Business environment risk in practice
In order to illustrate the impact of this change in risk name and scale, and the factors justifying the level of the business environment risk, we have briefly explained the business environment ratings of a few large countries below.
China is rated D/G, i.e. the fourth highest risk category. This moderate risk level is explained by multiple factors. Its fast-growing economy has experienced a slowdown since 2011 as a result of rebalancing to a consumer and services-based economy, and also due to the recent need to alleviate the heavy domestic debt burden. This structural process has become more challenging in the face of the trade war with the US, and of course from the huge economic shock arising from the Covid-19 pandemic that broke out in early 2020. The latter led to China’s worst annual economic deceleration (+2.3%) in more than 40 years. Meanwhile, the economy has recovered early and solidly since the second half of 2020 thanks to effective containment measures, the global export boost in the medical and electronics sectors and a large increase in bank credit supply. These factors had a positive impact on the RMB, which appreciated by 6.5% against the US dollar last year and thus reduced the costs of debt payments in foreign currency. In 2020, the payment experience with Chinese debtors deteriorated. Despite strong growth prospects in 2021 (+8.4% according to the IMF), persisting uncertainties surrounding the pandemic, global demand and a further increased heavy corporate debt burden may maintain high risks of payment delays and non-payments. Apart from its economic conditions, China presents a relatively good institutional environment. However, it tends to be less favourable over a range of sectors given the economic and trade tensions with western countries and a context of rising global protectionism, thereby elevating the level of business environment risk.
In light of the current Covid-19 crisis, the business environment risk for Saudi Arabia was downgraded in March 2020 from category E/G at the end of 2019 to category F/G. This classification has been maintained ever since. The reason that Saudi Arabia had such a high classification even before the start of the pandemic is due to its difficult business environment. While authorities have taken steps to try and improve this in recent years, the enforcement of contracts remains difficult, which is having a significant impact on the business environment risk. Nevertheless, two elements have historically continued to support business environment risk in Saudi Arabia; firstly, the peg to the USD remains very strong, meaning that companies in Saudi Arabia are not impacted by exchange rate fluctuations, and secondly, lending to the private sector has expanded steadily in recent years, supporting economic activity, although access to loans for SMEs remains more difficult.
The impact of the Covid-19 crisis and the drop in oil prices led to a sharp contraction of the economy (4.1%), which was the main driving factor for a downgrade of the business environment to category F/G. Given the oil price drop, oil GDP contracted heavily by 7.2%, which had spillover effects on non-oil GDP. However, lockdown measures also had a large impact on non-oil GDP given its influence on wholesale and retail sectors, as well as transportation sectors. The services, construction and nascent tourism sectors were also impacted. It should be noted that it was only due to support measures in the form of fiscal stimuli (which amounted to 3% of GDP) and loosening monetary policy that non-oil GDP contracted by just 2% in 2020.
The outlook is positive for 2021, because the steady recovery of the oil price will support growth; although in light of OPEC+ production curbs, oil activity will not expand significantly. A further reopening of the country is expected as the vaccination rollout is moving quickly, and this will support the recovery of non-oil GDP and could support an upgrade in the year to come. However, given the large degree of uncertainty related to the evolution of the global pandemic, the outlook remains skewed to the downside. Over time, fiscal spending will need to be reduced since the current deficit is estimated to reach 7.1% of GDP in 2021, leading to a reduction of liquidity buffers and a rise in public debt levels. As in other countries, exceptional Covid-19 support measures (such as temporary measures to support borrowers) will also need to be withdrawn, and the question is how this will affect the business cycle in the country.
The Turkish economy was resilient to the Covid-19 shock and heightened geopolitical tensions. Real GDP grew by 1.8% last year, and is expected to grow by 6% this year according to the IMF World Economic Outlook, April 2021. Economic growth has largely been driven by large fiscal and monetary stimuli that led to an increase in domestic and external imbalances. Notably, bank credit to the private sector rose sharply last year (34% YoY), which implies that access to credit was widely available for the corporate sector. On the negative side, the large credit growth further increased the already high levels of corporate indebtedness, which is largely denominated in foreign currency. Therefore, the risk would be an increase in non-payment risk – which would directly affect the banking sector – amid a further depreciation of the Turkish lira. Following a sharp depreciation last year, the exchange rate remains under severe pressure following the dismissal of Naci Ağbal, the very low level of foreign exchange reserves and high reliance on short-term capital flows, which leaves the country very exposed to changes in investor risk aversion. Monetary uncertainty is high, as the Central Bank is struggling to stem inflation pressure, and the annual inflation rate reached 17.1% in April this year (according to the Central Bank) compared to a target rate of 5%. In this context, the business environment risk category F/G for Turkey is largely explained by the depreciation of the lira, relatively high lending costs and high monetary policy uncertainty.
The business environment risk for Poland is rated E/G. Given the significant impact that Covid-19 had on the Polish economy, its rating was downgraded for the first time in April 2020 (from C/G to D/G) and then in May 2020 (from D/G to E/G), and has not changed since. Poland's real GDP fell 2.7%, a modest drop when compared with regional peers. The general lockdown imposed in Europe had a major impact on the Polish economy via two channels, primarily through exports. Almost three quarters of Polish goods exports are heading to the rest of Europe, where GDP rates fell even more, reducing demand for Polish exported products. In addition, exports were severely affected by border closures during the first lockdown. Poland’s economic impact was also affected by a decline in domestic consumption, which is usually a driving factor of the country’s economic growth. However, the flexible exchange rate allowed some of the shock to be absorbed, and furthermore, a large wave of defaults was avoided thanks to the substantial support measures provided by government authorities (estimated at 5.4% of GDP). The general government debt increased significantly due to lower revenues and higher expenses, but given the relatively healthy public finances before the pandemic, this is less of a concern. Inflation is under control, estimated at 2.5% in February 2021 – the target since early 2020 – and the Central Bank is expected to maintain its accommodative policy stance until 2022, leaving the PLN exchange rate around its current level. The institutional environment is good – corruption perception and doing business indicators are in line with the country’s regional peers. The positive outlook on economic growth could lead to an improved rating in the coming months, although it is too early to upgrade given the uncertainty around the pandemic’s evolution in Europe.
Brazil is rated G/G, i.e. the highest risk category, which can be explained by multiple factors. First of all, Latin America’s largest economy experienced a contraction of around 4% last year, its deepest recession in almost three decades. Economic growth is, in general, inversely related to fluctuations in bankruptcies, although the impact on bankruptcies comes with a lag, especially as huge fiscal support measures were implemented in Brazil in 2020. However, these measures have been rolled back since the beginning of this year, as public finances deteriorate (public debt stood at 99% of GDP at year-end 2020). Therefore, an increase in bankruptcies to a relatively high level could be expected in the coming months. On the upside, an economic recovery of 3.7% is on the cards for 2021 but this forecast is vulnerable to high downside risks. Since the start of this year, a more contagious (and possibly more deadly) variant of the Covid-19 virus is raging through the country. Together with a rather slow vaccination rate, a more prolonged Covid-19 pandemic is possible in Brazil, potentially hampering economic recovery and/or stirring social unrest. Moreover, the Brazilian real has depreciated in the past year to one of its weakest levels in five years, hurting local importers, companies repaying loans in foreign currencies and banks with large foreign exchange liabilities. Already weak, the currency is expected to remain under pressure in the coming months due to Brazil’s dire public finances, the forecasted current account deficit (projected at -0.6% of GDP in 2021) and the rising MLT interest rates in the USA. Another important driver of the high business environment risk rating is the relatively high lending rate for Brazilian companies, a long-standing problem in Brazil. As the Central Bank of Brazil is expected to tighten its monetary policy, lending rates are not expected to come down soon. A final, structural element hampering Brazilian business is the institutional environment – the relatively eminent corruption perception levels, elevated doing business indicators (due to cumbersome and complex taxation, among other reasons) and somewhat inadequate legal protection (mainly attributed to bureaucratic delays) are all impeding Brazilian businesses.
South Africa’s business environment risk classification was downgraded from category E/G to F/G in early 2020, as the impact of Covid-19 on South Africa has been very severe. In 2020, GDP contracted by 7% as the lockdown depressed consumer spending, which is a principle driver of South Africa’s economic growth. Moreover, South Africa’s economy appeared particularly vulnerable to the impact of the pandemic, as it is highly internationally orientated. Despite the sharp drop in capital inflows, the country’s adequate liquidity buffer and deep domestic capital markets helped to address large financing needs. In addition, the flexible exchange rate has been acting as an effective shock absorber. Nevertheless, to help deal with the socioeconomic impact of the Covid-19 crisis, South Africa made its first ever request for an IMF loan.
For over a decade, South Africa’s economic growth has been slow (averaging around 1.4% between 2009 and 2019), hampered by long-standing structural domestic constraints that remained unaddressed. The weak economic growth performance has kept the business environment risk valuation rather elevated, although compared to many other countries in the region, corruption perception and doing business indices are good, lending costs are limited and inflation targeting is a major monetary policy focus. Consequently, the strong fundamentals are there for a positive outlook, although the major challenge will be revitalising the business cycle again. The post-pandemic recovery plan is set to prioritise reforms to attract investments, promote job creation and improve power supply, which is all underpinned by the commitments made to the IMF in return for financial support. In any case, in 2021 the growth recovery is only expected to reach 3.1%, and to come down to 2% again in 2022.
Algeria’s current classification is F/G. Algeria’s classification fell to category G/G from F/G in April 2020. The main explanation for that downgrade was the double shock that the country’s economy experienced in 2020 as a result of Covid-19 and the related turbulence in the oil markets. A key weakness for Algeria is the low degree of economic diversification; the country relies on the hydrocarbon sector for 75% of its current account receipts, and oil rents represented on average 20% of GDP from 2010 to 2018. As such, economic growth is highly dependent on oil price fluctuations. It is therefore no surprise that the fall in oil prices and the restrictions introduced to mitigate the Covid-19 pandemic had a severe impact on the economy. In 2020, real GDP contracted by 6%.
The country returned to category F/G once again in April 2021. The upgrade was a result of the improvement of oil prices and the expected more favourable business environment in 2021. Despite the projected real GDP growth of 2.9% for 2021, the country was upgraded only by one category and remains in a high risk category. This is because Algeria suffers from several structural weaknesses in addition to the aforementioned low degree of diversification. For instance, the external position of the country has been under pressure for some years, and these external imbalances have put pressure on the Algerian dinar. Without any significant reforms they will continue to put pressure on the country’s currency. Moreover, the country business environment is quite weak due to structural and institutional barriers, and a low level of legal protection that make it hard to conduct business.
Italy is rated F/G, i.e. the sixth highest risk category, which is mainly explained by the large impact of the pandemic on the country’s economic activity. The most affected sectors (tourism, hospitality and retail) represent a large share of the economy, and indeed Italy’s contraction for the last year (almost 9%) is estimated to have been one of the largest in the EU. The country has been affected by a third wave of infections this spring, with numerous regions being placed under lockdown measures and mobility restrictions. Even though significant fiscal and monetary support has prevented a wave of bankruptcies up to now, bankruptcy risks will grow when those are lifted. Compared to other EU countries, the institutional environment (ease of doing business, corruption perception and legal protection indicators) is also lagging behind.