Fitch Ratings warns of the risks to emerging market (EM) sovereign creditworthiness from rising inflation and has developed a ranking of Fitch-rated EMs according to their vulnerability to inflation shocks.

"Rising inflation rather than slowing economies is the principle challenge facing policymakers in emerging economies. Low and stable inflation has underpinned macroeconomic stability and allowed governments to borrow locally rather than incur foreign currency debt in international capital markets. Failure to contain inflationary pressures risks undermining macroeconomic stability and medium-term growth prospects. In the worst case scenario, investors will lose confidence in local currency assets leading to volatile financial and currency markets," says David Riley, Head of Sovereign Ratings at Fitch. "

Fitch has constructed an index of relative EM vulnerability to inflation shocks based on inflation dynamics, the degree of domestic overheating, monetary conditions and the importance of the domestic government debt market to the sovereign. The top ten most vulnerable EMs according to this index are currently: Jamaica (1), Ukraine (2), Kazakhstan (3), Bulgaria (4), Suriname (5), Latvia (6), Lithuania (7), Ghana (8), Vietnam (9) and Sri Lanka (10).

Out of 73 Fitch-rated EMs, Jamaica, Ukraine and Kazakhstan appear the most vulnerable. Emerging Europe heavily populates the upper echelons of the vulnerability rankings in light of the significant economic imbalances in the region that have been fuelled by rapid private credit growth. Russia is also the most vulnerable of the BRICs (Brazil, Russia, India and China) by a wide margin.

A key conclusion of the report is that, though the current inflation shock has a large international component, the inflation challenges facing EMs are far from a "pure" supply shock. Significant chunks of the EM universe are facing underlying inflationary pressures, including in emerging Europe, parts of Asia, the Gulf Co-operation Council (GCC) countries and other commodity exporters. With fixed or heavily managed exchange rates back in vogue, the reluctance to allow nominal appreciation is ensuring that real exchange rate appreciation warranted by fundamentals occurs through higher inflation.

Many youthful EM monetary policy regimes are facing their first real tests. Inflation targets are being exceeded by a wide margin in many countries and core inflation has been rising since August of last year. There is an elevated risk of rising inflation expectations and second-round effects from higher headline inflation. This is much more severe than in the advanced economies, where slower growth will provide a dis-inflationary counter-balance to high food and energy prices and where central bank credibility is deeper. This makes swift policy responses crucial to prevent inflation becoming entrenched.