Grating ratings keep emerging markets shaking

With Brazil's sovereign debt rating relegated to junk by Standard and Poor's this week, investors fear that messy politics and flagging growth will erode the credit score of other once-buoyant economies.

Like Brazil, emerging markets such as Russia and South Africa have basked for around a decade in a the glow of investment-grade ratings. Now they are at risk of becoming "fallen angels", tumbling back below investment grade into junk.

A junk rating can set off a wave of capital outflows because it automatically excludes its bonds from certain high-profile indexes. That means some conservative funds - active managers as well as passive ones that "track" the index - are no longer able to buy and sell the bonds.

With Russia becoming a fallen angel earlier this year and Brazil halfway there, Turkey and South Africa could be next in line. Credit default swaps (CDS), which can be used insure against or to bet on national or corporate debt problems, forsee a wave of EM downgrades, according to an S&P Capital model called Market Derived Signal.

"We will continue to see CDS spread pricing in expectations of rating cuts especially in South Africa and Turkey, given agencies are focusing on structural issues more than anything else these days" said Simon Quijano-Evans at Commerzbank.

"And with political and commodity market worries growing just as the global liquidity tide begins to ebb, "Ratings metrics are so complex now," said Quijano-Evans.

"What do you weight more on, debt or lack of FX reserves? So I think they are focusing more on reform impulses and the possibility of pushing more reform and that's what essentially probably drove S&P on Brazil."

The number of countries on downgrade warnings, or "negative outlooks" in rating agency parlance, is relatively small and the firms emphasise many emerging markets have far better finances and currency arrangements than in the past.

Financial markets, however, are betting that not only will South Africa and Turkey lose their investment grades, but so will Colombia, Kazakhstan and Bahrain.

And although it may not make the crucial difference between IG and junk, the list of countries expected to be downgraded, in some cases heavily, include China, Chile, Mexico, Malaysia, Indonesia, Thailand, Israel and Saudi Arabia.

As an example of what a downgrade to junk can trigger, Russia lost investment estimated to be worth $140 billion when it was ejected from the Barclays Global Aggregate bond index earlier this year.

As for Brazil, JP Morgan predicts investors will dump $20 billion worth of hard currency corporate and government bonds and another 1.5 billion of local currency debt if Moody's or Fitch follow S&P in cutting it to junk.. South Africa also figures in the Barclays index.

Manolis Davradakis, senior economist at AXA Investment Managers, said that normally a Brazilian downgrade would benefit other emerging markets in the index. But this time, "further downgrades would intensify EM portfolio debt outflows and ramp up total EM portfolio outflows," Davradakis added.