When it rains, it pours. For emerging markets, the downpour has come in the form of credit rating downgrades by the big three global ratings companies. Fitch, Moody’s, and S&P took a record 1,971 negative rating actions on emerging market sovereign and government-related entities in 2016. Emerging economies are right to be concerned. With a ‘good’ credit rating (AAA), a sovereign state can borrow at very low rates of interest from investors. A poor rating could force states to pay significantly higher borrowing costs. Rating downgrades could have negative ripple effects throughout the affected economies, raising the cost of borrowing for banks and firms, and, in turn, consumers.

Infrastructure projects, business ideas, and consumer credit extensions, become unprofitable due to the higher cost of credit to banks, businesses, consumers, and governments. If a country is downgraded to ‘junk status’ (more formally known as ‘non-investment-grade’ or ‘speculative-grade’), it risks the mass exodus of investors from its bond markets. As the cost of borrowing for governments increases, this can lead to a dangerous downward spiral as borrowing and spending dries up business and consumer activity declines.

Getting back on course
So what is the best set of policies for emerging markets to recover their credit ratings? On one side are economists who argue for ‘austerity’. In their view, recovering from a ratings downgrade requires sharp reductions in state spending, even if this results in poor conditions in the short term. The benefits are twofold: It can reduce inflation and prices, thereby helping restore a country’s price competitiveness in international markets; and it can enhance the credibility of a government when it comes to containing profligate spending.

Former British Prime Minister David Cameron called this philosophy ‘expansionary austerity’. The problem is that there is not much evidence to support this idea. The EU enforced austerity among its member states in response to the 2007 financial crisis, until it helped propel a ‘double dip’ recession in 2011/12. Following this largely unsuccessful adventure with austerity, the EU turned towards more pro-growth policies, which supported expansions in infrastructure and fixed-capital investment, with notable success.Read More »