Asia-Pacific sovereigns face inflation, capital flow risks – S&P

Asia continues to outperform other regions in terms of growth and sovereign credit trends. Despite generally stable credit quality, various factors have combined to make the policy environment tricky for sovereigns in the region, said Standard & Poor’s Ratings Services in a report published on Monday.

The report, titled “Asia-Pacific Sovereigns In 2011: Generally Stable Credit Quality; Inflation, Capital Flows Make Policy Environment Tricky,” said the challenges of strong capital inflows and rising inflationary pressures bring in important credit risks. Domestic politics and increasing geopolitical risks further complicate policy decisions.

“In our base-case scenario, strong growth will support credit quality in Asia-Pacific,” said Standard & Poor’s credit analyst Elena Okorotchenko. “Economic growth will enable the public sector of high-income economies to reduce fiscal deficits and resume fiscal consolidation and allow emerging market governments to speed up structural reforms.”

But the downside risks to this scenario are growing beyond just a slower U.S. economy or the eurozone debt woes. Food and energy price increases, the familiar bugbears, are providing a strong inflationary impetus across the board, and present low-income sovereigns in particular with difficult political and fiscal choices.

“In our opinion, inflation has become — or continues to be — an important risk to macroeconomic and social stability in a number of countries in Asia-Pacific, including Vietnam, Sri Lanka, India, Indonesia, Mongolia, Cambodia, Cook Islands, Fiji, Pakistan, and Bangladesh," Okorotchenko said.

In addition to inflation, a number of sovereigns, such as Indonesia, Thailand, and Korea, could be facing problems with capital flows, either as a result of large inflows/outflows complicating exchange rate management or because of potential policy mistakes in trying to control such flows.

Recent developments in several Middle Eastern countries have raised questions about contagion effects. Such popular uprisings are highly unpredictable, although the risks appear to be more pronounced where high unemployment among the young, inflation, poverty or wide income gaps are combined with growing political disillusionment in an autocratic and often corrupt regime.

In Asia, there are countries with ongoing political/social tensions and risks independent of recent events in the Middle East: Fiji, Pakistan, Bangladesh, and Thailand. We have factored these risks into current ratings on these sovereigns, said Okorotchenko.

In a number of other countries, the risk of social unrest is present but mitigating factors are currently strong. These are China, Vietnam, Sri Lanka, Malaysia, and Cambodia.

“The risks in these countries are mitigated by some combination of strong growth, low unemployment, and a degree of popular support for the government,” she added.

The ability of Asia-Pacific governments to navigate external and domestic challenges adroitly while pushing ahead with economic reforms will determine the pace of ascent in their credit ratings. Of the 22 sovereigns that Standard & Poor’s rates in the region, 17 have stable outlooks on their ratings. Indonesia and Fiji have a positive outlook, and only three sovereign ratings are on negative outlooks: New Zealand, Vietnam, and the Cook Islands.