- Slowdown in real estate market contributes to the negative outlook on China’s regional and local governments
- Despite the inflationary impact, rising commodity prices are providing a tailwind to many emerging markets in Latin America and the GCC
- ESG risks increasingly impact credit, with diverging mitigating strategies
China Evergrande Group averted default on the final day of its 30 day grace period on November 10. Nonetheless, the financial troubles facing one of China’s largest property developers and the toll it is taking on the real estate sector will have repercussions on China’s local and regional governments (RLGs) as well.
Chinese RLGs are likely to suffer a drop in land sales revenue because of the growing challenges facing the real estate sector, while debt levels are likely to rise to maintain infrastructure investment in response to slowing real estate activity. Land sales are a significant revenue stream from China’s RLGs, accounting for roughly one-third in total revenue. Consequently, highly indebted provinces with higher land-sales reliance, such as Guizhou, will face fiscal pressure in a property market slowdown.
Aside from the revenue impact, the property slowdown is also likely to trigger a rise in RLG bond issuance in 2022, as falling land sales prompt the authorities to resort to debt-funded infrastructure investment to drive regional economic growth.
Despite the impact on RLGs, we expect that Evergrande credit distress will have limited direct impact on the sovereign, although the developer’s troubles are likely to trim economic growth, given the property sector’s large contribution to GDP, and the possibility that real estate may not recover as strongly as in previous cycles. Nonetheless, the authorities do have fiscal and monetary headroom to respond.
Similarly, our core view remains that the risks to the financial sector relating to Evergrande are manageable, even in the event of a default. The largest banks remain well-capitalized with strong loss absorption capacity, although some other financial institutions including trust companies are more directly exposed to losses arising from any potential default.
The emerging global economic recovery has driven a sharp increase in prices across a range of commodity markets, as pandemic-related restrictions were unwound and household spending recovered. In global oil markets, Brent crude exceeded $80/bbl a barrel in October, with the US Energy Information Administration now expecting that oil demand will marginally exceed pre-pandemic levels by the end of 2022. The rally has also extended to metals and agricultural products, with copper, corn and sugar all trading above 2019 levels this year.
The rising cost of raw materials has contributed to rising inflationary pressure across the globe, adding to the challenges facing policymakers as they navigate out of the pandemic, and prompting a slew of aggressive tightening cycles for several major emerging markets, including Russia and Turkey. However, for some emerging market sovereigns, higher commodity prices have been a boon, helping to offset the lingering effect of the pandemic as they grapple with lower vaccination rates and more protracted economic recoveries.
Among the major oil producers in the Gulf Cooperation Council, the sharp reversal in oil prices this year has provided a major tailwind to government budgets, which were under severe strain last year as Brent crude dipped below $30 a barrel at points, and averaged $42 a barrel for the year. In Oman, which alongside Bahrain has experienced the most significant erosion of its fiscal strength since the structural break in oil prices back in 2015, higher oil prices have significantly improved the outlook for government liquidity and external financing pressures, a key driver behind our decision to stabilize the outlook last month.
Meanwhile in Latin America, rising commodity prices supported by improving global demand throughout 2022 will buttress credit in the metals, mining and agricultural sectors, supporting the positive outlooks in these sectors. For example, in Chile, where copper accounts for around half of total exports, we expect the rally in copper prices will support corporate profits and encourage deleveraging in that sector, supported by the improving global economy and low inventories worldwide. However, rising demand for greater post-pandemic social spending has also raised the risk of greater taxation on the sector.
In addition to rising credit pressures, ESG considerations have become more relevant for emerging Markets than ever. Current research shows that an overwhelming majority of public sector rating actions were driven by an ESG consideration, mostly E, but social and governance considerations were also relevant, as is highlighted in the following report:
On the topic of environmental factors, physical climate risk is broadly credit negative for sovereigns, particularly for emerging markets with climate-dependent economic structures and low-quality infrastructure and healthcare systems. This infographic gives an overview of Moody’s framework for assessing physical risk.
However, where it comes to environmental factors, not all emerging market regions are effected equally. In fact Moody's ESG credit impact scores for Latin American and Caribbean countries highlight comparatively lower exposures to environmental risks and generally higher income levels, increasing the region's resilience to ESG risks.
The primary driver of physical climate risk is of course the volume of carbon emissions produced globally. Many of the world’s leading economies have set ambitious net zero targets but, as this podcast outlines, major nations such as China face a series of hurdles and credit implications to meet their carbon goals.
The recovery continues to remain uneven. Case in point, South Africa is facing weak growth and social pressures threatening public-sector finances. And with challenging funding conditions, liquidity pressure is high and elevating credit risk.
However, emerging markets, even those with a relatively large tourism sector, have begun to make positive strides to revive their economies by reopening their borders and welcoming back tourists after 18 months of tight restrictions. The following two reports discuss the credit-positive implications for two tourism-dependent countries: Fiji and Thailand.
Meanwhile, Russian regions’ own-source revenue increased 27% during January-August 2021, and their expenditure growth remained contained at just 7%, driven by growing tax proceeds and cost controls, which is offsetting spending pressures from higher inflation.
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