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Alternative Market Briefing

Sovereigns under threat by the dual impact of COVID-19 and oil price shock

Tuesday, March 10, 2020

Laxman Pai, Opalesque Asia:

Sovereign credit fundamentals and ratings already under pressure from the coronavirus outbreak may be further hit by the oil price shock.

According to Fitch Ratings, the dual impact of COVID-19 and the latest oil price collapse will affect countries depends on their classification. The oil price shock is driven by Saudi Arabia's announcement Sunday that it will increase production and cut prices following failed talks with Russia.

In developed markets, the key drivers will be the effect on growth, if it persists, and the fiscal and monetary responses said the report.

Emerging markets face additional risks related to commodity export receipts, capital flows and exchange-rate pressures.

Oil prices had their biggest drop in nearly three decades after Saudi Arabia said on Sunday it would increase production and cut prices after talks with Russia on production cuts collapsed.

Low oil prices weighed on ratings of major exporters in 2014-2016 and will do so again if the oil price war leads to sustained lower prices. The collapse in commodity prices in 2014 led to numerous EM sovereign downgrades and many oil-exporting sovereigns are still struggling to adjust to that shock, with break-even oil prices well above current market rates.

However, higher-rated exporters have large buffers, mainly in the form of sovereign wealth funds.

The economic effects of an oil shock may be longer-lasting than 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.

As COVID-19 concerns have escalated, global policymakers will be increasingly pressed to respond to a weaker economic outlook while containing the spread of the virus. In the short term, tax revenues will fall and demands on government will increase. Several international institutions are encouraging national authorities to enact fiscal support measures.

Several sovereigns have already announced fiscal actions 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.

Fitch expects the list of sovereigns engaged in fiscal expansion to grow much longer and fully recognizes that timely and targeted policies can help to reduce the risk of a permanent loss of output.

G7 public finances are consistently among the weakest relative to their respective rating peers, which, in part, reflects a previous lack of urgency in using the low interest-rate environment to undertake fiscal consolidation.

Instead, most G7 governments have increased non-interest spending, effectively preserving historically high levels of public debt.

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.

EM 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.

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.

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