Emerging market credit profiles at risk from strong US Dollar

May 14, 2024 (MLN): Fitch Ratings believes a sustained period of US dollar (USD) strength against emerging market (EM) currencies could weigh on some EM sovereign credit profiles, potentially softening the current positive ratings momentum for EMs.

Most at risk in such a scenario, which does not form part of our base case for 2024-2025 would be sovereigns that experience large and durable depreciation against the dollar or large declines in official foreign reserve buffers, and that have a large share of their debt denominated in foreign currencies.

The nominal effective exchange rate of EM currencies against the USD has historically been strongly correlated to EM sovereign ratings, with a stronger USD being associated with weaker EM credit profiles.

Fitch believes this relationship is likely to remain robust in 2024-2025 if the USD experiences a period of sustained strength.

Nonetheless, the net balance of rating Outlooks for Fitch’s EM sovereign portfolio as a whole is currently Positive, reflecting prospects for improvement in many of the credit profiles.

The picture varies regionally, with Emerging Europe and Latin America both having a relatively large number of EM sovereigns on Positive Outlook, and Asia having more sovereigns on Negative Outlook than Positive.

Ratings of EM commodity importers and smaller and frontier EMs remain significantly weaker than before the Covid-19 pandemic, so some credit profiles may have room to improve as pandemic-related economic and fiscal scarring fades and global activity normalizes.

EM exchange rates, in aggregate, were also relatively stable against the USD over 4M24, compared with the USD’s stronger appreciation against some developed market currencies, including the yen and Swiss franc.

The agency further believes this contributed to the overall strength of EM prospects. Still, a number of EM currencies did weaken somewhat over 4M24, including Brazil’s real and some Asian currencies.

Fitch’s baseline assumption remains that US Treasury yields will fall over 2024-2025 as the Federal Reserve begins to cut rates.

This should allow more EM currencies to appreciate against the USD. Nonetheless, the resilience of the US economy and, in turn, the persistent inflationary pressure there have highlighted risks to this outlook.

If US rates remain at a high plateau or rise even further this could result in sustained USD strength, with potential adverse consequences for some EM credit profiles.

Fitch views EM sovereigns with larger shares of USD-denominated debt as being more exposed to exchange rate risks, as depreciation against the dollar increases the burden of debt repayment in local-currency terms.

External government debt exceeded 50% of GDP in 2023 for nine Fitch-rated EM sovereigns, all in the speculative ‘B’ rating category or lower and was over 30% for a further 27.

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