Nonetheless, the massive accumulation of international reserve assets by emerging market central banks - Fitch estimates another USD500 billion will be added to already record stocks of foreign assets in 2006 - combined with further falls in public external debt, should shield the creditworthiness of governments against all but the hardest of landings for the US and global economy. A gradual decline in the US dollar as part of the long awaited re-balancing of the global economy would broadly be beneficial for most emerging markets, allowing central banks to ease interest rates as their currencies appreciate while boosting capital inflows as investors seek to reduce their exposure to US dollar assets. And while central banks will incur large valuation losses on their dollar reserves, private sector balance sheets will likely benefit from positive valuation effects. "Nonetheless, for central and Eastern Europe where current account deficits are already substantial and private credit booming, appreciating currencies will make it even harder for policymakers to prevent macroeconomic imbalances widening, rendering the region more vulnerable to a sudden shift in investor sentiment," says Brian Coulton, Head of Global Economics at Fitch's Sovereign team.
The secular improvement in emerging market sovereign creditworthiness continued through 2006 with 11 upgrades, including for Brazil, Russia and India, and is expected to persist through 2007 with 10 ratings on Positive Outlook compared to just four Negative Outlooks. As the credit quality of emerging-market sovereigns has risen, they have also begun to exit from international capital markets, preferring to meet their declining financing needs from debt denominated in their own currency and issued in their local market. International bond issuance by sovereigns is estimated to total USD45bn this year and fall to a low of just USD32bn in 2007. In contrast, financial market flows to emerging-market banks and companies are at all-time highs, with international bond issuance set to exceed USD120bn. The credit quality of many emerging-market issuers has also been improving, boosted by strong commodity and metals prices and benefiting from relatively low leverage but the credit quality is often much lower than that of the sovereign. The average rating of issuance out of Russia and Kazakhstan over the last year, for example, is in the 'BB' category compared with sovereign ratings of 'BBB+' and 'BBB' respectively. In the event of tightening credit conditions, the terms and access to international credit markets could pose refinancing challenges for some private-sector borrowers, though most emerging-market central banks are well placed to be the "last resort" provider of foreign currency if borrowers are forced to return to local sources of finance.
The global economic outlook once again largely rests on the performance of the US economy, despite recoveries in Japan and Europe gaining traction in 2006. Fitch's assessment of the US economy is that of a soft landing with growth of 2.4% next year and consequently it expects the Fed to keep rates on hold at 5.25% compared to current market expectations of 4.5% by end-2007. There is a danger that further downward shifts in interest rate expectations and consequently dollar weakness will increase the risk of 'stagflation' as the Fed's room for maneouvre is limited by rising import price inflation amid a tight labour market. While the uncertainty surrounding the outlook for the US economy is even greater than usual, Fitch's current 'bottom up' forecasts for the 100 economies covered by the agency imply that the global economy will post another year of 3+ percent growth and emerging markets will expand by 6%, only slightly down on this year.
A copy of Fitch's Sovereign Review is freely available from www.fitchratings.com
