The FINANCAL — Amid the 2020 global pandemic, Georgia, Turkey and Argentina are the “risky–3” in Scope’s biennial update of its external vulnerability and resilience framework, whereas Taiwan, China and Switzerland are the 2020 “sturdy–3” of the most well positioned economies against external shocks from a sample of 63 economies.
Fraught global trading and “risk–off” market conditions exacerbated by the coronavirus outbreak and oil price declines of 2020 expose vulnerabilities that many economies face due to balance of payment pressures. This year, Lebanon defaulted on a USD 1.2bn Eurobond, Argentina and Ecuador’s debts re-entered selective default, and Zambia is on the brink. There are concerns about a wider emerging market crisis. Meanwhile, with Brent prices at below USD 30 a barrel, this level is significantly under prices all oil exporters require for balanced budgets. With severe stressing factors in play, external vulnerabilities are key to monitor in assessing countries’ debt repayment capacities.
In this report, Scope provides an update of its external vulnerability and resilience two- axis coordinate grid, introduced in 2018, which assesses countries on a) vulnerabilities to balance of payment crisis and b) degrees of resilience in the advent of such crises.
Scope’s 2020 external vulnerability and resilience rankings indicate a fresh “risky-3” of Georgia (rated BB/Negative), Turkey (BB-/Negative) and Argentina (unrated) – three economies that not only have vulnerability to the onset of balance of payment issues but also show significant weakness in abilities to withstand crises. Argentina slides into this year’s risky-3, edging out Ukraine, which was in the original 2018 risky-3 roster. Ukraine, Colombia, Indonesia, Egypt and Pakistan (all unrated) are highly at-risk economies just outside the riskiest 3. In addition, Scope observes a 2020 “sturdy-3” of Taiwan (unrated), China (A+/Negative), and Switzerland (AAA/Stable) – economies that are the most robust to external shocks. Taiwan replaces Japan (A+/Stable) in this year’s sturdy-3.
Scores for major Western economies vary: the United States (AA/Stable) receives strong marks on external resilience, supported by dollar primacy (4th most resilient of 63), and Italy (BBB+/Stable) and Germany (AAA/Stable) continue to display external sector strengths – supported by current account surpluses. France (AA/Stable) has average scores but Spain (A-/Stable) continues to score weakly on both framework axes. The UK (AA/Negative) displays deficits especially on external vulnerabilities.
Inside the EU, Scope finds that Cyprus (BBB-/Stable), Croatia (BBB-/Stable) and Romania (BBB-/Negative) are the three EU member states facing the greatest external sector risks. On the other end, Malta (A+/Stable), Luxembourg (AAA/Stable) and Denmark (AAA/Stable) are the EU sturdy-3.
Scope’s external vulnerability and resilience framework
Scope’s sovereign credit rating assessments are based on five analytical pillars, of which “external economic risk” represents one of these five dimensions, with a 15% weight in the overall sovereign rating review process. However, the significance of external sector risks may be disproportionately important in 2020 as global trade flows weaken to multi- decadal lows and capital outflows escalate amid a global sudden stop due to the Covid- 19 crisis. Emerging economies exchange rates have been hit hard, making their foreign- currency-denominated debt more difficult to repay, while foreign and local currency borrowing rates have increased as investors become more sceptical about the most vulnerable issuers. International reserves decline as the crisis wears on and sources of FX revenues and capital inflows dry, threatening countries’ capacities to source and repay external loans. With these risks to remain significant over the course of 2020, a lens on economies especially vulnerable to sudden deterioration in external trading and financial conditions is warranted.
In this spirit, this report presents a biennial update on Scope’s external vulnerability and resilience two-axis evaluation framework that assays countries on: i) their respective external vulnerabilities to the onset of balance of payment crises and ii) the extent of their resilience in the event of a balance of payment crisis.
While external vulnerability assessments and rankings have traditionally centred on emerging markets, Scope notes that external risks are not unique to developing countries, but rather shared across nations, as evidenced over the European sovereign debt crisis when risks from large current account deficits, increasing Target 2 liabilities and external competitiveness gaps were exposed across peripheral Europe – instigating capital outflows and increases in bond yields. As such, this report is based on assessing a global set of economies – including advanced and emerging.
External vulnerability and resilience framework: global results
Figure 3 (next page) displays the external vulnerability and resilience framework results 1
for 63 countries . The graph is divided into four quadrants: Quadrant I. countries that are vulnerable and not resilient to external shocks; II. countries that are not vulnerable to external shocks but also not resilient; III. those that not vulnerable to and resilient in the advent of a crisis; and IV. countries that are vulnerable but resilient. The dividing lines between quadrants reflect the median country scores on the vulnerability and resilience axes. Individual country scores and rankings are summarised in Annexes I and II, underlying data is summarised in Annex III, and the summary of component variables is located in Annex IV.
In considering overall country rankings on the basis of a two-axis framework, we take into account the sum-score of the two axis-level scores.
Scope’s two-axis framework identifies a 2020 “risky-3” of:
1) Georgia 2) Turkey
These are economies in Quadrant I of Figure 3 that not only show vulnerability to the onset of balance of payment crises but also exhibit prevailing weaknesses in abilities to cope with crisis. Other countries amongst the most at risk in Quadrant I include Ukraine, Colombia, Indonesia, Egypt and Pakistan.
In addition, Scope observes a 2020 “sturdy-3” of economies in:
These are countries in Quadrant III of Figure 3 that are not only less vulnerable to the onset of balance of payment crises but are also well positioned to deal with a crisis were one to take place. Thailand, Malta and Singapore are further economies amongst the least at risk.
Furthermore, Quadrant IV portrays a set of countries that are vulnerable to crisis but highly resilient in one, notably incorporating the US, the UK and Japan – reserve currency countries able to bridge global external shocks and paper over prevailing external vulnerabilities through currencies’ safe haven statuses. Russia (BBB/Stable), with much enhanced FX reserve coverage (Figure 4), cushioning vulnerabilities from sharp drops in Brent crude prices in 2020 to under USD 30 a barrel, alongside Brazil and New Zealand (both unrated) are also Quadrant IV countries.
Scores for major Western countries vary. As noted, the United States is in Quadrant IV of Figure 3 as the 20th most vulnerable (of 63 nations) to external crises – in view of a significant current account deficit of 2.3% of GDP in 2019 (moreover the world’s largest current account deficit in nominal dollar terms), however anchored by the fourth highest resilience score in the 63 country-set, related to dollar primacy and limited foreign currency debt. Germany ranks strongly overall as the 7th least vulnerable economy – boosted by a 2019 current account surplus of 7.8% of GDP alongside a strong net international investment asset position – but Germany has only middling scores on resilience owing in part to high non-resident holdings of German government bonds. France is mid-table as the 33rd most vulnerable economy but 23rd most resilient. Italy is only the 41st most vulnerable, weakened though by capital outflows of recent years, but receives a very strong resilience mark (11th most resilient), helped by not only the euro reserve currency but also a high share of Italy’s government debt held domestically (almost 70% as of Q2 2019). Spain is a Quadrant I economy and receives a weak overall score – as the 17th most vulnerable economy, weakened by net international investment liabilities of 78% of GDP as of Q3 2019, alongside receiving the 24th poorest mark on external resilience due to high non-resident holdings of government debt and significant foreign-currency-denominated lending in the Spanish banking system.
Among Scandinavian economies – Sweden, Norway and Denmark (all rated AAA/Stable) receive strong scores, with healthy current accounts and robust net international investment positions (NIIPs), as well as developed-market, safe-haven currencies.
The UK ranks as the 9th most vulnerable economy (a modest improvement from 8th most vulnerable in the 2018 report), but nonetheless weighed upon by a wide current account deficit (of 3.8% of GDP in 2019), and sterling volatility in recent years related to Brexit uncertainties. While the UK’s resilience mark is bolstered by sterling’s reserve currency status (4.6% of all global allocated reserves were held in sterling in Q4 2019), the UK ranks overall as only the 25th most resilient country, weakened by high foreign-currency lending in the City of London.
Scope’s Risky-3 in more detail
We next discuss the 2020 risky-3 of Georgia, Turkey and Argentina, as well as Ukraine (as the fourth weakest country in the 2020 rankings) in greater detail.
As was the case in the 2018 update, the weakest country in the 2020 report is Georgia (BB/Negative). Georgia displays high external vulnerability and low resilience to balance of payment crises. The economy has displayed elevated current account deficits, reflecting high investment needs of a developing economy with inadequate domestic savings, a narrow export base, and a dependence on goods imports. The current account deficit has, however, declined from -6.8% of GDP in 2018 to -5.1% in 2019 and has been, moreover, predominantly financed over the last decade by more reliable foreign direct investment (FDI) flows. Nevertheless, Georgia’s small, open economy depends on external financing, as reflected in a large, negative NIIP, amounting to USD 23.8bn or -135% of GDP as of Q4 2019 – a core driver of the weak vulnerability score, alongside the Georgian lari’s volatility in recent years.
External public sector debt, amounting to around 80% of total public debt (with total public debt of 41.4% of GDP in 2019), is denominated in foreign currency (mostly in US dollars or euros), leaving the government balance sheet vulnerable to significant exchange rate fluctuations. Moreover, 58% of government debt does represent concessional multilateral loans, and an ongoing IMF Extended Fund Facility programme institutes a buffer against balance of payment disturbances over the programme duration to April 2021.
While foreign currency transactions inside the Georgian banking sector have declined through the proactive actions taken by authorities in recent years, the level of FX lending and deposits nonetheless remains very elevated at 55% of all loans and 62% of all deposits (mostly in US dollars and euros). FX reserves stood at USD 3.2bn as of March 2020, down slightly compared with USD 3.3bn in March 2019. While reserves’ coverage level of short-term external debt had previously improved, it remains below an IMF adequacy threshold of 100%.
Turkey (BB-/Negative) remains a member of the risky-3 in this year’s list. The Turkish lira is 27% weaker compared with recent August 2019 peaks vs the dollar (trading near 7 against the dollar), which represents a dilemma given 52% of central government debt denominated in foreign currency (meaning FX devaluation automatically feeds through to impairment of public debt serviceability) alongside a significant private sector net FX debt position, which, while cut from February 2018 peaks of USD 223bn, totalled nonetheless USD 175bn as of January 2020. In addition, non-residents hold 39% of Turkey’s government debt.
In data through March, past improvements in Turkey’s trade balance had sharply reversed since 2019 – with much wider recent monthly trade deficits. Official reserves declined to USD 89bn as of 10 April, compared with a 2013 peak of USD 135bn, while – netting out Turkey’s short-term FX borrowings – official net international reserves had declined to USD 26.3bn as of 10 April, from USD 41.1bn at end-2019. Weakened FX reserves mean Turkey is less resilient should capital outflows escalate – and will be an area requiring constant monitoring going forward. Turkey has rejected suggestions of turning to the IMF for support over this crisis.
External sector risks in Turkey are also exacerbated by mismanagement of the economy, in part due to ongoing consolidation of power in the hands of President Recep Tayyip Erdoğan. The policy one-week repo rate has been reduced to 9.75% (from 24% as recently as July 2019) – partly under suspected political influence, resulting in a negative real policy rate in view of March inflation of 11.9% YoY. Accommodative monetary policy had brought lira lending to the domestic economy to elevated levels of +19.1% YoY as of March. Such prevailing macro-economic imbalances sap foreign investor confidence especially in moments of weakness in global sentiment, making Turkey more susceptible to capital outflows that drain reserve stocks, weaken the currency and inhibit the economy. Turkey (BB-/Negative) is the lowest rated issuer in Scope’s rated sovereign universe.
Argentina rounds out Scope’s 2020 risky-3, performing weakly on both assessment axes. Argentina’s public debt increased to nearly 90% of GDP at end-2019, from 56% in 2017, with around 53% of public debt denominated in US dollars. Amid a deep recession in 2020 – exacerbated by nationwide lockdowns since 20 March to impede a coronavirus outbreak in Argentina – President Alberto Fernández announced on 5 April that the government will suspend payments on foreign-currency securities issued in the domestic market for potentially the remainder of 2020 to save remaining resources to support the economy – sliding the government back into selective default – while restructuring talks continue on the side-lines over USD 69bn in foreign-law debt.
Since July 2019 peaks, the Argentine peso has depreciated around 37% against the US dollar and international reserves have dropped by USD 24bn to USD 43.6bn as of March 2020.
Argentina’s private sector is exposed to currency fluctuations in view of elevated foreign- currency-denominated loans outstanding, accounting for 23% of total bank loans.
Moving just off this year’s risky-3 is Ukraine, displayed in Figure 3’s Quadrant I. Ukraine needs to repay around USD 10.7bn in dollar debt over 2020-21, which is significant relative to FX reserves of only USD 23.6bn as of March 2020 (FX reserves have nonetheless increased compared with March 2019 levels of USD 19.6bn). Inadequate FX reserve coverage represents a core danger to Ukraine’s resilience in external crises. Against this backdrop, a continued commitment to reform and cooperation with international financial institutions are keys to maintaining external debt sustainability. The IMF and Ukrainian authorities reached agreement on a new three-year Extended Fund Facility programme of USD 5.5bn in December, which will replace the 14-month Stand-By Arrangement of USD 3.9bn approved in December 2018.
Scope’s Sturdy-3 in more detail
The sturdy-3 represents three economies with the lowest levels of external risk: Taiwan (unrated), China (A+/Negative) and Switzerland (AAA/Stable) – each displaying limited external vulnerability and greater resilience in the event of an external shock.
Taiwan is this year’s most robust economy to external sector risks. Taiwan’s low vulnerability is helped by a very large current account surplus of 10.6% of GDP in 2019. In addition, low volatility of the Taiwan new dollar and a large net international asset position (Figure 6) support vulnerability marks. On resilience, Taiwan’s scores are secured by a robust 2.7x reserve coverage of short-term external debt, low non-resident holdings of government debt, a lack of FX debt in overall government debt and low foreign currency loans in the domestic banking system (with FX loans totalling only 5% of GDP). Taiwan has been one of the most successful countries to date with respect to government mitigation actions in response to the Covid-19 crisis, including aggressive containment, quarantine, and monitoring measures that started early on (in December 2019), creating a response framework for emulation elsewhere in the world. Supported by this, the Taiwan dollar has been stable through this crisis.
China maintains its placement within the sturdy-3 in 2020 with the second strongest overall score in this year’s rankings. This includes status as the most resilient economy in the 63-country sample to external stress factors (up from 3rd most resilient in the 2018 report) alongside 12th least vulnerable of 63 economies (up from 19th). China’s foreign currency reserve stock of USD 3.06trn – by some distance the world’s largest nominal reserve stock – represents 26% of all global FX reserves, presenting the People’s Bank of China an abundant resource to preserve macro-economic stability and stem balance- of-payment issues. This is even though FX reserve levels declined sharply in March amid global economic stress and remain well off 2014 peaks of USD 3.99trn. Strong reserve adequacy bolsters China’s external resilience, a key credit strength considered in China’s A+/Negative sovereign ratings.
The increased use of the renminbi in the global economy enhances China’s significant external strength. The internationalisation of the renminbi has in the past seen its inclusion in the IMF’s Special Drawing Rights basket of currencies (of five currencies) since October 2016 and the establishment of a new renminbi-denominated Shanghai oil futures market in March 2018. Presently, the share of yuan claims in total global FX reserves stands at 2.0% as of Q4 2019, double the 1.1% as of Q2 2017.
The supervision of China’s financial system remains in a transition stage and the capital account remains largely closed (although gradually opening up), with investors in China’s onshore bond market still predominantly being domestic institutions. Foreign currency denominated government debt amounts to only 2.4% of general government revenues (although foreign currency borrowing is increasing). While China’s comparatively closed, mostly renminbi-premised financial system shields the government from global financial volatility, increased opening to foreign investors and rising demand for foreign currency borrowing from domestic institutions might lower this resilience in the future.
China’s net international investment position peaked in 2007 (at 33.4% of GDP) and has dropped to a still robust +15% of GDP as of Q4 2019. The current account balance has dropped from a peak surplus of 9.9% of GDP in 2007 to 1.0% in 2019, weighed upon moreover by trade conflicts with the United States, higher tariffs on Chinese goods and tariff impacts on export volumes. While reductions in China’s current account support global rebalancing and reduce global risks, a nearly balanced Chinese current account represents a major change in the global economy as China posted the world’s largest nominal current account surplus as recently as in 2015.
However, slower economic growth this year due to the Covid-19 pandemic – which we estimate at about 4% in China with significant downside risk (China grows, for example, only 2% under one alternative scenario) – may nonetheless endanger ambitious goals of purchases of an extra USD 200bn of US goods over the next two years as part of the phase-one trade compromise with the United States and has contributed to weakening the yuan, which now trades above 7 to the dollar. Such events could risk that an unpredictable US government might re-visit the trade truce – which, if so, could test China’s external resilience. Higher capital outflows since H2-2018 are another relevant risk area to track.
Switzerland maintains its role within Scope’s sturdy-3 in 2020 (though falling from the #1 overall rank), ranking as the second least vulnerable economy of 63 countries (down one spot from first in 2018) and the 20th most resilient (up one rank). Since 1981, Switzerland has persistently generated large current account surpluses, which have averaged almost 10% of GDP since 2015, underpinned by the high competitiveness of its exporting sector alongside a large portion of fairly price-insensitive export products, such as in pharmaceuticals. This has helped shape a prodigious net international asset position of 116.2% of GDP at end-2019. Switzerland’s economic resilience to international shocks, including to the 2020 corona crisis (even as cases and mortalities in Switzerland have increased significantly), is supported by the franc’s reserve-currency status and highly liquid capital markets that provide unabated access to liquidity in times of international financial market volatility.
Switzerland’s high national savings, totalling 33% of GDP, support a predominantly resident holding of the country’s government debt, at over 85% ownership of the total. Foreign exposures (claims) of Swiss banks fell steadily after the global financial crisis to USD 1.08trn in Q3 2019 (from USD 2.66trn in Q2 2007). However, a sizeable share of loans denominated in foreign currency (around 40% of total loans) weakens Switzerland’s resilience score.
In the EU, among the least vulnerable countries to external shocks include an EU sturdy- 3 of:
2) Luxembourg 3) Denmark
In addition, Italy, Estonia, Belgium and Germany score well. For Malta, Luxembourg, Denmark and Germany, large positive net external financial assets (with an average NIIP of +66% of GDP in 2019), sustained current account surpluses that averaged 7.5% of GDP in 2019, as well as strong safe haven currencies (in the euro and the Danish krone), liquid capital markets and moderate levels of public debt underpin external positions.
On the other hand, the three most at risk member states of the EU (Figure 7, previous page) are:
1) Cyprus 2) Croatia 3) Romania
Cyprus (BBB-/Stable) is displayed in Quadrant I in Figure 8; Croatia (BBB-/Stable) and Romania (BBB-/Negative) in Quadrant II. Hungary drops off the EU risky-3 roster in this year’s report, with Cyprus taking its place. Greece (BB/Positive), Spain (A-/Stable) and Poland (A+/Stable) represent three other EU countries with comparatively high vulnerabilities to external shocks.
The EU Risky-3 in detail
Cyprus leads the EU risky-3. Cyprus’s current account deficit widened to 6.7% of GDP in 2019, from 4.4% of GDP in 2018. The economy’s external position is characterised by high deficits in its trade in goods (21.5% of GDP in 2019), offset by very high surpluses in services trade (21.3% of GDP), the latter due to Cyprus’s standing in tourism services and as a financial services hub. Nonetheless, current account deficits have resulted in one of the largest negative NIIP levels among EU economies at -116%, alongside very high gross external debt levels of 936% of GDP in Q4 2019, which, nonetheless, still represent deleveraging against a 2015 peak at 1,263% of GDP. In addition, well above 70% of government debt is held by non-residents (Figure 9, next page).
We, however, note that special purpose entities (SPEs) in Cyprus considerably distort the economy’s external position while having limited links to real economic activity: excluding SPEs, the NIIP and gross external debt were more modest at -34.3% of GDP and 262% of GDP respectively as of Q3 2019, even if nonetheless still worse than the euro area average. Importantly, Cyprus benefits from euro area membership, unlike in the cases of peers in the 2020 EU risky-3: Croatia and Romania, giving Cyprus access to credit strengths in crisis moments such as reduced FX volatility and capped borrowing rates deriving from the common reserve currency.
Croatia stands out as a Quadrant II economy in Figures 2 and 8, a characteristic shared, for instance, by Bulgaria (BBB+/Stable). Croatia and Bulgaria are economies with lesser balance of payment vulnerabilities but also less resilient than most nations were a balance of payment crisis to nonetheless occur. As such, while risks for a balance of payment crisis might be lower than in most countries with both economies holding current account surpluses alongside successful, long-standing fixed or managed floating exchange rate regimes against the euro, resilience in a currency crisis, however unlikely, would be more subject to question, with both economies highly euroised – meaning any break in Croatian kuna or Bulgarian lev exchange rates against the euro could threaten financial stability.
Croatia is the 4th least vulnerable economy in the EU (and 10th least vulnerable overall in the 63-country set) but is the EU economy with the weakest scores on external resilience (and 2nd least resilient overall of 63). Croatia’s current account surpluses have averaged over 2% of GDP over the past two years, driven by large surpluses in services trade, while goods trade has been in deficit. Current account surpluses have helped to curtail Croatia’s negative NIIP to -50.8% of GDP as of Q4 2019, from -65.6% in Q3 2017.
Any unforeseen depreciation in the kuna would adversely impact government and private sector balance sheets by raising the value of foreign-currency debt in local currency terms, with 51% of private sector loans and almost 70% of government debt denominated in foreign currency. Croatia’s (as well as Bulgaria’s) resilience to short-term external shocks will be materially enhanced after the countries join the EU’s Exchange Rate Mechanism II (ERM II) and, eventually, adopt the euro, a process which both countries are making important progress towards.
Romania remains in the 2020 EU risky-3 as an economy in Quadrant II of Figure 8. Romania’s current account deficit widened modestly to 4.7% of GDP in 2019, from 4.4% in 2018. The current account is expected to remain below -5% of GDP over the 2020-21 period. A high share of foreign-currency-denominated public debt (amounting to 18% of 2019 GDP) and widening fiscal deficits constitute significant risks to Romania’s debt sustainability. The country’s negative NIIP was relatively unchanged at -43.5% of GDP in 2019. Romania’s external sector competitiveness remains a weakness due to high inflation, which is only partly compensated for by depreciation in the Romanian leu.