Download Scope’s 2022 Sovereign Outlook (report).

New variants of Covid-19, elevated inflation, and withdrawal of fiscal and monetary support are risks for the robustness of the recovery. GDP growth will normalise to a degree next year but remain above trend, at 3.5% in the US, 4.4% in the euro area, 3.6% in Japan and 4.6% in the UK. China will grow nearer its long-run trend of 5%.

“Amid an uneven recovery, we see a modest slowdown over Q4 2021 and Q1 2022 across many economies, if not in some cases temporary contractions in output, as European countries reintroduce generally lighter restrictions following renewed rise in cases, including associated with a new Omicron variant,” says Giacomo Barisone, head of sovereign ratings at Scope. “But we see economic rebound regaining traction by the spring of 2022.”

“As expected, full economic normalisation has remained vulnerable to the renewed introduction of restriction as transmissible virus variants challenge public-health systems, though we expect the severity of virus risk for the recovery to continue moderating with time as governments adopt more targeted responses, virus becomes more transmissible but less lethal, and businesses and people adapt ways of doing business,” Barisone says. “Currently, we consider risk to the 2022 outlook to be skewed to the downside.”

“Inflationary pressure is likely to remain more persistent than central bank projections, running above pre-crisis averages even after price changes begin to moderate by next year,” Barisone says. “This is likely to result in greater divergence of monetary policy among the world’s largest economies, and with it, the possible crystallisation of risks associated with high debt and frothy asset prices as central banks pull back monetary stimulus.”

“This is especially true for the UK and the US, where inflation is likely to continue testing 2% mandates, though much less for Japan, with the euro area somewhere in between with inflation potentially remaining under 2% over the long run.”

By end-2022, the ECB and the Bank of Japan will have kept policy rates on hold. The ECB is seen halting the Pandemic Emergency Purchase Programme (PEPP) next year, adapting it and/or other asset-purchases facilities to retain room for manoeuvre to help markets adjust. The Bank of England and Federal Reserve will increase rates.

Higher and more persistent inflation has both favourable and adverse implications for sovereign ratings. Somewhat higher trend inflation supports higher nominal economic growth, helping reduce public debt ratios, and curtails a longer-standing risk of deflation in the euro area and Japan. However, rising interest rates push up debt-servicing costs especially for governments carrying heavy debt loads and running budget deficits. Emerging economies, with weakening currencies and subject to capital outflows, are particularly at risk.

“More limited central bank capacity to impede market sell-off due to high inflation compromising monetary space might expose latent risk associated with debt accrued in the past,” says Barisone.

“Diverging monetary policy presents challenges of its own, creating pressure on central banks otherwise reluctant to tighten policy to do so to protect currencies from further depreciation, which could exacerbate underlying inflation,” Barisone says. “Central banks are now holders of significant amounts of government debt: such ‘fiscal dominance’ might slow normalisation of monetary policy in some cases. Recent monetary-policy innovation during the crisis – such as the flexibility introduced under the PEPP – is, however, enhancing sovereign creditworthiness.”

Sovereign borrowers with a Stable Outlook make up more than 90% of Scope’s publicly rated sovereigns, indicating less likelihood of ratings change in 2022 compared with 2021, though economic risks could present upside and downside ratings risk. Only one sovereign is currently on Negative Outlook: Turkey (B).

Download Scope’s 2022 Sovereign Outlook (report).

See video explainer: Scope introduces the 2022 Sovereign Outlook.