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Thursday, May 29, 2008

Moody's and Hard Landing Vulnerabilities

Emerging European sovereign ratings could be vulnerable to a hard landing, ratings agency Moody's said on Thursday, adding that as a consequence the ratings of Hungary, Latvia and Lithuania would be “under significant pressure".

"Macroeconomic stress has been gradually building across Emerging Europe and is starting to reach critical levels. Several years of current account deficits and rapid credit growth have left a number of countries vulnerable to a rapid and difficult economic adjustment, a so-called hard landing," said Kenneth Orchard, a Moody's Vice President - Senior Analyst and author of the report.

In the meantime, however, Moody's sovereign ratings have barely changed, because its base case scenario remains a “relatively orderly reduction in growth and imbalances over time."

In an effort to promote transparency about the potential course of rating actions, Moody's has examined a stress scenario, which, if it were to materialise, would generate tangible negative rating pressure for some countries.

“We are most concerned about moderate to severe hard landings, defined as a rapid and difficult economic adjustment following an extended period of strong economic growth. Typically, the economy would contract substantially, and the current account deficit would sharply decline or even reverse. We would also expect to see problems in the financial sector, and possibly a decline in the value of the currency," Orchard elaborated.

The agency has identified 11 countries - ranging from Iceland to the much lower rated Baltic states - with large economic imbalances, i.e. high current-account deficits and a substantial increase in domestic credit to GDP ratios.

“The probability of these imbalances ending in hard landings has increased with the recent turmoil in the global capital markets," Orchard said.

“Although capital flows into the surveyed countries have been maintained so far, international banks and investors have become more risk averse and capital constrained," he added.

“Rising imbalances are reflected in the fixed income and credit default swap (CDS) markets, where CDS prices have risen and bond spreads have widened significantly since July 2007 and - for some countries - these markets are now factoring a material risk of default," Orchard noted.

He added, however, that downgrades might still not lead to an alignment with market CDS-implied ratings, “which in some cases have moved from being much more optimistic to much more pessimistic than Moody's sovereign ratings".

The analysis outlined in the report allows Moody's to consider the impact of moderate to severe hard landings on sovereign creditworthiness, projecting debt/GDP ratios for each country and evaluating liquidity outcomes.

Moody's said Bulgaria, the Czech Republic, Estonia, Iceland and Kazakhstan had demonstrated "excellent financial strength" and their rating would most likely be resilient to a severe but unlikely hard landing.

The second group of the three identified in the report that were differentiated by the potential impact of hard landing on sovereign ratings comprises Croatia, Poland and Romania, which, according to Moody's, were in a relatively strong position. Nevertheless, the agency said these could still be faced with a medium to large increases in public debt and so potentially a moderate downward ratings pressure.

The third group with Hungary, Latvia and Lithuania in it is the most vulnerable, and the ratings of these three would be “under significant pressure".

“This analysis means that the first signs of a materialisation of a - still unlikely - severe hard landing would require heightened attention from Moody's Sovereign Risk Unit," Orchard concluded.

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