Which EM sovereign credit ratings are due for adjustments?

Summary

In this report, we update our sovereign credit ratings framework and offer insight into which emerging market sovereigns could see notable adjustments to their credit ratings in the coming quarters. According to our analysis—which we believe may be more forward-looking relative to the major credit assessment agencies—Latin American sovereigns such as Chile, Colombia and Mexico could see negative ratings actions over the course of the next 12 months. We also believe China will potentially be downgraded, which could have ripple effects given China's importance to the global economy. And despite an electoral surprise in India, we continue to believe India can receive a rating upgrade as the nation's reform agenda and strong growth profile remain intact.

Assessing sovereign credit ratings

At the end of March we published a report outlining how we felt sovereign default risks across the developing world have receded. In that report, we highlighted how asset positions have improved, and how vulnerabilities and weaknesses in sovereign debt profiles have been reduced. The framework we used to assess sovereign default risks still identified nations where the probability of default was elevated, but our analysis indicated that another wave of sovereign defaults in the emerging and frontier markets was unlikely at this time. And going forward, if global growth remains solid and the U.S. dollar weakens as we expect, sovereign stress risks should remain limited for at least the next few years. While there is a degree of fundamental sovereign credit analysis embedded into our framework, we would not necessarily consider our sovereign default analysis to be a full creditworthiness assessment. We do, however, have a more robust framework that we consider to be a comprehensive creditworthiness analysis. We built this framework to get a sense of where domestic credit conditions are evolving as well as identifying which sovereigns could be moving closer to, or further away from, investment grade status. Our sovereign creditworthiness framework incorporates a more robust set of indicators and is designed to signal where credit ratings for larger emerging market sovereigns could be in the next 12 months. Our methodology for determining credit ratings is similar to the approach employed by rating agencies such as Moody's and S&P Global Ratings (S&P). Broadly speaking, indicators for assessing sovereign creditworthiness fall into four categories. These categories are: economic strength, financial resources & asset positions, political risk and institutional strength, and the composition of the sovereign debt profile. Each of these categories comprise multiple variables that, in aggregate, are representative of sovereign creditworthiness. As far as the individual variables that make up each category, the full set of indicators we incorporate to determine sovereign credit ratings are similar to the major ratings agencies, although our methodology does include indicators not employed by agencies. Our approach also excludes some variables used by agencies that we believe do not have a significant influence over sovereign creditworthiness.

In addition to the indicators in our framework, we overlay our methodology with discretionary judgment, especially where data may not have fully caught up to new economic or political realities. For example, we apply judgment to our assessment of political risk and institutional strength, and more specifically the governance and rule of law variables. While we use the World Bank's World Governance Indicators as a numerical starting point, the World Bank scores are updated on an annual basis, and in that sense can at times become dated. World Bank scores may not fully capture most recent political developments and any new risks to governance structures, especially around times of an election. To complement World Bank scores, we apply judgment to increase or decrease our political risk and/or institutional strength assessment to develop scores we believe are more timely and accurate. Political risk and institutional strength is up for interpretation, and the amount of judgment or the direction of judgment could explain a gap in the way we rate a sovereign versus how Moody's or S&P assigns their respective rating. Discretionary judgment could be a source of differentiation between our ratings and the agencies; however, the forward-looking nature when assessing each economic variable could also result in a gap between our rating and agency ratings. Not only could forecasts vary, but the way these forecasts act as an input into each analysis could also differ. Moody's and S&P incorporate forward-looking forecasts when assigning their credit ratings, and do not rely purely on historical performance or current conditions. However, we believe our methodology may be even more forward-looking. To that point, we utilize a rolling one-year outlook that is designed to consistently incorporate forecasts 12 months ahead of time. For example, in this analysis which covers the four quarters from Q3-2024, we incorporate 50% of the 2024 forecast for each variable and 50% of the 2025 forecast. If we were, for example, to update our analysis in a few months' time to cover the four quarters from Q4-2024, we would roll our calculations forward to include 25% of the 2024 forecast and 75% of the 2025 forecast. Using this approach to incorporate forecasts ensures that we are always dynamic, always forward-looking and always incorporating a view on potential future economic performance into the way we rate emerging market sovereigns. This methodology is slightly different from the approach employed by rating agencies, and is also likely to be a source of potential ratings differences.

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