Emerging Market Credit Quality Still Upbeat, But Risks Loom
More emerging market entities continue to be listed with a positive bias than a negative one, in contrast to developed economies (see Chart 1). As of 30 June, 16% of rated parent issuers in the emerging markets were listed either with a positive outlook or CreditWatch with positive implications, compared with 14% at the end of March and 13% a year ago. Meanwhile, the negative bias declined to 14% from 20% a year ago. The positive bias in emerging markets is being sustained by high commodity prices, which are stoking growth in many markets. Whether these conditions will result in actual upgrades-versus merely returning to stable at existing rating levels-will depend on the extent to which economic demand is strengthened and extended to non-commodity sectors.
Notwithstanding the positive momentum in the outlook distribution, the outlook in general for emerging market credit quality has been called into question by the turnaround in U.S. interest rates, which began with the Federal Reserve raising rates 25 basis points on June 30. A prolonged period of low interest rates in the US benefited emerging markets enormously as investors consciously sought higher yielding securities. The prospect of rising interest rates in the U.S., however, poses the risk that the pace of fund inflows into the emerging markets will decelerate in the coming months, even though the stop-start pace of economic recovery leaves room for extended gains. High oil prices are also creating a temporary windfall for oil-producing nations. Conversely, the repercussions of an eventual
slowdown in China would be keenly felt among commodity-exporting emerging markets. Varying credit quality prospects by region imply that investors will continue to differentiate selectively. In large part driven by EU accession plans, the Eastern Europe/Middle East/Africa (EEMEA) region shows the most promise for potential upgrades, with 20% of rated entities listed with a positive bias and only 11% listed with a negative bias. Meanwhile, the trend of upgrades outpacing downgrades in the emerging markets continued in the second quarter of 2004, for the fourth quarter in a row. The downgrade ratio-the ratio of downgrades to total rating actions-declined to 11%, compared with 16% for the first quarter of 2004 and 54% a year ago. (Count of rating actions includes nonfinancial and financial corporate entities based in the emerging markets, as well as sovereigns, but excludes entities in public finance or structured finance.)
Emerging market credit quality has been continuously improving for several quarters, with upgrades outpacing downgrades for the fourth consecutive quarter. During the second quarter of 2004, fewer upgrades were recorded than in the previous quarter, but because the number of downgrades had shrunk to half, the downgrade ratio declined. The downgrade ratio decreased to 11% (based on 16 upgrades and two downgrades) from 16% at the end of March and 54% a year ago (see Chart 2). The downgrade ratio is the lowest recorded since the fourth quarter of 1997, which saw a spurt of upgrades in Latin America, primarily in Argentina and Brazil.
The global downgrade ratio (ratio of downgrades to total rating actions) for all financial and nonfinancial issuers decreased to 54% in the second quarter from 56% and 62% in the two previous quarters. The global tally of rating actions for the second quarter was 110 downgrades and 93 upgrades, affecting long-term debt outstanding worth US$121.3 billion and US$173.3 billion, respectively. For the first time since the second quarter of 1998, the volume of debt affected globally by upgrades exceeded the volume affected by downgrades; this was due to upgrades on U.S.-based Tyco International Ltd. and Japan-based Sumitomo Mitsui Financial Group Holding Co., which together accounted for 26% of the total upgrade volume. Corporate credit quality showed divergent trends by region during the second quarter, even though downgrades still outpace upgrades in the more economically developed regions. This applies to the U.S., where downgrades as a share of total rating actions totaled 54%, down from 64% a quarter ago. With 62 upgrades and 72 downgrades in the second quarter, the U.S. share of total ratings actions was 65%. The quarterly movements in credit quality in the other developed economies-Europe, Japan, and Canada-were not favorable, although these movements may be exaggerated owing to the smaller size of the rated universe. In Europe, the downgrade ratio increased to 80% compared with 59% a quarter ago. In Canada, the downgrade ratio increased to 80% from 78%, and in Japan to 53% from 33% a quarter ago.
Within the emerging markets, much of the rating activity occurred in banks and sovereigns in the second quarter. The banking sector recorded six upgrades and one downgrade, while there were five upgrades and no downgrades among sovereigns (see Chart 3). All of the banking upgrades affected Asia-Pacific commercial banks. On April 2, Bumiputra-Commerce Bank Berhad, a Malaysian commercial bank and subsidiary of Commerce International Merchant Bankers Berhad was upgraded to ‘BBB’ from ‘BBB-‘ due to its improved credit asset quality and capitalization. Chohung Bank, a Korean commercial bank, was upgraded to ‘BBB’ from ‘BBB-‘ on April 15 due to its recent acquisition and convergence with the credit quality of its parent, Shinhan Financial Group. Another Korean commercial bank, Korea Exchange Bank, was upgraded on June 9 to ‘BBB-‘ from ‘BB+’, designating the entity as a “rising star”-an issuer the credit rating on which is raised to investment grade (‘BBB-‘ and higher) from speculative grade (‘BB+’ and lower). The remaining three upgrades occurred on June 24 when three Thai commercial banks were upgraded to ‘BB+’ from ‘BB’. The sole downgrade in the banking sector occurred on April 8 when the International Commercial Bank of China, a Taiwanese subsidiary of Mega Financial Holding Co. Ltd., was downgraded to ‘A-‘ from ‘A’.
Of the five upgrades among sovereigns, three occurred in EEMEA and two in Latin America and the Caribbean. On May 13, Slovenia, which was admitted into the EU on May 1, was upgraded to ‘AA-‘ from ‘A+’ as a result of its fiscal prudence and sustainable progress in reducing high inflation. Kazakhstan became a rising star on May 20 after being upgraded to ‘BBB-‘ from ‘BB+’ due to external and fiscal improvements in financial policies. Likewise, Bulgaria achieved investment grade status after being upgraded to ‘BBB-‘ from ‘BB+’ on June 24. Bulgaria has made vast economic reforms toward prudent fiscal policy and sustainable growth in hopes of joining the EU as early as 2007. In Latin America, Peru was upgraded on June 8 to ‘BB’ from ‘BB-‘ after it implemented a strategy to stabilize its high external debt burden. Lastly, Trinidad and Tobago were upgraded to ‘BBB+’ from ‘BBB’ due to a decline in external debt, a sizeable current account surplus, and increased foreign direct investment.
Apart from the downgrade in the banking sector, the only other downgrade in the second quarter was in the oil and gas exploration and production sector. On April 20, OAO Siberian Oil Co. (also known as Sibneft), a Russian oil company, was downgraded to ‘B’ from ‘B+’ after its proposed merger with OAO NK Yukos came under pressure due to the latter’s legal troubles. The Russian judiciary filed a $3.4 billion tax claim against Yukos and froze the company’s assets, which includes a 92% stake in Sibneft.
Five upgrades were recorded in the nonfinancial sector, two in telecommunications and one each in consumer products, media and entertainment, and metals, mining, and steel. The nonfinancial downgrade ratio in the emerging markets plummeted to 17% in the second quarter from 67% in the same quarter a year ago, and is the same as the ratio recorded a quarter earlier.
Upgrades outpaced downgrades in each of the major regions, but the pace of improvement was strongest in Latin America (see Chart 4). Latin America recorded four upgrades and zero downgrades, compared with six upgrades and three downgrade in the previous quarter and four upgrades and 12 downgrades a year earlier. Meanwhile, the downgrade ratio in the Asia-Pacific region dropped to 11% in the second quarter, even with a quarter earlier, but substantially lower than the 60% in the same quarter of 2003. The only region to experience a slight degradation was EEMEA, where the downgrade ratio rose to 20% in the second quarter compared with 11% in the same quarter a year earlier.
Two-thirds of all emerging market rating actions in the second quarter-11 upgrades and one downgrade-occurred in the speculative-grade segment (‘BB+’ and lower), accounting for 56% of the rated emerging-market universe. This segment recorded a downgrade ratio of 8%, an improvement over the 20% in the previous quarter and 62% a year ago. The investment-grade sector had a downgrade ratio of 17%, slightly higher than the 14% for the first quarter but less than the 33% a year ago.
No “fallen angels”-issuers that migrate from investment grade to speculative grade-were recorded in the emerging markets in the second quarter, bringing the tally of fallen angels in the first half of 2004 to one. As of June 30, two issuers were vulnerable to acquiring fallen angel status . The two issuers remain on the list since the previous quarter.
Conversely, four rising stars were recorded in the second quarter after none appeared in the first. In addition to the two sovereigns (Kazakhstan and Bulgaria) and one bank (Korea Exchange Bank), a Mexican consumer products entity was upgraded to investment grade. On June 11, Gruma, S.A. de C.V. was upgraded to ‘BBB-‘ from ‘BB+’ due to lower debt levels and increased cash flow. As of June 30, five entities, all in the Asia-Pacific region, appear most likely to attain rising star status. Of the potential rising stars, four are banks and one is in the automotive sector.
Positive momentum in credit quality among emerging market entities persists, with the proportion of entities listed with a negative bias steadily falling in favor of more entities with a positive bias. The positive bias in emerging market credit quality is still being sustained by high commodity prices, which are stoking growth in many markets, but whether these conditions result in actual upgrades (as opposed to returning to stable at existing rating levels) will depend on the extent to which economic demand is sustained and extended to non-commodity sectors. As of June 30, of the 403 entities rated at the parent level in the emerging markets, 14% were listed with a negative bias, 70% were stable, and 16% were listed with a positive bias. A quarter earlier, 16% of entities exhibited a negative bias, 70% stable, and 14% positive. The corresponding proportions at the end of the second quarter of 2003 were 19%, 68%, and 13%. The negative bias is much lower among emerging market entities than among their global counterparts either in the U.S. or Europe. Nonetheless, the outlook for credit quality remains differentiated by region.
Geographically, EEMEA-based entities continued to have the highest potential for upgrades, with 20% having a positive outlook or CreditWatch with positive implications and 11% with either a negative outlook or CreditWatch with negative implications. Countries well placed to benefit from potential upgrades include Romania, Turkey, Kazakhstan, and Bulgaria. Some of these countries-Romania, Turkey, and Bulgaria-have made significant strides in financial discipline and structural reform with the goal of securing accession to the EU in the future.
Russia has the largest number of entities with a positive bias (seven), representing 16% of the rated population. Of the entities listed with a positive bias, three are from the wireless telecommunications sector, which is expected to benefit from an increased subscriber base due to improvements in personal income. Of the remaining four entities, two are from the banking sector and two from the utilities sector.
Asia-Pacific showed a greater propensity for upgrades as well, with 17% of rated entities having a positive bias versus 14% with a negative bias. Countries with the highest potential for upgrades within the Asia-Pacific region were Thailand, Indonesia, and South Korea. On the other hand, entities listed with a negative bias (17%) still outweighed issuers listed with a positive bias (9%) in Latin America, even though the gap has narrowed enormously since the same time last year when the proportions were 29% and 7%, respectively. Mexico accounted for the highest number within Latin America with five entities at risk of potential downgrades scattered throughout the industrial sector.
By sector for emerging markets overall, high technology, telecommunications, and banking appear best positioned for potential upgrades, with 21% or higher of rated entities within each sector listed with a positive bias. Potential upgrades in high technology are concentrated within the Asia-Pacific region, with Taiwanese computer and components companies accounting for 80% of the total number owing to growth in exports, especially to China. Within the telecommunications sector, three entities each from Indonesia and Russia look best positioned for potential upgrades. Meanwhile, of the 111 banks rated at the parent level in emerging markets, 21% (23 entities) were listed with a positive bias, with more than half located in the EEMEA region.
Conversely, issuers in the homebuilders/real estate and oil and gas exploration and production sectors appeared among the most vulnerable to potential downgrades, with a negative bias in each sector of 35% or more. Vulnerability in the homebuilders/real estate sector was concentrated exclusively in Hong Kong, where negative rental reversions have hurt entities. Meanwhile, despite the record high oil prices experienced during the quarter, the emerging market oil and gas exploration and production sector was affected by country-specific issues, such as the current legal trouble in Russia surrounding OAO NK Yukos, and is indicative of the risk of lending in many sectors where the legal framework is weak and court decisions unpredictable.