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New Europe: Mind the ratings

Thu, Mar 22 2007, 14:51 GMT
by Thomas Salomonsen, Lars Christensen

Danske Bank A/S

• We take a look at the prospects for sovereign debt credit ratings in the EU8+2 countries (Estonia, Latvia, Lithuania, Poland, Hungary, the Czech Republic, Slovakia, Slovenia, Romania and Bulgaria)
• Our analysis shows that the “ratings cycle” is turning negative for the EU8+2 countries and that six of 10 countries are likely to face negative rating action (either in the form of downgrades or change of outlook in a negative direction) in the coming year.
• Especially Latvia’s ratings outlook looks negative and we expect Latvia to be downgraded over the coming year. Romania could also be facing a downgrade. Furthermore. Estonia, Lithuania, Slovakia and Bulgaria could be facing negative rating action.
• The Czech Republic could be upgraded over the coming year and Hungary might end years of speculation over possible downgrades as the country gets rewarded for fiscal consolidation with positive rating action. The rating status for Poland and Slovenia are likely to remain broadly unchanged.
• The generally negative prospect for the rating of the EU8+2 countries further underlines the need to be careful about the market risks in the Baltic States and Central and Eastern Europe.
  

Less bright prospects

Outlook for EU8+2 credit ratings Recently the ratings agency Standard & Poor’s (S&P) changed its outlook for Latvia’s sovereign debt to “negative” from “stable”, see our Flash Comment “Latvia: S&P changes outlook to negative ”, February 19 2007. The negative ratings action from S&P sparked a mini run on the Latvian lat and wider speculation about the sustainability of the Latvian boom.

Furthermore, the focus on Latvia’s imbalances and strong credit growth has increased focus on similar problems in other Baltic and Central and Eastern European countries. In our paper “Research – New Europe: A Warning not to be ignored”, February 23 2007, we take a closer look at these concerns and evaluate whic countries in the Baltics and Central and Eastern Europe looks most “unbalanced ” and most likely to face a hard landing in the economy and possibly also financial distress. In this paper we follow this path further and take a closer look at whether these imbalances could lead to possible negative rating action from the three major rating agencies, Standard & Poor’s, Fitch and Moody’s. We focus on the same countries as in our previous research report – Estonia, Latvia, Lithuania, Poland, Hungary, the Czech Republic, Slovakia, Slovenia (EU8) and Romania and Bulgaria (EU2). Our analysis starts out by estimating quantitative models based on macro economic and institutional fundamentals for the EU8+2 countries.

Our analysis shows that more countries are likely to face negative rating than positive action. Hence, our analysis indicates that five countries (Estonia, Latvia, Lithuania, Slovakia, Bulgaria and Romania) are likely to face negative rating (either a change of ratings outlook in negative directions and/or downgrades), while only two countries (the Czech Republic and Hungary) are likely to face positive rating action. We expect stable ratings for Slovenia and Poland. Especially Latvia stands out and our analysis clearly shows that the risk of downgrades of Latvia ’s sovereign debt is substantial.

Furthermore, our analysis shows that ratings of the two EU newcomers, Bulgaria and Romania seem to be a bit too positive given the underlining fundamentals in the two countries and negative news – for example lack of progress in EU related reforms and/or a continued rise in the external imbalances in Romania and Bulgaria – could lead to negative rating action for the two countries’ sovereign debt. The outlook is most negative for Romania’s ratings and we would expect a downgrade of Romania’s sovereign debt rating from at least one of the rating agencies (most likely Fitch).

It should also be noted that Slovakia looks a bit “over rated” and hence negative news – for example postponed euro adoption – could trigger negative ratings action. Equally interesting, our analysis indicates that Hungary – which for long time have been the prime candidate for ratings downgrades in the region – in fact looks “under rated”. Hence, the ratings of Hungary are in general lower than what our models predict. Therefore, Hungary could in fact face positive rating actions in the coming year, but much will naturally dependent on whether the planned fiscal consolidation has the expected positive impact on public finances and the current account situation. It is striking that our models indicate that the countries, which are most fragile to negative rating actions are to a large extent the same countries that are likely to face a hard landing in the economy and possibly also financial distress. These countries are Estonia, Latvia, Lithuania, Bulgaria, Romania and Slovakia.

For a complete overview of our forecasts for the ratings for the individual countries, see the table in the end of this report. We expect the rating news in general to be more negative in the coming year compared to what we we have been used to in recent years. There are a number of common factors that are likely to contribute in a negative direction to the ratings of the EU8+2 countries’ sovereign debt. These factors are:

• Signs of overheating leading to increased and unsustainable external imbalances.
• Too strong and unsustainable credit growth.
• Increased inflationary pressures.
• Postponed euro adoption.
• Signs of bubbles in some local property markets.
• Pro-cyclical fiscal policy.
• Continued high political uncertainties.
• Negative external shocks: Continued tightening of monetary policy in Euroland and moderation of wider European growth. This will be negative for the financing conditions and export growth in EU8+2.

• Download full New Europe: Mind the ratings with charts

Published on  Thu, Mar 22 2007, 15:03 GMT