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The convergence of credit headwinds and geopolitical uncertainty is putting pressure on countries' credit quality. With many sovereigns rated 'CCC+' and below, defaults could occur. But a look at sovereigns that defaulted or were downgraded to speculative-grade ('BB+' and below) and then able to regain investment-grade ratings points to the possibility to recover from stress, as well.

What We're Watching

Almost halfway through this year, governments are continuing to navigate the implications of higher-for-longer interest rates and intensifying geopolitical fragmentation amid generally softer GDP growth, elevated interest and defense spending, and a busy election schedule that will see more than 60 countries' voters go to the polls.

The outcomes of these challenges are likely to shape markets and sovereign rating dynamics in the longer term.

Over time, a plethora of shocks have resulted in sovereign downgrades to the lower end of the ratings scale at 'B-' or below and, eventually, defaults. Most recently, six sovereigns have defaulted on their debt over the last year. A heavier reliance on local markets, as cross border funding was either closed or prohibitively expensive for lower-rated sovereigns, drove the local currency default rate to 2.86%—the highest since 1993.

This is still relevant given current credit conditions and an uncertain geopolitical environment—especially considering that 47 of the 137 sovereigns we rate (or 34%) are assessed as speculative-grade, of which six have a negative outlook.

At the same time, seven investment-grade sovereigns currently have negative outlooks. (We assign a positive or negative outlook generally when we believe that an event or trend has at least a one-in-three likelihood, as a broad guideline, of resulting in a rating change in two years for investment-grade credits and in one year for speculative-grade credits. The shorter time frame for speculative-grade credits reflects their very nature: They are more volatile and more susceptible to nearer-term risks.)

S&P Global Ratings sees particular risk for the lowest-rated sovereigns, with seven at 'CCC+' and below. Of the 'CCC+' cohort, four have stable outlooks (Burkina Faso, Mozambique, Pakistan, and Suriname), while Bolivia has a negative outlook. We rate Argentina at 'CCC' with a stable outlook, and Ukraine at 'CC' with a negative outlook. (Issuers rated 'CCC' are vulnerable and depend on favorable business, financial, and economic conditions to meet their financial commitments. The 'CC' rating is used for issuers that are highly vulnerable, when a default hasn't yet occurred, but S&P Global Ratings expects default to be a virtual certainty regardless of the anticipated time to default.)

For the remainder of this year, the lowest-rated sovereigns could face an elevated risk of default if governments' cost of funding remains high, geopolitical tensions exert sustained pressures on commodities prices, and/or election outcomes add to uncertainty.

What We Think And Why

Recent ratings transitions illustrate the multitude of factors that can affect sovereign creditworthiness, both upwards and downwards.

After lowering our rating on Morocco from investment-grade ('BBB-') to 'BB+' during the pandemic due to its worsened budgetary position, we revised the outlook to positive in March—reflecting the economy's resilience in the face of multiple shocks and its ability to maintain access to domestic and external financing.

Similarly, we raised our global scale credit ratings on Brazil to 'BB' with a stable outlook from 'BB-' in December, following the strengthening of the country's track record of pragmatic policies that have helped anchor macroeconomic stability. In our opinion, Brazil’s ability to regain an investment-grade rating will depend largely on its political commitment to economic reforms to achieve improved fiscal consolidation and economic growth.

Historically, a small number of sovereigns were able to recover after defaulting on their debt and eventually regain investment-grade ratings—indicating the possibility for recovery, if only over a drawn-out period.

Cyprus, Greece, Indonesia, and Uruguay are the only four sovereigns we rate that have defaulted and then worked back to investment-grade. And their recoveries took five to 15 years to materialize.

These defaults usually stemmed from underlying external vulnerabilities and were often (although not always) triggered by events abroad, with the countries caught in a downward spiral that affected economic growth, the viability of their financial sectors, and the sovereigns' debt burdens. Post-default improvements in these sovereign ratings stemmed from a strong political commitment to boost economic performance, encourage investment, and strengthen public finances despite the weakness of financial markets immediately after default.

On the other hand, a substantial number of sovereigns rated in the 'B-' and 'CCC' categories have maintained these ratings for prolonged periods, and defaulted repeatedly over time—for example, Argentina.

In the case of Argentina, its main vulnerabilities stemmed from the volatility and lack of predictability of policies that have led to swings in exchange rate regimes, approaches to monetary policy, the size of the state, and its influence on investment and growth—all contributing to structurally low growth prospects. This has also impaired sovereign debt payment capacity and has undermined the payment culture.

What Could Change

Against the backdrop of challenging credit conditions, we expect sovereign borrowing from long-term bond issuance to grow to $11.5 trillion by year-end—more than 50% above the levels recorded before the 2020-2021 pandemic-induced peaks and an 8% increase from last year. A confluence of factors is driving this significant increase in sovereign borrowing, including slowing GDP growth and persistent structural spending adding to budget deficits; a multitude of fiscal measures on the table that are difficult to contain or roll back in a busy elections period; and elevated interest spending.

While investment-grade sovereign borrowing will account for the majority of issuance, the challenging credit conditions we expect through year-end heighten the contagion risks for the lowest-rated sovereigns and their borrowing costs. We now think monetary policy normalization in emerging markets will take longer than we previously expected.

Because many sovereigns going to the polls this year have weak fiscal and external balance sheets, their election outcomes could multiply the effects of any radical policy shifts. This also increases the risk of further political and social polarization around the world, which could curtail governments' capacity to make future changes.

Our sovereign ratings reflect our analysis of the factors that, in our opinion, affect a government's willingness and ability to service its financial obligations—as illustrated by over a century of sovereign defaults. These key credit factors are institutional and governance effectiveness, economic structure and growth prospects, external finances, and fiscal and monetary flexibility.

Writers: Molly Mintz and Joe Maguire