The threat from lower commodity prices was already manifest as COVID-19 weakened global growth prospects, and we viewed this as the main channel to Middle East & Africa sovereigns via the hit to fiscal revenue, foreign-currency earnings and economic growth, and this will be significantly magnified if oil prices do not recover from their current levels. Commodity dependence is also common across Latin America. Globally, it is most pronounced in Angola, Iraq, Suriname and Gabon, and there are a dozen more EMs for whom commodities exceed 70% of foreign-currency income.

Investor sentiment can ultimately affect capital flows, and EM sovereigns whose currencies have weakened the most against the US dollar since end-2019 include Brazil, Uruguay, South Africa and Chile. Those with the largest external funding requirements (including short-term debt) in dollar terms in 2020 are Brazil, India, Turkey and Poland.

With the 10-year Treasury yield now under 0.60% and with the 30-year Treasury yield just under 1.00%, this feels like a time when many emerging markets, particularly those with a high dependence on tourism and oil, might have less demand as the world is moving its assets into safe-haven assets.

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