Ratings
Analyst:
John Chambers, CFA, New York (1) 212-438-7344; David T Beers, London
(44) 20-7847-7101
Publication date: 11-Feb-03, 20:08:40 EST
Reprinted from RatingsDirect
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Political Risk
Economic Structure and
Growth Prospects
Fiscal Flexibility, Actual and
Contingent Liabilities
Monetary Stability
External Finances
Conclusion
As the threat of war looms against Iraq, questions arise about
how such a conflict might affect Standard & Poor's 93 sovereign
ratings and about the possible events that could lead to changes
to those ratings. Should war break out, the creditworthiness of all
the rated sovereigns in the Middle East (broadly defined as
Bahrain, Egypt, Israel, Jordan, Kuwait, Lebanon, Oman,
Pakistan, Qatar, Turkey) would come under scrutiny. Countries
that rely heavily upon commercial cross-border financing,
however, may be more at risk.
Ratings are forward-looking assessments of an issuer's capacity
and willingness to service its debt on time and in full. Ratings are
also meant to withstand normal economic, political, commodity,
and interest-rate cycles. Given their forward-looking nature,
ratings draw from judgments by senior analysts as to how
business or political leaders will react when faced with
exogenous shocks. A war in Iraq could push the four cycles out
of their normal range and would test the mettle of all leaders.
Standard & Poor's has maintained its sovereign ratings with a
view that a war, should it occur, would be short and decisive. Its
impact on oil and other commodity prices (including gold) would
be short-lived. Weakness in regional tradable currencies, such as
the Israeli shekel, the Egyptian or Lebanese pounds, or the
Turkish lira, would be manageable. Risk aversion by crossborder
investors and lenders would not rise materially. Under this
benign set of assumptions, any downgrades of sovereign ratings
would stem from factors specific to decisions by the governments
themselves. Conversely, the boost to global consumer and
investor sentiment ensuing from a change in Iraq's regime could
help governments reliant upon commercial external financing and
ease the geopolitical threat currently facing several sovereigns in
the region.
However, as argued in "Looking Back, Looking Forward: A
January View of Sovereign Credit Trends" (RatingsDirect, Dec.
19, 2002), a war in Iraq would tilt the risks to the downside.
Although the most likely outcome of a war in Iraq would be a
speedy victory, much worse scenarios could unfold. A war could
be prolonged, with extensive street fighting in Iraqi cities. Iraqi oil
wells could be set afire. Collateral war damage could extend
beyond Iraq, with extensive damage to oil and port facilities in the
Gulf States. Tel Aviv could be attacked with chemical or
biological weapons. Events such as these could raise the risk to
sovereign creditworthiness in several ways. Following the
methodology for rating sovereign governments set out in
"Sovereign Credit Ratings: A Primer," (RatingsDirect, April 3,
2002), they can be grouped into five categories.
Political Risk
Economic Structure and Growth Prospects
All of the sovereign ratings in the Middle East incorporate
geopolitical risk posed by bellicose regional sovereigns, by the
Intifada, and by the concentration of decision making in those
countries that have limited representative forms of government.
In some cases, the political risk limits upward movement on the
ratings. In none of the ratings is the political environment a
supporting rating factor. However, the rationales for almost all of
the sovereign ratings in the region assume that any conflict will
not inflict permanent damage to a country's productive capacity
and that the current leadership can withstand economic and
political shocks without losing broad support of their populations
for market-oriented programs.
Demonstrations against a war in Iraq may take place in the
Middle East, in Europe, and, indeed, in many countries with
sovereign ratings. In the Middle East and North Africa such
demonstrations may appear to threaten the established order,
but, in fact, may be a useful mechanism that allows public
expression to release local tensions and direct them toward
outside foes. Standard & Poor's views the existing political
institutions in the region as sufficiently strong to resist any
uprising over war protests.
However, if these assumptions prove wrong, if the collateral war
damage is greater than expected, if the current regional
leadership does not respond as well as it responded during
Operation Desert Storm, or if policymaking is paralyzed by civil
dissent, then Standard & Poor's reappraisal of the political risk for
the sovereigns concerned will lead to lower ratings.
Setting aside the risk that a war may result in lasting damage to
the ports, natural gas facilities, or oil wells of the Gulf States
(which, as stated above, is not part of Standard & Poor's central
forecast), a war in and of itself would not materially alter any
rated sovereign's economic structure. Economies that enjoy a
high level of income would continue to do so. The structure of
industry and the operation of labor markets would not be
affected. Financial intermediation and demand for money should
be unchanged, unless the war takes a very bad turn.
However, global growth prospects for the next several years will
be made hostage to the war's outcome. A brief war with limited
collateral damage would bolster prospects for a subsequent
global recovery. However, a prolonged war would keep oil prices
high, perhaps at even twice their current level, which, in turn,
would induce a global economic contraction. All 93 rated
sovereigns would be tested in such an environment. Their fiscal
accounts would worsen, except for the handful of sovereigns with
state-owned oil companies that contribute a large share of
government revenue and national exports. External imbalances
(of both creditor and debtor countries) would become more
pronounced. Trade and capital flows would constrict. Sovereign
ratings that currently have a negative outlook (such as those of
Brazil, Guatemala, India, Israel, Italy, Jamaica, Japan, Morocco,
Fiscal Flexibility, Actual and Contingent
Liabilities
Monetary Stability
the Philippines, and Ukraine,) would be at particular risk of
downgrade.
A traditional fiscal objective of government is to strive in
prosperous periods to maintain flexibility in its budget and to
keep its debt stocks low in order to be able to marshal resources
quickly in time of political and economic pressure, including war.
Thus, for example, a shift in the general government deficit of the
U.S. to a 2.8% of GDP deficit in 2003 from a 0.4% of GDP
surplus in 2001 would not be of concern if it had stemmed only
from inland security and preparations for a war with Iraq (given
the fiscal prudence of the previous decade and America's
relatively modest levels of general government debt, at 51% of
2002 GDP). However, this war comes at a time when several
other sovereigns have particular vulnerabilities (at their various
rating levels) on the fiscal side. War only worsens these fiscal
risks.
Israel's ratings came under pressure in 2002 because of
mounting fiscal problems. Although the government was able to
meet its revised fiscal target for the past year and to pass a
prudent budget for 2003, the worsening economic environment
will necessitate further expenditure reductions. These reductions
may be hard to obtain given the coalition dynamics in Israel, and
its ratings may suffer as a consequence. Lebanon, Turkey, and,
to a lesser extent, Morocco and the Philippines all face
deteriorating debt dynamics, given a past accommodative fiscal
stance, diminished prospects for privatization receipts, and high
debt stocks. Public finances are especially fragile in Lebanon and
Turkey, and without a successful fiscal adjustment these
sovereigns will default. Morocco and the Philippines enter this
potentially troubled period in a stronger position, but they, too,
face downgrades if deficits persist at their current levels.
Most of the sovereign governments in the Middle East have
strong international reserve positions relative to their monetary
bases and stable monetary aggregates. Some Middle Eastern
governments have recently have taken proactive measures to
increase their monetary flexibility. For example, Egypt decided
last month to float the Egyptian pound.
Although banking systems in the region are generally adequate
given the state of development of their respective economies,
three systems were singled out in Standard & Poor's annual
survey of banking conditions as already under stress (see
"Global Financial System Stress," RatingsDirect, Dec. 11, 2002).
Should the war turn badly, this stress will only grow for Egypt,
Lebanon, and Turkey. The fragility of the current state of the
economy and the quality of past loan underwriting standards
have left Turkey and Egypt particularly vulnerable to spiking
levels of nonperforming loans. Standard & Poor's estimates that,
in a reasonable worst-case scenario, gross problematic assets (a
concept more inclusive than nonperforming loans as defined by
domestic regulators) could exceed half of domestic credit in
External Finances
Turkey and Egypt. Although the fiscal costs of providing
assistance to these three banking systems is not
disproportionate to the governments' existing levels of debt
outstanding (given the low level of financial intermediation),
system-wide banking crises in any of the three countries would
disrupt domestic government finance, create difficulties in rolling
over interbank cross-border debt, and would depress economic
activity.
A war with Iraq could worsen many sovereigns' external finances
through two channels. First, the loosening fiscal stance of the
U.S. is likely to keep its current account deficit near 5% of GDP.
Financing this deficit will continue to absorb international capital
flows that would be otherwise available for investment
elsewhere. Nations that rely heavily upon foreign capital and that
are not large exporters to the U.S. would be most affected.
Second, heightened uncertainty would (if Standard & Poor's
assumption on the course of a war proves optimistic) lead to
increased risk aversion, particularly on the part of cross-border
investors. Countries with large commercial external financing
requirements (be they from the public or private sectors) would
be at greater risk than those that do not rely upon confidencesensitive
capital flows. Sovereign ratings at risk would include
those of Brazil, Dominican Republic, Jamaica, and Turkey. To a
lesser extent, the ratings of Belize, Mexico, and the Philippines
could also come under pressure.
Policymakers, however, can mitigate these risks. In some cases,
sovereign governments have been active in raising external
financing early in this year to satisfy much of the public sector
external borrowing requirement. Colombia, Peru, and Chile, to
name but three, have been active issuers in January. Others
sovereigns, such as South Africa, have deep domestic capital
markets with strong local banks. Ongoing privatization programs,
as in Bulgaria, can also help. But indirect risks remain to a
sovereign if the private sector cannot roll over its external debt.
Such is the risk in Brazil, for example, which could place
renewed pressure on the Brazilian real and again increase the
cost of servicing dollar-denominated and dollar-linked public
sector debt due to the effects of currency depreciation.
In other cases, sovereigns have markedly augmented their
international reserves ( China, Hong Kong, Korea, and India).
These reserves can help instill confidence and compensate for
any interruption in inward capital flows. Even though high
reserves are neither a substitute for prudent fiscal policy (see
"Asia: External Strength Can Mask Internal Weakness," Ratings
Direct, Sept. 24, 2002) nor a buttress for political stability, they
expand a sovereign's room to maneuver.
For the Middle Eastern sovereigns in net external asset
positions, this room to maneuver should allow them to safeguard
their financial systems and to ease pressure on their local
currencies. For the net external debtor countries without widely
traded currencies, however, the lack of room to maneuver will be
a stern test.
Conclusion
Within each component of our sovereign rating opinion, Standard
& Poor's makes key forward-looking assumptions. On politics,
they include judgments about internal political stability and the
possibilities of war. On the real economy, they reflect trends on
competitiveness and global economic growth prospects. On
fiscal and monetary policy, they center on the willingness of
policymakers to adjust when needed. On the external position,
they focus on the willingness of policymakers to husband
international reserves and to prefinance maturing external debt,
and on the private sector's capacity to maintain access to
international capital markets. They also make assumptions on
the likelihood of support from the International Monetary Fund
being forthcoming in the case of a balance of payment crisis and
the possibility that such support could engender private sector
involvement requiring debt forgiveness. A quick and decisive
war, if it occurs, should not occasion much change to sovereign
creditworthiness among rated governments. A more difficult war
would be a greater challenge, one that will not necessarily
dissipate as the distance from Baghdad increases. Sovereigns
reliant upon global growth to improve domestic living standards
or to maintain fiscal debt trajectories and, particularly, countries
reliant upon commercial external debt may be far from the
conflict but have their creditworthiness hurt more than those
nations directly in the fray.
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