Fiscal credibility and sovereign risk

Fitch Ratings warned that although Central American sovereigns have resisted the global crisis pretty well so far, they now require fiscal consolidation in order to maintain their credit ratings.

Thursday, January 14, 2010

Fitch‐rated Central American sovereigns have thus far withstood the destabilizing effects of the global economic and financial crisis, despite monetary and exchange rate policy challenges. 1 Nevertheless, weaker public finances could lead to negative rating actions if fiscal consolidation is not achieved over the medium term.

Sustaining macroeconomic stability and policy credibility could also be critical to upholding investor confidence and supporting economic recovery, especially as inflationary pressures increase and multilateral support is withdrawn.

The cyclical downturn has exposed structural weakness related to growth underperformance, close economic ties with the US, and relatively narrow tax revenue bases in the region. Central America experienced a sharper‐than‐expected economic contraction in 2009, due to the limited scope for expansionary economic policies, comparatively low external private capital inflows, and economic narrowness. On an aggregate basis, Fitch does not expect Central America to rebound as quickly as Latin America as a whole in 2010. The agency projects the region’s economic growth to recover to 2.8% in 2010 from 0.6% in 2009, compared with 3.6% aggregate growth forecast for Latin America. Public finances deteriorated in the region as overall fiscal revenue contracted across the board in real terms and fiscal stimulus required increased borrowing.

As a result, widening budget deficits and higher government debt ratios in 2009 and 2010 are common among these sovereigns.

The timing and pace at which to withdraw fiscal stimulus and proceed with fiscal consolidation represents a most critical challenge facing DR‐CAFTA 2 policymakers as concerns about fiscal imbalances could undermine creditworthiness.

Additionally, in the absence of higher growth, most Central American sovereigns will require a revenue‐enhancing fiscal reform to support positive debt dynamics.

Stronger growth and credible fiscal strategies to reduce or stabilize public debt burdens over the medium term could support creditworthiness among Central American sovereigns. Further strengthening of external balance sheets, as well as monetary and exchange rate policy frameworks for non‐dollarized economies in particular, could benefit these sovereign’s ability to cope with external shocks and in turn, creditworthiness.

Conversely, sustained fiscal slippage and deteriorating debt dynamics would be negative for creditworthiness. While not Fitch’s base case scenario, a significant increase in gross external financing requirements, a sharp decline in non‐debtcreating capital inflows, or capital flight resulting in sustained erosion of international reserves and disorderly currency adjustments could also put downward pressure on ratings.

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