The North Atlantic financial crisis has shown that the biggest risks to the global financial system lie not in the periphery, but in the heartland of capitalism.
While emerging markets were at the centre of earlier crises, such as the Latin American debt crises of the 1980s, Mexico’s tequila crisis in the early 1990s and the Asian bust of the late 1990s, the last two severe jolts to the global economy—the dot-com implosion and the current crisis—had their roots in the developed world. That hasn’t, however, led to a corresponding change in the way the rating agencies look at the emerging markets.
Look, for instance, at Italy. Government debt is 101% of the gross domestic product (GDP), according to a report from McKinsey Global Institute, and total debt, including that of households and businesses, is 298% of the GDP. Italy’s sovereign rating, according to rating agency Standard and Poor’s (S&P), is A+.
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The McKinsey study says that they see a risk “that the mature economies may remain highly leveraged for a prolonged period, which would create a fragile and potentially unstable economic outlook for the next five to 10 years.” And in a recent speech John Lipsky, first deputy managing director of the International Monetary Fund (IMF), said that all the G-7 countries, except Germany and Canada, will have public debt to GDP ratios close to or exceeding 100% by 2014.
A note by Credit Suisse points out that fiscal deficit of the UK is the worst according to IMF data. Says the note, “We think that £/$ could weaken to 1.35 as we believe seven factors are worse than the US: UK consumer leverage, UK banks leverage, UK fiscal position, the rise in inflation swaps, the overvaluation of housing, the reliance on QE (quantitative easing) to fund the budget deficit and, although the UK economic momentum has improved recently, it’s still worse than (that of the) the US.” UK’s rating, according to S&P is, of course, AAA.
Even Greece, which was at the centre of the recent crisis in the European Union and which has a fiscal deficit of 12.7% of GDP and a public debt to GDP ratio of over 100%, has a rating of BBB+. Contrast Russia’s public debt of less than 10% of GDP and its rating of BBB. Or contrast India’s consolidated debt to GDP ratio of around 80% (with practically all the debt being domestic debt), its 8% GDP growth rate and its foreign exchange reserves of around $280 billion (around Rs12.76 trillion) and its sovereign rating of BBB-.
Moreover, the financial systems in emerging economies have suffered only a few scratches from the crisis, while those of the developed world are, in many instances, still on life support from the government. In short, the point of reiterating all these instances is to suggest that the risks in the mature economies are being underestimated, while those in the emerging economies are being overstated.
So far, however, these sentiments were usually restricted to people from emerging markets wondering why their countries didn’t get a better credit rating. But that is changing. Deutsche Bank Research has pointed to precisely this discrepancy in a recent note “The great risk shift—or why it may be time to rethink the developed/emerging markets distinction”. The note tries to understand just why rating agencies are so reluctant to upgrade emerging markets vis-a-vis their developed counterparts.
Here’s the crux of its argument: “The rating agencies rated Greece A until very recently, while both Indonesia and Turkey carry a sub-investment-grade rating. The rating agencies rationalize this in various ways. Sovereign ratings assess creditworthiness ‘through’ the cycle. Typically, the investor base in the DM (developed market) is much broader, domestically and internationally. Capital markets are much deeper, and their sovereign debt structures are often (though by no means always) less vulnerable than in the average EM (emerging market). Finally, DM debt service track records are typically very strong. While some of these arguments have some merit, the rating agencies almost certainly underestimate the improvement in the creditworthiness of EM sovereigns and potentially underestimate the deterioration in DM creditworthiness.”
It goes on to debate whether it’s political risk in emerging markets that may be the problem. It’s hard to see much political risk in India and, in fact, it may be claimed that the nanny states of Europe are more vulnerable to social unrest as a result of cutting back on their social security expenditures than the Asian states, which have no social safety nets anyway.
It’s time rating agencies removed their blinkers and realized that the world around them has changed, though, given their track record, that may be too much to hope for. The markets, however, seem to be adjusting to the new realities, especially after the crisis in Greece. While spreads on emerging market bonds have continued to narrow, spreads on credit default swaps of developed markets widened. Recently, fund tracker EPFR Global reported that emerging market bond funds had their biggest weekly inflow in over a decade.
The world’s centre of economic gravity is shifting from the North to the South. The markets are waking up to the new reality.
Manas Chakravarty takes a weekly look at trends and issues in the financial markets. Your comments are welcome at email@example.com