Fitch Ratings says in its semi-annual Sovereign Review that the economic and credit outlook for emerging market economies is deteriorating, driven primarily by rapidly rising inflation.

"It is the surge in inflation, rather than the direct consequences of the global credit crunch, that is the principal threat to macroeconomic and financial stability in many emerging markets," says David Riley, Group Managing Director in Fitch's Sovereigns team. "The risk faced by several central banks is that the failure to contain inflationary pressures will result in downward pressure on exchange rates - especially if the Fed surprises with earlier rises in US interest rates - leaving policymakers with the unenviable choice of either allowing currencies to depreciate, which in turn will stoke inflation further, or intervening in support of their currencies and raising interest rates much more aggressively with negative consequences for growth."

While economic growth and exports in Latin America have been buoyed by high and rising commodity prices, the terms of trade for commodity-consuming emerging Asia and Europe have worsened. Inflation in Asia, in particular, has accelerated sharply as policymakers have been reluctant to raise interest rates, while much of emerging Europe remains exposed to a reversal of private capital flows due to large current account deficits and (non-sovereign) external borrowing.

Economic activity has continued to be robust in most emerging markets despite the slowdown in the G7 economies. Fitch predicts that emerging markets will grow 6.2% in 2008, compared to 7.2% last year. However, inflation has accelerated at an alarming pace in many emerging markets to multi-year highs. The monetary policy response to rising inflation has been disappointing, with several central banks apparently reluctant to raise interest rates and allow their currencies to appreciate in response to what is perceived as external and temporary price shocks. However, with consumer price inflation in several emerging market economies now significantly above official targets and accommodated by wage increases, including by hikes in public-sector salaries, the risk of a wage-price spiral as inflation expectations shift upwards is increasing.

Inflation can have an insidious impact on sovereign creditworthiness by heightening the incidence of macroeconomic volatility, not least by encouraging a flight into foreign currency assets, and increases the risk of exchange rate and banking crises. Rising fuel and food prices are also placing government budgets under pressure as subsidies become more expensive. These concerns have been at the forefront of several negative rating actions by Fitch in recent months and the net balance of Positive to Negative rating Outlooks has fallen to just 3 (12 Positives/9 Negatives) from 16 (19 Positive/3 Negative) less than a year ago, suggesting that the positive rating momentum of recent years is dissipating despite recent high profile rating upgrades, notably of Brazil to investment-grade.

Fitch notes that the global credit crunch has so far not had a noticeable impact on private sector credit growth which remains strong, while rising commodity prices have boosted incomes in resource-rich emerging economies. But it warns that the full impact of the downturn in the US and other advanced economies is yet to be fully felt in terms of reduced export demand. The agency further warns that commodity prices are expected to moderate from current levels and central banks are being forced to tighten monetary policies in response to the upsurge in inflationary pressures.