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Brazil’s downgrade to junk status this week by Standard & Poor’s, the credit rating agency, is not only a severe blow to investors, policymakers and citizens in Brazil, but it also opens the prospect of a wave of further downgrades across emerging markets, as credit spreads widen and investors become increasingly gloomy about a global economic slowdown.

“We are entering a different phase,” says Bhanu Baweja, emerging market strategist at UBS in London. “For the longest time we have thought that even if EM growth is weak, EM balance sheets, or their ability to service their debts, have been broadly OK. But now things are getting more serious.”

Analysts say the three main global rating agencies — S&P, Moody’s and Fitch Ratings — are increasingly basing their ratings decisions on broad macroeconomic criteria rather than on a country’s narrow ability to service its foreign currency sovereign debts, traditionally the agencies’ main focus.

Brazil, indeed, has relatively little foreign currency sovereign debt. However, it does have a lot of government debt denominated in local currency, as well as a lot of foreign currency bonds issued by companies — Petrobras, the crisis-stricken oil company, being a prime example.

Increasingly, the ability to service those debts is being seen as a function of more than the size of a country’s foreign exchange reserves or its budget balance, although both are still important.

“There is such a wide variety of metrics and [gauging ability to pay] has become so complex that it is very hard for the agencies to allocate a weight to specific factors in a matrix,” says Simon Quijano-Evans, EM strategist at Commerzbank in London.

Rating agencies, he says, are looking at structural issues such as the business environment and levels of corruption. In particular, he says, they are concerned about the path of structural reform and whether, in the case of commodity-dependent emerging markets, there has been progress in diversifying the economy into other areas.

“In places like Brazil, Russia, South Africa and now China, things have been going on a downward spiral,” he says. “Policymakers have had time to get on the reform path and it hasn’t happened.”

Even if investors think a sovereign’s ability to service its foreign debts is not at risk, a downgrade from investment grade to junk matters because it pushes up borrowing costs across an economy. On financial markets, it may result in forced selling of bonds, as many asset managers can only buy investment grade-rated assets.

Rising bond yields can also affect other assets, such as equities. “When credit spreads widen, every asset class gets hit,” says Mr Baweja at UBS.

Brazil’s economy and the prospects of any recovery have deteriorated swiftly. On August 31, the government abandoned any intention of delivering a primary budget surplus this year, meaning its level of debt to gross domestic product is set to rise rather than fall as previously planned.

Brazil’s level of government debt to GDP fell from a peak of 78 per cent in 2002 to 61 per cent in 2011. But it has since been on the rise. The situation is similar in Russia, South Africa and Turkey. Even though debt to GDP levels are much lower than in many developed markets, the fact that debt is rising has set alarm bells ringing.

“The issue is the dynamics of the debt and the lack of any coherent policies to address it,” says Mr Quijano-Evans.

Mr Baweja and colleagues at UBS issued a report hours before Brazil’s downgrade suggesting that debt sustainability is worsening across many emerging markets. They devised a score of balance sheet risk based on 12 variables grouped into leverage, the external sector, fiscal balance and supply side and institutional factors.

Brazil’s score peaked at 14 in November 1999 and fell to 9.8 in December 2008, as a joint commodity and credit-led consumer boom helped it through the global financial crisis relatively unscathed. But its score has since risen again to 11.6.

“It doesn’t take a lot of imagination to see how it could go up from here,” says Mr Baweja. “This score is already consistent with subinvestment grade and even a further downgrade.”

On the same basis Turkey, South Africa and Malaysia look vulnerable to a downgrade, he says.

Other analysts also point to Russia because of its entrenched dependency on the oil sector and failure to diversify, as well as its political issues.

But Mr Baweja warns that the problem is general across EMs. “Balance sheets are deteriorating and EMs have not delivered the diversification we thought they would,” he says. “Policymakers are finding it very hard to get their house in order and as the downgrades come and credit spreads widen, the medicine is going to get more and more bitter.”

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