Sovereign Credit: US Policy Shifts Point to Tariff-light, Trade-war, Economic-crisis Scenarios

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The recent announcement of US trade tariffs marks a notable escalation in the protectionist policy adopted by the Donald Trump administration.

If implemented, the tariffs would represent the biggest peacetime trade shock to the global economy in more than 100 years. If sustained, this policy shift will have important credit implications for both the United States (rated AA by Scope with a Negative credit Outlook) and for sovereigns globally.

Conversely, even their full reversal, although unlikely, would not fully restore the confidence of previous alliances and supply chains, indicating a degree of durable economic loss.

Given such uncertainty, Scope has identified three scenarios to inform the forthcoming update of its growth and fiscal forecasts as well as other credit-relevant factors: i) a ‘tariff-light’ scenario, ii) a full-scale trade war, and iii) an economic and financial crisis.

US Trading Partners Face Multiple Options in Their Tariff Responses

The eventual impact on growth, inflation, public debt, external credit metrics and thus sovereign credit ratings will ultimately depend on the macroeconomic environment that emerges from the polices the US adopts, the responses by trading partners, and the underlying credit strengths and vulnerabilities of countries before this trade shock.

Possible responses among the US’s trading partners range from appeasing the Trump administration through tariff negotiations to a mix of adopting countermeasures, striking free trade agreements and deepening domestic economic reforms to partially offset the adverse impacts of US tariffs.

Scope will evaluate both the scale of the trade shock as well as the adequacy and quality of regional and national monetary and fiscal policy responses, focusing on the fiscal adjustment capacity and underlying economic resilience of sovereigns to absorb and reverse the impact of the shock over the longer run.

Questions to Grow Over Dollar’s Status If the Trade War Worsens

One of the most exposed sovereigns is the US itself as the epicentre of this unorthodox policy shift, particularly in Scope’s more extreme scenarios.

In a scenario of a protracted trade war and/or the introduction of US capital controls, viable alternatives to the dollar could emerge. For example, China and the EU could decide to deepen their trading relationship, China could decide to further open its capital account, and/or the EU could accelerate its Savings and Investments Union. These developments are unlikely to happen swiftly, but if doubts about the exceptional status of the dollar were to increase, this would be very negative for the United States’ credit ratings.

Countries with significant trade surpluses with and/or financial exposures to the US are also highly vulnerable to adverse consequences from the shift in US trade policy, although the impact in Europe will be uneven.

Overall, sovereign vulnerabilities include:

1. high openness to global trade and business cycles (e.g. Ireland),
2. sensitivity to higher financing rates (e.g. Italy),
3. exposure to weaker currencies (e.g. Turkey, Georgia), and/or
4. dependence on oil prices (oil-exporting sovereigns) that could materialise in a scenario of a synchronised trade war and/or an economic and financial crisis.

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Alvise Lennkh-Yunus is the Head of Sovereign and Public Sector ratings at Scope Ratings GmbH. Eiko Sievert, Senior Director, Thomas Gillet, Director, and Brian Marly, Senior Analyst, at Scope Ratings, contributed to drafting this article.