S&P Viewpoint

After years of a preponderance of sovereign upgrades over downgrades in Europe, changes in 2006 were exactly balanced between three upgrades (Slovenia, Russia, and Bulgaria) and three downgrades (Hungary, Italy, and Iceland). (For full official names and ratings, see table at end of article. As there have been no relevant rating actions so far this year, all year-end 2006 references still apply on Jan. 17, 2007.) The positive ratings momentum weakened throughout 2006 and the fourth quarter actually brought more downgrades than upgrades (see chart 1). Consequently, the perspective for 2007 is not particularly promising. In fact, the median rating of the 41 sovereigns rated by Standard & Poor's dropped for the first time ever into the 'A' category during the fourth quarter of 2006, as Italy and Iceland fell out of the 'AA' category (see chart 2; all ratings and rating actions in this commentary refer to long-term foreign currency ratings, unless noted otherwise).

 Chart 1

 Chart 2

No. On the contrary, Standard & Poor's expects that sovereign upgrades should once again exceed downgrades this year. This prediction derives from the balance of sovereign ratings with positive and negative outlooks. Standard & Poor's uses outlooks to signal to investors that a rating will be under upward or downward pressure in the coming six months to two years. An outlook is not necessarily a precursor of a rating change, although it has strong predictive power. At present, there are no negative outlooks on any European sovereign, an unusual situation (see chart 3). At the same time, four sovereigns start with a positive outlook going into 2007: the Czech Republic, and the Balkans sovereigns Romania, Montenegro, and Serbia.

 Chart 3

When comparing the present outlook balance with that prevailing at the beginning of 2006, it appears highly likely that there should be fewer rating actions (either up or down) in the next six to 18 months than in the past year. In total, 90% of all rating outlooks are now stable, compared with 73% in the first quarter of 2006 (see chart 3). Positive outlooks still prevail over negative ones, as they did then, but by a smaller margin than in early 2006. In other words, 2007 could become an unusually calm year for sovereign ratings in Europe.

No. It is true that the economic recovery in 2006 was stronger than we had anticipated at this time last year, bringing with it a warm rain of unexpected tax revenues. This helped to reduce the budget deficits in most sovereigns, not only in the dynamic Central and East European (CEE) subregion, but also in the Eurozone heavyweights. The positive momentum is likely to carry over into 2007. We expect that the economies of the rated European sovereigns will grow by 2.7% this year, marginally less than the 3.2% of 2006, but still quite respectable by recent standards.

Public finances, however, will remain in the same deficit position, around 0.9%, in both years. This demonstrates that on average, little will be achieved in terms of structural fiscal consolidation. In this regard, Standard & Poor's credit opinions are informed by long-term considerations, assessing the probability of default on financial obligations over a horizon typically spanning 5-10 years. We therefore strive to filter out the gyrations of the business cycle when determining sovereign ratings. The mentioned downgrades of Italy and Iceland are a case in point: in 2006, both experienced strong growth by their national standards and improving headline deficits in the case of Italy or a sizable surplus in the case of Iceland. However, both sovereigns also took policy choices that Standard & Poor's considered as weakening the long-term outlook for sovereign creditworthiness.

(For more details regarding Standard & Poor's cyclical assumptions for all rated European sovereigns, please see "Data Watch: European Sovereigns In 2007," published on Jan. 17, 2007.)

The region's current account deficits are certainly exceptionally large in the emerging market universe. Yet, external imbalances are not unexpected in countries that are growing rapidly and investing heavily, very often in export-oriented production. A large part of these deficits is financed through secure channels, such as foreign direct investment (FDI) and capital transfers from the EU. Nevertheless, it is true that the financing structure has become more insecure as the external deficits continued to surge. More and more countries depend on short-term portfolio flows, a situation that makes them more vulnerable to sudden downturns in confidence and financing. The turbulence across emerging markets currency and capital markets in the second quarter of 2006 provided a little flavor of the risks lurking. Most vulnerable in our opinion are those countries where the large current account deficit is driven by a domestic credit and consumption boom, especially where much of this retail credit is granted in foreign currency, for example in Hungary and Romania (for more details, see "The Foreign Currency Gamble--Rising Risks For Banks In Central And Southeast Europe," published on Aug. 23, 2006).

Moreover, external imbalances also matter in sovereigns that are already members of the Eurozone and cannot therefore be subject to a traditional balance of payments and currency crisis. Even with the benefit of Eurozone membership, current account deficits approaching 10% of GDP, as in Spain, Greece, and Portugal, are unsustainable and the concomitant rise in external debt and debt service will stunt future domestic demand and growth potential, especially if external competitiveness has been weakening, as is the case in the Southern European trio. With lower growth would come weaker budgets, and public finances are an even more important rating factor inside monetary union than outside.

Consequently, external balances do matter for sovereign ratings. Indeed, the downgrade of Iceland in December 2006 and the outlook revision on Georgia to stable from positive a month earlier are both to be viewed in the light of these countries' exceptionally large external imbalances. While in themselves current account deficits did not trigger rating actions in Europe, they did leave sovereigns more exposed to inappropriate policy choices (Iceland) or geopolitical risks (Georgia).

Actually no, in fact convergence has slowed down considerably since 2005, and reversed even earlier within the subgroup of EMU members (excluding Slovenia). The average ratings for EU accession and candidate countries (including Romania and Bulgaria, which joined in 2007) and the "Class of 2004" (members that joined the EU in May of that year) have been increasing and catching up steadily with those of the EU-15. The latter group has in the past three years experienced a decline in average ratings with downgrades to Italy (2004 and 2006), Portugal (2005), and Greece (2004; see chart 4). Meanwhile, convergence within the "Class of 2004" has also stopped, and 2006 even witnessed some divergence within that group, as the strongest ratings rose further (Slovenia) and one of the weakest was lowered (Hungary).

 Chart 4

There is no reason to believe that, over an extended period of time, the ratings in any given region would automatically converge. Although the effort to achieve EU membership brings about in most cases a truly structural change that leads to a modernization of institutions that would otherwise only have occurred over a very long time span, if at all, most of the benefits tend to accrue typically in the run-up to accession, when the changes are most dramatic. In terms of creditworthiness, the period directly preceding membership was the most advantageous for the new members of the "Class of 2004" (see chart 4). With many of the new members engaging more in domestic political issues and forging their new self-understanding and identity, as demonstrated by populist victories following the spate of elections in the region in late 2005 and in 2006, Standard & Poor's case-by-case ratings approach is more justified than ever. One of the members of the "Class of 2004," Slovenia, joined the Eurozone in 2007 and is now rated higher than several of its EMU peers, whereas other candidates like Hungary and Poland may take up to the middle of the next decade to join the Eurozone, and their ratings remain the lowest in the region at 'BBB+'.

The sovereign credit default swap (CDS) market has indeed grown strongly and allows investors to "insure" against an event of default. Although a strong correlation between ratings and CDS pricing exists (see chart 5), it is not exact, and the outliers are significant. Italy's rating, for example, is 'A+', whereas default protection is priced more dearly than for any other 'A', or even 'A-' rated European peer. Conversely, the CDS market prices the probability of default in Romania at less than one for Russia, although the latter is rated two notches higher. Russia is a particular noteworthy outlier, possibly reflecting investor nervousness about political risk.

 Chart 5

There may be many reasons why, despite the strong correlation between the CDS spreads and the ratings, the relationship is not perfect. Market liquidity varies and CDS prices are far more volatile than sovereign ratings. Also, the time horizon of Standard & Poor's when assessing ratings is likely to be different from that of capital market participants purchasing default insurance, or simply speculating on short term movements of sentiment.

Bulgaria's rating was upgraded in October 2006, while that on Romania was placed on a positive outlook one month earlier. In both cases, the rating actions were in large part due to a growing track record of structural reforms, which have been underpinned by the policy anchor of the EU accession process. They were also based on the further benefits expected to stem from EU entry on Jan. 1, 2007, including improved prospects for investment-driven economic modernization, and continued efforts in areas of importance to the business environment. The ratings on both countries have also benefited from sustained improvements in their public finances, as evidenced by their low debt burdens.

At the same time, with EU entry come new challenges. The prospect of increased investment inflows and buoyant domestic demand brings with it the possibility of economic overheating, putting additional onus on fiscal prudence and expenditure rationalization, at a time when the incentive is great for governments to loosen the purse strings in order to cofinance EU transfers. Meanwhile, the next goal for both countries is EMU membership. The ability of both governments to steer their countries toward that goal and meet the Maastricht criteria, particularly on inflation, will be material to the evolution of their sovereign ratings, as their external imbalances are comparatively large and joining the Eurozone would remove the potential for a classic balance of payments crises.

The October 2006 downgrade reflected the center-left government's inadequate response to Italy's structural economic and fiscal challenges. The 2007 budget does little to drive forward meaningful supply-side reforms, and will actually lead to net increases in spending as a share of GDP, instead of curtailing high current expenditure, which is the root cause of Italy's fiscal imbalance. By avoiding tackling the key issues head-on, the government of Prime Minister Romano Prodi is following the muddle-through tradition established under his predecessor Silvio Berlusconi, which had led to a previous downgrade of the sovereign in July 2004. Furthermore, the upfront tax-and-spend concessions to the reform-skeptical members of the center-left coalition have effectively reduced the bargaining power of the modernizers in the cabinet. The Ministry of Finance's unwavering commitment to reducing the budget deficit below 3% of GDP in 2007 may further undermine reform prospects, as the sense of urgency to press forward with unpopular reforms will weaken once Italy is perceived to be exiting from the EU's Excessive Deficit Procedure.

This assessment does not ignore the fact that Italy's public revenues have benefited greatly from the modest economic revival in 2006 and the government has effectively borrowed €20 billion (or one-tenth) less than Standard & Poor's had expected a year ago. This is a very significant improvement. But it is too early to conclude with confidence what part of this positive revenue development is a windfall owed to good luck (revived economic activity) and what share of it is the result of good policies (e.g. improvements tax administration).

The outlook on the sovereign rating is stable, indicating that rating changes are not expected in the next one to two years. For a further lowering of the rating, a significant and sustained rise in the public debt ratio would need to occur, which is currently not expected. Conversely, if the government were able to credibly commit to implementing its stated expenditure consolidation strategy that would lead to an unambiguous, significant, and sustainable downward trend of the government debt ratio, the outlook, and ultimately the rating, could improve again. Implementation is key, and announcements alone will not move the sovereign rating on Italy.

The revision of the outlook on the 'BBB+' rating on Hungary in December 2006 reflects the sovereign's progress in pushing forward legislation and measures required to stabilize the country's rapidly rising general government debt burden. Years of budgetary profligacy have seriously undermined the credibility of fiscal policy, culminating in an expected general government deficit of 9.8% of GDP in 2006. Consequently, the local currency rating on Hungary has been lowered three times since 2000. Following the general elections in April 2006, however, the government's candid approach to the substantial fiscal challenges, as well as its demonstrated determination to implement the impressive consolidation agenda, should ensure that fiscal targets will be met, at least for the next two years. As a result, we now expect that the government will manage to push down the general government deficit to 4.3% of GDP by 2008, in line with Hungary's convergence program targets. The government debt-to-GDP ratio will therefore peak at 71% in 2008, before embarking on a downward path again.

The government is at present firmly committed to pressing ahead with unpopular measures and Prime Minister Ferenc Gyurcsány appears to be betting his and the coalition's political future on the success of the adjustment package. Nevertheless, risks of slippages remain, especially if the economy were to slow more dramatically than expected in 2007 as a result of the imposed austerity measures. A departure from the government's current fiscal consolidation plan would quickly lead to renewed and strong downward pressure on the ratings. We currently assign a low probability to such a scenario, but this probability might increase as general elections in 2010 draw nearer.

The Urals oil price would have to fall below $37 per barrel to push Russia's 2007 general government budget into deficit. It is therefore safe to assume that Russia will run another sizeable surplus in 2007, estimated at 5.6% of GDP in 2007. Likewise, it would take a comparable drop in oil prices to drive the current account surplus to zero, from the 8.5% of GDP expected in 2007. Financial ratios will therefore improve further even in an environment of moderately falling oil prices. Indeed, a weakening of commodities prices may be a boon for the Central Bank of Russia (CBR) in its attempt to drive down inflation, which is still near 10%, as it would reduce the volume of reserve accumulation (and thus liquidity generation) required to prevent the ruble from appreciating.

More significant risks to macroeconomic stability stem from the parliamentary and presidential elections in December 2007 and March 2008, respectively. Further fiscal loosening would exacerbate inflationary pressures and could force the CBR to permit an acceleration of the ruble's appreciation to contain price rises, further undermining non-oil sector competitiveness and obstructing attempts to diversify the economy. It is widely expected that incumbent President Vladimir Putin's (still-to-be) chosen successor will easily win the presidency, supported by a comfortable majority in parliament. This should help to contain populist pre-electoral spending commitments. That said, as the Kremlin has extensively centralized power during Mr. Putin's second term in office, a change at the helm brings with it above-average uncertainties and risks to policy continuity. Significant policy slippages would undermine the foundations of Russia's recent economic successes and could lead to downward pressure on the sovereign ratings, as could an unforeseen political crisis or a sharp slump in commodity prices. If fiscal prudence is sustained following the elections, however, Russia's creditworthiness could be bolstered further.

In June 2006, S&P revised the ratings outlook on Turkey back to stable at the 'BB-' level, from positive. The reason for this was that a mix of global risk aversion and domestic Turkish risk had converged in May and June to propagate a massive reversal in what had up to that point been impressive inflows of portfolio capital in Turkey's domestic equity and capital markets, resulting in a 25% depreciation in the Turkish lira and, more importantly, a 425 basis point hike in interest rates by the Central Bank of the Republic of Turkey (CBRT). Although the rise in rates was regarded as a positive policy response, reinforcing central bank independence and shoring up confidence in the direction of monetary policy, it nevertheless spelt an end, at least in the short-term, to the rapid economic growth that Turkey had been experiencing over the past four years. Indeed, real GDP growth slowed significantly in the second half of 2006, to less than 4% on an annual basis from more than 7% in the first six months of the year. The slowdown in growth, together with the threat of further lira instability, was judged to have partially taken the positive momentum out of the country's improving creditworthiness, as knock-on effects on public finances through sluggish revenue growth and increased debt servicing expenditure are likely in the coming year.

Importantly, however, the decision to revise the outlook back to stable was also made in the belief that further market volatility was likely in the coming eighteen months, with uncertainty surrounding the fate of EU accession talks given the ongoing stand-off between Turkey and the EU over the Cyprus issue, and two major elections in 2007. The current rating, therefore, takes these risks into account, as evidenced by its stability following the decision of the EU to partially suspend accession talks in December 2006. Similarly, Standard & Poor's expects and has incorporated into the rating a degree of political uncertainty and market volatility that is likely to surround the presidential elections in May 2007, and the parliamentary elections in November.

The rating on Serbia remains constrained by significant political risks, stemming primarily from the unresolved status of Kosovo, and insufficient cooperation with the War Crimes Tribunal at The Hague. The latter dispute is currently delaying talks on EU integration, after the EU halted negotiations about the Stabilization and Association Agreement in May 2006. Such political pressures increase the risk of policy reversals, bringing to a halt or even undoing part of the reform progress. The upcoming elections on Jan. 21, 2007, are expected to return a reform-minded government into power, as the radical and nationalist parties, while attracting probably at least one-third of the electorate, would not be able to form a majority of their own. Yet, the forced marriage of the reformist parties is hampered by sometimes antagonistic personal relationships, which can impede serious progress toward EU integration. The risks are likely to peak this year, when the final status of Kosovo will be decided, as this subject touches not only issues of prestige and power, but also on extremely sensitive and emotional issues related to national identity and history.

Externally, Serbia remains exposed, as revealed by a large current account deficit, which is expected to remain around 9% of GDP in the medium term. To date, this deficit has been comfortably financed through FDI inflows. In addition, macroeconomic stability remains vulnerable, as demonstrated by persistent (albeit declining), inflation, which slowed to 7% in 2006 from 18% in 2005, owing to tight monetary measures.

The positive ratings outlook on Serbia assumes that the prospect of EU integration will remain a driver for political stabilization and economic modernization after the election, in which case an upgrade is likely in 2007. It is too early, however, to consider this benign outcome as a near certainty. If, after the post-electoral dust of government formation has settled, a significant reversal of Serbia's structural reform and stabilization effort were on the agenda, macroeconomic prospects and fiscal sustainability would be negatively affected. This, as well as ongoing political uncertainty and volatility, most likely to be Kosovo-related, would preclude an upgrade and, if severe enough, could even put downward pressure on the ratings.

European Sovereign Ratings List
Sovereign	Foreign currency ratings	Local currency ratings
Andorra (Principality of)	AA/Stable/A-1+	AA/Stable/A-1+
Austria (Republic of)	AAA/Stable/A-1+	AAA/Stable/A-1+
Belgium (Kingdom of)	AA+/Stable/A-1+	AA+/Stable/A-1+
Bulgaria (Republic of)	BBB+/Stable/A-2	BBB+/Stable/A-2
Croatia (Republic of)	BBB/Stable/A-3	BBB+/Stable/A-2
Cyprus (Republic of)	A/Stable/A-1	A/Stable/A-1
Czech Republic	A-/Positive/A-2	A/Positive/A-1
Denmark (Kingdom of)	AAA/Stable/A-1+	AAA/Stable/A-1+
Estonia (Republic of)	A/Stable/A-1	A/Stable/A-1
Finland (Republic of)	AAA/Stable/A-1+	AAA/Stable/A-1+
France (Republic of)	AAA/Stable/A-1+	AAA/Stable/A-1+
Georgia (Government of)	B+/Stable/B	B+/Stable/B
Germany (Federal Republic of)	AAA/Stable/A-1+	AAA/Stable/A-1+
Hellenic Republic (Greece)	A/Stable/A-1	A/Stable/A-1
Hungary (Republic of)	BBB+/Stable/A-2	BBB+/Stable/A-2
Iceland (Republic of)	A+/Stable/A-1	AA/Stable/A-1+
Ireland (Republic of)	AAA/Stable/A-1+	AAA/Stable/A-1+
Isle of Man	AAA/Stable/A-1+	AAA/Stable/A-1+
Italy (Republic of)	A+/Stable/A-1+	A+/Stable/A-1+
Latvia (Republic of)	A-/Stable/A-2	A-/Stable/A-2
Liechtenstein (Principality of)	AAA/Stable/A-1+	AAA/Stable/A-1+
Lithuania (Republic of)	A/Stable/A-1	A/Stable/A-1
Luxembourg (Grand Duchy of)	AAA/Stable/A-1+	AAA/Stable/A-1+
Macedonia (Republic of)	BB+/Stable/B	BBB-/Stable/A-3
Malta (Republic of)	A/Stable/A-1	A/Stable/A-1
Montenegro (Republic of)	BB/Positive/B	BB/Positive/B
Netherlands (State of The)	AAA/Stable/A-1+	AAA/Stable/A-1+
Norway (Kingdom of)	AAA/Stable/A-1+	AAA/Stable/A-1+
Poland (Republic of)	BBB+/Stable/A-2	A-/Stable/A-2
Portugal (Republic of)	AA-/Stable/A-1+	AA-/Stable/A-1+
Romania (Republic of)	BBB-/Stable/A-3	BBB/Stable/A-3
Russian Federation (The)	BBB+/Stable/A-2	A-/Stable/A-2
Serbia (Republic of)	BB-/Positive/B	BB-/Positive/B
Slovak Republic	A/Stable/A-1	A/Stable/A-1
Slovenia (Republic of)	AA/Stable/A-1+	AA/Stable/A-1+
Spain (Kingdom of)	AAA/Stable/A-1+	AAA/Stable/A-1+
Sweden (Kingdom of)	AAA/Stable/A-1+	AAA/Stable/A-1+
Swiss Confederation (Switzerland)	AAA/Stable/A-1+	AAA/Stable/A-1+
Turkey (Republic of)	BB-/Stable/B	BB/Stable/B
Ukraine	BB-/Stable/B	BB/Stable/B
United Kingdom	AAA/Stable/A-1+	AAA/Stable/A-1+
Note: ratings are as of Jan. 17, 2007.