2016 mid year sovereign review and outlook

Sovereigns Global

2016 Mid-Year Sovereign Review and Outlook Record Number of Negative Rating Actions Possible in 2016 Outlook Report Rating Outlook

Brexit Heightens European Risks: A period of uncertainty hangs over Europe following the UK vote to leave the EU. The most immediate and dramatic political consequences have been within the UK itself, but longer-term implications elsewhere could be supportive of populism and Euroscepticism.

STABLE Rating Outlooks Positive/RWP

Stable

Negative/RWN

100% 80%

The short-term economic impact on the UK will be decidedly negative, resulting in weaker public finances and rising government debt. Fiscal consolidation in eurozone countries will drop further down the list of priorities, as leaders focus on agreeing the terms of the UK exit and ensuring it is not an example for other countries to follow.

60% 40% 20%

0% End-2015 (%)

Current (%)

Source: Fitch

US Monetary Conditions’ Slow Normalisation: Fitch has revised down its US GDP growth forecasts, but we still expect the Federal Reserve to raise policy rates by year-end. The European Central Bank (ECB) and the Bank of Japan (BOJ) are forecast to continue aggressive balance sheet expansions, implying a potential resumption of US dollar strengthening. Global economic growth is projected at 2.5% in 2016, virtually unchanged from the 2011-2015 average.

Commodities Recover, EM Ratings Don’t: With some important exceptions – including China and India – emerging-market (EM) economies are net exporters of commodities. The partial recovery in commodity prices in 1H16 has led to improved market sentiment toward EMs, but sovereign credit fundamentals are not improving as quickly. Public and external finances in many EMs are not yet aligned with the new price environment. More than one in three ratings in the ‘BB’ and ‘B’ categories carry a Negative Outlook.

Related Research Global Economic Outlook (May 2016) Sovereign Data Comparator (March 2016) Rising Private Sector Debt: Risks to EM Sovereigns (December 2015)

Analysts James McCormack (Global) +44 20 3530 1286 james.mccormack@fitchratings.com Charles Seville (North America) +1 212 908 0277 charles.seville@fitchratings.com Ed Parker (Western Europe) +44 20 3530 1176 ed.parker@fitchratings.com Andrew Colquhoun (Asia-Pacific) +852 2263 9938 andrew.colquhoun@fitchratings.com Paul Gamble (Emerging Europe) +44 20 3530 1623 paul.gamble@fitchratings.com Shelly Shetty (Latin America) +1 212 908 0324 shelly.shetty@fitchratings.com Jan Friederich (Middle East and Africa) +852 2263 9910 jan.friederich@fitchratings.com

www.fitchratings.com

Asia-Pacific – Between China and the Fed: While markets reacted positively in 1H16 to accelerated credit growth and other signs of activity picking up in response to Chinese policy easing, regional financial volatility is likely to persist as long as Chinese policymakers send mixed messages with respect to addressing the country’s corporate debt problem. Fitch expects higher US rates to contribute to renewed downward pressure on the renminbi later in 2016, with possible regional implications.

Russian Stabilisation, Central European Populism: The recession in Russia is easing and higher oil prices are supportive of the fiscal position, but spending may rise ahead of September elections and a new medium-term fiscal plan unveiled after the polls will be an important rating consideration. Political populism is gaining traction in central Europe, partly in response to migrant flows through the region. There has been some associated fiscal easing, though governments are trying to avoid deficits in excess of 3% of GDP. Latin America Still Contracting: Headed for its second consecutive year of contraction, Latin America is facing subdued commodity prices, weak external demand (notably China, relative to previous growth rates) and tighter external financing conditions. Larger government deficits and tepid growth combined with currency depreciations are contributing to rising government debt.

Middle East and Africa Ratings Pressured: The shock from falling commodity prices has prompted substantial fiscal adjustments across the region, but they have generally been insufficient to offset lower commodity revenue, leading to higher deficits. More than half of global negative rating actions in 1H16 were in the Middle East and Africa, and 10 of 22 sovereigns currently on Negative Outlook are in the region.

7 July 2016

Sovereigns Global Macroeconomic Conditions and Policies Fitch’s latest Global Economic Outlook (May) projects world GDP growth of 2.5% in 2016 and 2.9% in 2017. The US (AAA/Stable) forecast for this year was trimmed (to 1.8% from 2.1%) to reflect weaker-than-expected first-quarter activity on the back of falling exports and a marked decline in capital expenditure in the energy sector. As caution extends to the US business sector more broadly, Fitch expects private investment to grow by only 0.5% this year, well down from 4% in 2015. The US household sector is holding up better, as the energy sector has little impact on employment growth, and real incomes are growing at 3% annualised.

Growth in the eurozone is forecast to be 1.6% in 2016, virtually unchanged from last year.

Previous falls in energy prices contribute to higher real disposable income, supporting household consumption, but business investment continues to face subdued confidence and relatively weak potential growth rates across the region. There will be a confidence shock related to the UK’s exit from the EU, the extent of which will depend on newsflow in the coming months.

Developments in China (A+/Stable) have been well received by global markets this year.

Broader EM sentiment improved as concerns about the policy mix receded along with those related to potential contagion from weaker Chinese growth. While we have revised up our 2016 growth forecast – marginally, by 0.1pp to 6.3% – Fitch does not believe the sharp swings in view on China are warranted. Macro policy easing supports the short-term outlook, but the associated increase in debt adds to the long-standing challenges of too much leverage in the corporate sector.

Monetary Policy Decisions to Vary Rising wage and unit labour cost inflation, low unemployment and an expected rebound in headline consumer prices due in part to the recovery in oil prices will prompt a resumption of the normalisation of monetary policy in the US in 2H16, in Fitch’s view.

The BOJ and the ECB are on track to continue easing, though we do not believe either will push policy interest rates much further into negative territory. Negative rates are accompanied by risks to commercial bank profitability, possibly affecting their willingness to lend, and the overall impact on demand is unclear. Policy easing will be enacted more by ongoing balance sheet expansions by the BOJ and the ECB. The divergent paths of monetary policy may imply a stronger US dollar, counter to the weakening during the first half of this year. The stronger dollar could, in turn, have implications for the recent recovery in commodity prices, which appear, for reasons other than the value of the dollar, to have found a floor. The dollar and commodities are critical factors for EM sovereigns.

Europe to Focus on UK Exit The significance of the UK’s (AA/Negative) pending exit from the EU is difficult to overstate. A period of considerable political uncertainty lies ahead, with a change of Prime Minister, possible early elections and questions arising again on Scotland’s future in the UK. The short-term economic implications will be meaningful. Household and business confidence will be shaken by the political upheaval, possible job losses as firms evaluate the merits of using the UK as a base for European business, and the prospects of widespread changes to the legal and regulatory environment in a post-EU economy. Negotiations on exit are likely to be protracted, complicated and approached from a European perspective with a view to discouraging other countries from following the UK. Developments in the UK make it more probable that populist and/or Eurosceptic parties will find greater support elsewhere in the EU. Political fragmentation and polarisation were already evident in the aftermath of the eurozone crisis, and may now be given another boost. Fiscal

2016 Mid-Year Sovereign Review and Outlook July 2016

2

Sovereigns consolidation will drop further down the list of priorities, as remaining EU member states focus on agreeing among themselves on the terms of the UK’s exit and its relationship with the EU thereafter. Differing views have already emerged, suggesting the negotiations will have multiple dimensions of difficulty.

Sovereign Ratings – Possible Record Year for Downgrades There have been 15 sovereign downgrades in 2016, and 22 ratings are on Negative Outlook.

The previous high for downgrades was 20 in 2011, 15 of which were investment-grade sovereigns. The majority of this year’s downgrades have been in speculative grade, and more than one in three sovereigns in the ‘BB’ and ‘B’ categories now carry a Negative Outlook.

Based on the number of downgrades and ratings on Negative Outlook, 2016 is likely to set a new high for negative rating actions.

Lower commodity prices continue to be the single most important factor responsible for downward ratings momentum. Seven of the 10 most commodity-dependent sovereigns rated

by Fitch – those with the highest shares of commodity exports in total current account receipts – have been downgraded in 2016 and/or are on Negative Outlook. All are emerging markets.

Commodity-exporting emerging markets are, by definition, highly dependent on merchandise export revenues generated by commodities. They are often also highly dependent on the commodity sector for fiscal revenue, such that current account and fiscal balances can be closely aligned with commodity prices cycles. Although ratings are intended to be consistent “through the cycle”, much depends on the amplitude of the cycle and its duration.

General Government Balances Commodity exporters

Current Account Balances

Other EMs

Commodity exporters

(% GDP)

(% GDP)

4 3 2 1 0 -1 -2 -3 -4 -5 2000 2002 2004 2006 2008 2010 2012 2014 2016

6

-2

Source: Fitch

Source: Fitch

Other EMs

4

2 0

-4 -6 -8 2000 2002 2004 2006 2008 2010 2012 2014 2016

In Fitch’s view, there is a structural element to the decline in commodity prices since 2014, as our medium-term projections do not envisage a return to a USD100/barrel oil price. In these circumstances, ratings are informed by corrective policy responses focused on fiscal and current account balances. On the fiscal side, this may include diversifying the sources of government revenue, scaling back non-mandatory government spending, reducing subsidies and imposing greater discipline to avoid episodes of fiscal largesse during cyclical upswings in commodity prices. Policy approaches to current account deteriorations will vary, depending in part on the exchange rate regime, but the analysis focuses on the sustainability of the external sector as well as the extent and burden of debt financing.

Ratings vs Markets The effects of unconventional monetary policies on government bond yields in advanced economies are well understood, with negative nominal yields (if securities are held to maturity) in a number of jurisdictions. Fitch estimates that 14 sovereigns had negative-yielding debt that, in sum, exceeded USD11trn in June. These are the most obvious current examples of how market pricing and sovereign credit fundamentals can be misaligned. Ratings are reflective of credit fundamentals, which, for most advanced economies, are not typically affected by market pricing.

In Fitch’s view, eurozone policymakers in particular have moved toward an easing of fiscal

2016 Mid-Year Sovereign Review and Outlook July 2016

3

Sovereigns policy, prompted by the diversion of focus to issues surrounding migration, austerity fatigue and the consequences of rising political support for populist parties that are often more sceptical of national commitments to broader European objectives. One upshot is that low interest rates brought about largely by continued monetary accommodation are not resulting in smaller deficits and/or lower debt levels to the extent they might. In essence, the fiscal space created by lower rates is being absorbed by larger deficits. From a ratings perspective, this is a marginal negative, since comparatively high government debt levels are observed in several eurozone sovereigns.

Emerging Market Spreads vs Sovereign Ratings Spread EMBI-Global vs. 10-year US Treasury (LHS)

(%)

Fitch EM SCI (RHS)

8

8.0

7

8.2

6

8.4

5

8.6

4

8.8

3 2

9.0

1

9.2

0 2006

9.4 2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

Source: Fitch, Datastream

EM yields are not immune to monetary policy in advanced economies. Spreads on the JPMorgan Emerging Market Bond Global Index (EMBI Global) relative to 10-year US Treasuries have widened by about 130bp since mid-2014, but the deterioration in EM ratings has been more pronounced (see above chart). Consistent with pressures noted above with respect to the trend decline in commodity prices and prior US dollar appreciation, the unweighted average EM sovereign rating (EM SCI in the above chart) is the lowest in more than a decade. On this basis, EMs appear to offer another example of ratings being misaligned with market pricing, at least for the broad EMBI Global.

Regional Issues and Outlooks North America Narrowing in the US federal government deficit has come to an end. This reflects a deceleration in revenue growth and the cost of deals reached by Congress in 2015 that have pushed up spending, as well as a host of temporary factors. With the fiscal deficit back below 3% of GDP, impetus towards consolidation has faded, but medium-term fiscal challenges loom.

Congressional Budget Office analysis shows that mandatory spending commitments related to population ageing will increase the burden on the budget over the next decade. At the same time, there is broad agreement that the tax system should be made simpler and more competitive. The US has one of the highest corporate tax rates in the OECD.

US Deficit and Debt GG deficit (RHS)

(% GDP)

GG debt (LHS)

2025

2024

2023

2022

2021

2020

2019

2018

2017

2016

2015

2014

2013

2012

-15

2011

-10

0

2010

-5

20

2009

0

40

2008

5

60

2007

10

80

2006

15

100

2005

120

Source: Fitch

2016 Mid-Year Sovereign Review and Outlook July 2016

4

Sovereigns This makes the US the most indebted ‘AAA’-rated sovereign, although it also has higher debt tolerance and benefits from strong global demand for assets denominated in dollars, the preeminent reserve currency. In our latest projection of debt/GDP for the US, debt continues to rise 7pp of GDP through 2025, from an estimated 101% of GDP in 2016. More negative debt dynamics are largely based on a more negative growth outlook. We expect growth of 1.8% in 2016 and 2.1% in 2017, illustrating the deterioration in medium-term growth prospects driven by slower growth in the labour force and productivity. As the current economic expansion heads into its eighth year – lengthy by comparison with predecessors – the chances of a recession rise, though this is not Fitch’s expectation, especially with the Federal Reserve keeping interest rates low.

Fitch estimates that if growth and inflation both average 2% and interest rates rise gradually, then a narrowing of 0.5pp-1pp of GDP would be enough to stabilise debt/GDP, while a larger primary surplus or stronger growth would bring debt/GDP down. The scale of the adjustment required is modest, but any tax and spending measures must meet congressional approval.

The presidential election to be held in November is likely to offer a stark choice of fiscal proposals between Hillary Clinton, whose fiscal stance represents continuity with that of the present administration, and Donald Trump, who has pledged tax cuts without touching entitlement spending, a combination of policies that would lead to higher deficits and debts.

The presidential race has had little impact on the treasury market to date. The prospect of a Trump victory, if this was interpreted to mean looser fiscal policy, could lead to higher borrowing costs.

The result of the Congressional elections is no less important for the direction of US economic policy over the next presidential term. Polls indicate that the Democrats will likely regain a majority in the Senate and that Republicans will retain control of the House. Divided government is again likely, hampering policy implementation and underlining a lack of policy coherence compared with other ‘AAA’ sovereigns, contrasting with a still-respectable growth performance.

Canada (AAA/Stable) is the second-most indebted ‘AAA’ sovereign after the US, and economic policy has shifted since the Trudeau government took office in November 2015. Fiscal policy has been loosened to help stimulate an economy buffeted by a steep fall in oil prices, with the federal government planning to run a deficit of 1.5% of GDP in FY16 (April 2016 – March 2017) and FY17. Canada is responding to G20 calls for fiscal stimulus, and around half of the loosening is accounted for by a boost to infrastructure spending. A second phase of the infrastructure plan will involve public-private partnerships. Policymakers believe the federal government has fiscal space, with debt of just 31.5% of GDP, and there is no commitment to balance the federal budget over the medium term. However, the federal debt/GDP ratio should start to fall from 2018. Provinces carry the majority of the general government debt, and while the situation in Ontario and Quebec, the two biggest debtors, is gradually improving, Alberta – where up to 20% of revenue comes directly from oil – has been pushed into recession by the fall in oil prices and will run a sizeable deficit this year.

Western Europe The European project encountered its largest-ever setback as the UK voted in June to leave the EU. Brexit, when it happens, will create the precedent of countries leaving the EU. If the UK were to thrive outside of the EU, it would threaten the principles of European integration that underpin most centrist governing parties in the region. In this respect, the political incentives of the UK and remaining EU countries are badly aligned entering into exit negotiations, which are likely to be intensive once they begin and open up new fronts of disagreement with the EU.

2016 Mid-Year Sovereign Review and Outlook July 2016

5

Sovereigns Combined with the long-lasting effects of the migrant crisis, we expect the referendum outcome to boost support for more radical/populist parties. For countries in the run-up to elections, this will reduce incumbent governments’ desire to implement unpopular structural reform (eg France (AA/Stable) and Germany (AAA/Stable) in 2017). A referendum in Italy in October on constitutional reform will also be a test of populist pressures and could trigger political instability. For countries where elections are being held, weaker governments are being produced, for example Portugal’s (BB+/Stable) and Ireland’s (A/Stable) minority governments and Spain’s (BBB+/Stable) double election and ongoing government formation process.

Fiscal Targets Missed General government deficits Gov't target (t-1)

(% GDP)

Latest target/outturn

6 5

4 3 2 1 0

ES

PT

FR 2015

BE

IT

ES

PT

FR

BE

IT

2016

Source: Stability Programmes 2014-2016

Although the nature of the eventual UK-EU relationship will not be known for some time, Fitch expects Brexit to reduce EU exports to the UK. The most exposed countries are Ireland, Malta, Belgium, the Netherlands, Cyprus and Luxembourg, for all of which exports of goods and services to the UK are at least 8% of GDP. Fitch is sceptical there is the political willingness to deepen EU or eurozone integration in response to Brexit or agreement over what form it would take. Brexit could precipitate Scotland leaving the UK, which might intensify secessionist pressures in other parts of the EU, such as Catalonia in Spain. The UK aside (see below), we do not anticipate negative rating actions in the near term as a result of the referendum, but the above factors are credit negative over the medium/long term for the region.

The UK sovereign rating was downgraded to ‘AA’/Negative following Brexit based on a weaker economic outlook, the effect on the government deficit and changes in our government debt projections, which now call for rising debt over the forecast period. Considerable political uncertainty adds to questions over the policy outlook, including when exit negotiations with the EU will begin and the UK-EU relationship thereafter.

In June, the Eurogroup officially confirmed completion of Greece’s (CCC) first review under its third official programme, giving the country a much needed EUR7.5bn disbursement. Although progress to date has been slow, the programme’s policy conditionality is unusually frontloaded, making this a significant development which has dramatically reduced liquidity risk in 2H16.

As the eurozone crisis has faded, there has been a shift in focus of European policymaking away from the main themes of previous years, namely fiscal discipline, economic reform and European financial institution-building. In fiscal terms, the European Commission and many eurozone governments have moved away from strict interpretation of the European fiscal rules, favouring looser budgetary policy. This outcome is likely to be growth-supportive in the near term but further undermines fiscal credibility. Public debt remains a key rating constraint for many sovereigns in the region, and we expect this to remain the case for several years at least.

2016 Mid-Year Sovereign Review and Outlook July 2016

6

Sovereigns Asia-Pacific Asia-Pacific economies face the likelihood of ongoing financial volatility in the second half of 2016 amid ongoing market uncertainty over China’s prospects for a smooth adjustment and as the US Federal Reserve moves toward further rate increases. Sovereigns’ own buffers and shock-absorbers, both financial and in terms of scope for credible policy adjustment, are likely to be central in determining the extent to which these pressures feed through to domestic economies, and potentially to sovereign ratings.

At one end of the scale, Fitch downgraded Sri Lanka to ‘B+’ with a Negative Outlook on 29 February, just before the country secured agreement with the IMF on a USD1.5bn programme, in recognition of the pressure on the country’s external liquidity and persistent deterioration in the public finances. The Negative Outlook reflects Fitch’s reservations over the Sri Lankan authorities’ ability to meet their obligations under their IMF-sponsored programme.

The success or otherwise of the programme will be the key factor determining whether the Outlook is stabilised or whether the rating is downgraded.

The ratings of Indonesia (BBB−) and Malaysia (A−) remain on Stable Outlooks despite relatively stretched external liquidity and high commodity dependence, underscoring the point that the policy response matters too. Both sovereigns have made structural fiscal reforms and have either reduced the budget deficit (Malaysia) or maintained it at a low level (Indonesia).

Both sovereigns have also contained the deterioration in their external positions in part through relatively tight policy settings over sustained periods.

Fitch expects growth in China to accelerate on a sequential basis in the second half of the year from 1.4% qoq sa in 1Q16, in line with the agency’s 6.3% forecast for the year. Aggressive policy loosening in the latter part of 2015 and into 2016 bore fruit in exceptionally rapid credit growth in the first three months of the year and in a pick-up in fixed asset investment, particularly in infrastructure. However, the credit surge has reignited a property boom in the big cities that has already triggered expectation of renewed macro-prudential tightening.

Signals of Chinese policymakers’ intentions are unclear. The authorities’ official economic targets, in the Five-Year Plan agreed in March 2016, imply further leveraging of the economy in pursuit of a 6.5% annual growth target. However, a prominent interview with an anonymous policymaker in the People’s Daily on 9 May included a remark that “it is neither possible nor necessary to force economic growth by levering up” and warned of the risks of a financial crisis caused by high and rising debt.

Mixed policy signals coupled with drift over reforms and lack of clarity over the strategy for dealing with China’s debt problems add to uncertainty over the economy’s prospects for a smooth adjustment to a more sustainable growth path. Fitch expects higher US rates to contribute to renewed downward pressure on the renminbi later in 2016, which would intensify financial pressures and sharpen the dilemma facing policymakers between the longer-term consequences of letting debt build up and the short-term risks of tighter credit.

The Japanese government (A/Negative) announced on 1 June its decision to postpone into 2019 a consumption tax increase previously scheduled for April 2017 that would have raised about 0.8% of GDP in additional revenue towards deficit reduction, on Fitch’s estimates. The reason given for the delay was the need to shore up growth to help the economy break out of deflation. The introduction of a negative interest rate by the BOJ on a portion of bank reserve deposits in January 2016 has had mixed effects and has not forestalled a further rise in the Japanese yen or a slide in business inflation expectations.

The authorities reaffirmed their commitment to the target of restoring the primary budget to balance by fiscal 2020 (April 2020 – March 2021), from a 3.3% deficit in fiscal 2016. However, the consumption tax increase has now been delayed twice (it was originally scheduled for October 2015), undermining confidence in political commitment to fiscal consolidation.

2016 Mid-Year Sovereign Review and Outlook July 2016

7

Sovereigns Emerging Europe High-frequency data suggest that the recession in Russia (BBB−/Negative) is easing and a return to growth is likely by the end of the year. First-quarter GDP was better than consensus, with a 1.2% year-on-year contraction, and industrial production is strengthening as the economy rebalances away from the consumer. Higher oil prices are supporting the fiscal position, but there remains uncertainty over possible spending ahead of the legislative elections in September and over the medium-term fiscal plan, which will be unveiled after the polls.

Russia Growth Indicators Real GDP

(%)

Industrial production

6 4 2 0 -2

-4 -6 2012

2013

2014

2015

2016

Source: Federal State Statistics Service

The stabilisation of the Russian economy, and a modest appreciation of the rouble, should support performance in regional trading partners. However, the likely tepid pace of growth in Russia is not expected to have a material impact on investment or on the employment of expatriates whose remittances are a key source of revenue to some near neighbours, particularly Armenia (B+/Stable) and Georgia (BB−/Stable).

Political populism appears to be rising in central Europe, in part triggered by the large flow of migrants through the region. Politicisation of institutions is becoming more prominent; in Poland (A−/Stable), the European Commission formally warned the government over interference with the constitutional court. Populism has been manifest in fiscal loosening in some sovereigns, notably Hungary (BBB−/Stable), Poland and Romania (BBB−/Stable). The loosening comes at a time of solid fiscal dynamics (reflecting healthy growth and improving revenue collection), meaning that a forecast deterioration in the structural position is not expected to be directly reflected in headline data. Regional sovereigns have so far been careful to state their desire not to exceed the 3% of GDP threshold that could trigger action under the Excessive Deficit Procedure, but in some cases this is inconsistent with policy commitments.

Structural Balances Poland

Romania

Hungary

(% GDP) 0 -1

-2 -3 -4 -5 2012

2013

2014

2015e

2016f

2017f

Source: European Commission

Pressure on the fiscal position has been absent in Turkey (BBB−/Stable), where data for the first four months of 2016 show a central government surplus despite the implementation of election-related spending commitments. However, the president has maintained his views on the need for lower interest rates, and monetary policy has been loosened under a new central

2016 Mid-Year Sovereign Review and Outlook July 2016

8

Sovereigns bank governor, despite structurally high core inflation. The appointment of a new prime minister supportive of constitutional reform that will expand the powers of the presidency could revive political uncertainty, and the process could undermine institutional checks and balances.

The economies of Kazakhstan (BBB/Stable) and Azerbaijan (BB+/Negative) are starting to adapt to lower oil prices and the abrupt exchange rate adjustments in the second half of last year. In both cases, the authorities are focusing on building the necessary conditions and policy toolkits to manage floating currencies. The first stage is restoring confidence in the local currency, which is reviving faster in Kazakhstan due to the earlier and better communicated exchange rate adjustment. In contrast, the central bank continues to limit supply of local currency in Azerbaijan, due to fears that this will be converted to FX. As a result, while the Kazakh central bank has started to rebuild reserves, in Azerbaijan deposit dollarisation is over 80% and central bank reserves are only rising due to purchases from the state oil fund, with the latter also the main source of FX. Exchange rate adjustment has put both sovereigns in a position to avoid further material erosion of external buffers.

Economic performance remains weak, with both economies forecast to shrink this year and record double-digit inflation. This is putting pressure on already troubled banking sectors that were also hit by open FX positions. Poor disclosure means the true health of the banks is difficult to determine, but Fitch assumes that some sovereign support for the sector will be required. Social strains have also become evident.

Latin America The biggest challenge for Latin America is to regain economic momentum in the context of a subdued commodity price outlook, weak external demand (notably China, relative to previous growth rates) and tighter external financing conditions. Commodity exporters have experienced either a contraction or a marked slowdown in investment, and the negative spillover of falling exports on confidence and broader income has hit consumption growth as well. Estimates for potential growth are being lowered for several commodity exporters. The region is poised for a second consecutive year of economic contraction before a modest recovery takes hold in 2017.

Intensification of the above-mentioned external headwinds represents downside risks for economic prospects in 2016-2017.

Real GDP Growth Average 2009-2014

(%)

2015

2016

8 6 4

2 0 -2 -4 -6

Panama

Peru

Dominican Republic

Colombia

Argentina

Chile

Brazil

Mexico

Source: Fitch

Although the regional growth projections are influenced by the deep recessions in Brazil (BB/Negative) and Venezuela (CCC), most countries are growing, albeit at a moderate pace.

Ecuador (B/Stable) is expected to experience its first recession in over a decade, and Argentina’s (B/Stable) economy could contract mildly as part of its adjustment process. In spite of having a diverse economy, Mexico (BBB+/Stable) has been hit by lower oil prices and the sluggishness of the US industrial sector. The diverse and service-oriented economies of Panama (BBB/Stable) and the Dominican Republic (B+/Positive) will remain the fastest growing in the region.

2016 Mid-Year Sovereign Review and Outlook July 2016

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Sovereigns Exchange rate flexibility has helped the region transition to the new external environment, but the pass-through from weaker currencies has increased inflationary pressures. Currently, only Mexico’s inflation rate is within the target range, while Brazil, Chile (A+/Stable), Colombia (BBB/Stable) and Peru (BBB+/Stable) have above-target inflation rates. Anchoring mediumterm inflation expectations in line with the targets will be important to maintain the credibility of central banks in the region.

Reduced commodity prices, weaker growth and continued spending pressures have led to fiscal deterioration in several countries, while higher deficits and tepid growth combined with FX depreciations have led to government debt increases. Fiscal buffers such as stabilisation funds are small or non-existent in most countries, with the exception of Chile and Peru. Countries with weak fiscal fundamentals are already rated low (Argentina, Ecuador, El Salvador (B+/Stable), Jamaica (B/Stable) and Venezuela) and have been downgraded (eg Brazil) or are on Negative Outlook (Costa Rica, at BB+).

Commodity exporters have seen a widening in external imbalances as they are still in the process of absorbing the negative terms-of-trade shock. Brazil and Chile have seen the fastest adjustment in their current account deficits, with the former’s adjustment being helped by the steep recession and BRL depreciation. The external adjustment of other commodity exporters such as Colombia, Peru and Uruguay (BBB−/Stable) has been somewhat slower, while Mexico’s external imbalances remain moderate. Inadequate adjustment of current account deficits, reduced FDI flows and weaker external debt metrics could be sources of increased vulnerability, especially if external conditions deteriorate further.

Commodity Exporters' Current Accounts Average 2009-2014

2015

2016

(% GDP) 6 4 2 0 -2 -4 -6 -8 -10 Bolivia

Colombia

Peru

Venezuela

Ecuador

Argentina

Chile

Brazil

Source: Fitch

The election cycle is relatively light in 2016, and Fitch does not expect the election outcomes in Peru, the Dominican Republic and Nicaragua (B+/Stable) to affect their sovereign ratings. The focus will be on the new administrations in Argentina and Brazil that are embarking on economic adjustments.

The Macri administration in Argentina has made an impressive start by eliminating capital controls, devaluing the currency, reducing or removing certain export taxes, and curing the default by settling with the holdout creditors and accessing the international capital markets for the first time in over a decade. However, the government’s minority in congress, a weak economy, rising unemployment rate and high inflation pose challenges for his administration to maintain support and opposition cooperation to successfully complete the process of rebalancing the Argentine economy.

Brazil’s government under acting President Temer has committed to adjust economic policies, and has selected an economic cabinet to signal a market-friendly policy shift. However, governability challenges could persist given the uncertainty over the strength, stability and effectiveness of the governing coalition to approve difficult reforms and the continued Lava Jato investigations that could prolong political uncertainty.

2016 Mid-Year Sovereign Review and Outlook July 2016

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Sovereigns Middle East and Africa The shock from falling commodity prices has prompted substantial fiscal adjustments across the region, but they have generally been insufficient to offset lower commodity revenue, leading to higher deficits. In most countries, particularly in sub-Saharan Africa, capital expenditure budgets have been the first to be cut. A large number of countries, including some non-oil exporters, have also made use of lower oil prices to abolish or reduce subsidies for petrol, which had been a large drain on resources. In the GCC countries, the shock has led to more focus on generating non-oil revenue, with Saudi Arabia (AA−/Negative) launching an ambitious programme to raise non-oil fiscal revenue by around 20% of non-oil GDP. Nigeria (BB−/Negative), instead, is focusing on improving tax collection, which is particularly low.

Several commodity exporters, such as Angola (B+/Negative) and Zambia (B/Negative), have allowed their currencies to depreciate. Angola has also tightened capital controls, and Nigeria refused for some time to allow its currency to adjust, instead imposing extensive controls on access to currency to avoid the inflationary effect of a weaker exchange rate. While the Gulf states have seen an increase in speculation about currency devaluations, they have resisted these pressures comfortably and Fitch does not expect any changes. The Central African CFA franc zone has seen a more substantial weakening of its reserves, but the backing from France has also allowed it to avoid an exchange rate adjustment.

General Government Debt

Change in General Government Debt

Median of rated Sub-Saharan Africa

2017 vs 2012

(% GDP)

(ppt GDP) 70

90 80 70 60 50 40 30 20 10 0

50 30

10 -10

Source: Fitch

Seychelles Nigeria Ethiopia Rwanda Mauritius Cote d'Ivoire Namibia South Africa Lesotho Uganda Kenya Cameroon Congo Ghana Cape Verde Gabon Angola Zambia Mozambique

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016f 2017f

-30

Source: Fitch

Since government debt reached its trough with the help of massive debt forgiveness around 2010, it has risen almost continuously. The drivers across the Middle East and Africa for this trend are the pressure to improve infrastructure, diversify economies away from commodities, political tensions (such as the Arab Spring) and most recently the fall in commodity prices. Debt levels in countries that had gone through debt forgiveness are still far below previous peaks. Due to the high share of concessional debt, debt servicing costs also remain contained for several countries.

However, interest expenditures as a share of revenue have reached worryingly high levels in countries such as Egypt (B/Stable) and Ghana (B/Negative), and because of the very low revenue base even in Nigeria, despite its low level of debt. The disclosure of substantial debt to organisations controlled by the government of Mozambique (CC) has particularly raised concerns about debt sustainability, but it has also raised investor anxiety about further hidden debt across the region. The upward trend is likely to continue, and this will increasingly be a constraint in accessing further financing in some countries.

The commodity price fall as well as idiosyncratic pressures have led several countries to sign up to new IMF programmes. Tunisia (BB−/Negative) agreed to a four-year USD2.8bn programme mainly to help adapt to the shock from lower tourism revenues due to terrorism attacks. Rwanda (B+/Stable) signed a USD208m Standby Credit Facility, as did Iraq (B−/Negative), which agreed a three-year USD5.4bn programme to help adapt to the dual shock from lower oil prices and war against “Islamic State”. Angola and Zambia have formally asked for IMF programmes, although negotiations on the programme for Zambia will only accelerate after the presidential election on 11 August 2016.

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Sovereigns In many countries in the Middle East and North Africa, the threat of terrorism will remain a dominant theme. This is unlikely to change even if progress is made in capturing areas currently held by “Islamic State” and in stabilising Syria and Libya. In countries such as Egypt, Tunisia and Kenya (B+/Negative), a recovery of tourism is likely to remain slow even in the absence of further attacks.

Elections will contribute to heightened uncertainty in a number of countries. While the local elections in South Africa (BBB−/Stable) in August will not pose a threat to the dominance of the governing African National Congress, a significant weakening could raise pressure to increase expenditure in the face of widespread disaffection with the level of public services.

Parliamentary elections in Cote d’Ivoire (B+/Stable) in December are not expected to pose a serious threat to stability, although the history of civil conflict poses some concerns. Zambia, which has a presidential election in August, has a track record of peaceful elections. The same is true for Ghana, and the main threat from the election to the country’s creditworthiness stems from the experience of large arrears being built up ahead of the previous election.

2016 Mid-Year Sovereign Review and Outlook July 2016

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Sovereigns Appendix Long-term Issuer Default Ratings on 30 June 2016 LT FC IDR Western Europe & North America Andorra BBB Austria AA+ Belgium AA Canada AAA Cyprus B+ Denmark AAA Finland AA+ France AA Germany AAA Greece CCC Iceland BBB+ Ireland A Italy BBB+ Luxembourg AAA Malta A Netherlands AAA Norway AAA Portugal BB+ San Marino BBB Spain BBB+ Sweden AAA Switzerland AAA United Kingdom AA United States AAA Emerging Europe Armenia B+ Azerbaijan BB+ Belarus B− Bulgaria BBB− Croatia BB Czech Republic A+ Estonia A+ Georgia BB− Hungary BBB− Kazakhstan BBB Latvia A− Lithuania A− Macedonia BB+ Poland A− Romania BBB− Russia BBB− Serbia BB− Slovakia A+ Slovenia BBB+ Turkey BBB− Ukraine CCC Asia-Pacific Australia AAA Bangladesh BB− China A+ Hong Kong AA+ India BBB− Indonesia BBB− Japan A Korea AA− Macao AA− Malaysia A− Mongolia B New Zealand AA Pakistan B Philippines BBB− Singapore AAA Sri Lanka B+ Taiwan A+ Thailand BBB+ Vietnam BB−

2016 Mid-Year Sovereign Review and Outlook July 2016

FC Outlook

LT LC IDR

LC Outlook

Country Ceiling

S S N S P S S S S S S S S S S S S N S S S N S

AA+ AA AAA B+ AAA AA+ AA AAA CCC A− A BBB+ AAA A AAA AAA BB+ BBB+ AAA AAA AA AAA

S N S P S S S S S S S S S S S S S S S N S

A− AAA AAA AAA BB+ AAA AAA AAA AAA B− BBB+ AAA AA+ AAA AAA AAA AAA A+ A AA+ AAA AAA AAA AAA

S N S S N S S S S S S S N S S N S S P S -

B+ BB+ B− BBB BB+ AA− A+ BB− BBB− BBB A− A− BB+ A BBB BBB− BB− A+ BBB+ BBB CCC

S N S S N S S S S S S S N S S N S S P S -

BB− BB+ B− BBB+ BBB− AA+ AAA BB A− BBB+ AAA AAA BBB− AA− BBB+ BBB− BB− AAA AA+ BBB CCC

S S S S S S N S S S S S S P S N P S S

AAA BB− A+ AA+ BBB− BBB− A AA AA− A B AA+ B BBB AAA B+ AA− A− BB−

S S S S S S N S S S S S S P S N P S S

AAA BB− A+ AAA BBB− BBB AA AA+ AA+ A B AAA B BBB AAA B+ AA A− BB−

13

Sovereigns Long-term Issuer Default Ratings on 30 June 2016 (Cont.)

Middle East & Africa Abu Dhabi Angola Bahrain Cabo Verde Cameroon Congo, Republic of Cote d’Ivoire Egypt Ethiopia Gabon Ghana Iraq Israel Kenya Kuwait Lebanon Lesotho Morocco Mozambique Namibia Nigeria Qatar Ras Al Khaimah Rwanda Saudi Arabia Seychelles South Africa Tunisia Uganda Zambia Latin America Argentina Aruba Bolivia Brazil Chile Colombia Costa Rica Dominican Republic Ecuador El Salvador Guatemala Jamaica Mexico Nicaragua Panama Paraguay Peru Suriname Uruguay Venezuela

LT FC IDR

FC Outlook

LT LC IDR

LC Outlook

Country Ceiling

AA B+ BB+ B B B B+ B B B+ B B− A B+ AA B B+ BBB− CC BBB− B+ AA A B+ AA− BB− BBB− BB− B+ B

S N S S S N S S S N N N P N S N S S S S S S S N S S N S N

AA B+ BB+ B B B B+ B B B+ B A+ BB− AA B BB− BBB CC BBB BBAA A B+ AA− BB BBB BB B+ B

S N S S S N S S S N N S N S N S S S S S S S N S S N S N

AA+ B+ BBB+ B+ BBB− BBB− BBB− B B BBB− B B− AA− BB− AA+ B BBB BBB B− BBB B+ AA+ AA+ B+ AA+ BB BBB BB B+ B+

B BBB− BB BB A+ BBB BB+ B+ B B+ BB B BBB+ B+ BBB BB BBB+ B+ BBB− CCC

S S S N S S N P S S S S S S S S S N S -

B BBB− BB BB AA− BBB+ BB+ B+ B+ BB B A− B+ BBB BB A− B+ BBB CCC

S S S N S S N P S S S S S S S S N S -

B BBB BB BB+ AA+ BBB+ BBB− BB− B BB BB+ B A B+ A BB+ A− B+ BBB+ CCC

Source: Fitch

2016 Mid-Year Sovereign Review and Outlook July 2016

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Sovereigns

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