S&P Viewpoint

The background and the possible contagion of the current financial squeeze is markedly different from the Asian or "Tequila" crises or the emerging market debt crises of the 1980s. This time round the epicenter of the emerging market jitters is located in the U.S. property market. Although investors' reassessment of risk is not rooted in the imbalance in the emerging economies themselves, this is unlikely to shield the latter from the knock-on effects of the general repricing of risk among investors. Nowadays there is much more uncertainty about how the rediscovery of risk aversion is being transmitted throughout the markets, as it is still poorly understood which institutions hold the securitized subprime and related risks that have spooked investors over the past month or so. As recent disruptions in the asset-backed CP markets demonstrated, this lack of transparency on the ultimate holders of the often illiquid structured securities has led to a heightened reluctance of banks to lend to their peers, even for short periods of time. The vast and repeated liquidity-enhancing operations of the European Central Bank and the U.S. Federal Reserve, as well as some other central banks, have brought some semblance of order back to the markets, but concerns about credit risk remain widespread.

EM sovereigns have so far escaped lightly. Credit spreads as measured by the J.P. Morgan Emerging Market Bond Index Global (EMBIG) have risen to 243 basis points (bp) on Aug. 30, 2007, from the all-time low of 151 bp on June 1, 2007, surpassing the highest level during last year's market jitters (232 bp on June 27, 2006). Although the current EMBIG spread levels are still comparable to late 2005--and well below the 600-800 bp range during 1999 and 2002--the almost doubling of the five-year credit default swap spreads since the end of June this year emphasizes that confidence among emerging market investors has begun to wane (see Chart 1).

Emerging sovereigns globally are in much more robust shape than they were on the eve of any tumultuous financial conditions during the past quarter of a century. Many sovereigns have bolstered their insurance against adverse market conditions through the accumulation of sometimes colossal foreign exchange reserves. This is in marked contrast, for example, to the central bank of Thailand's forward-selling of its scarce reserves in the run-up to the Thai Baht's collapse in 1997 that triggered the Asian crisis.

However, while many key emerging markets have made good use of the benign financial environment of the past few years and bolstered their liquidity cushion, there are exceptions to this. Parts of emerging Europe clearly lie outside the global trend of stronger external and fiscal accounts. There, optimism about the economic consequences of EU and eventually EMU accession has led to a surge in confidence and credit-fuelled domestic consumption and investment booms. As much of this credit expansion has come through relatively short-term cross-border bank lines, the leverage of the private sector external has risen sharply in many instances, easily outpacing the accumulation of foreign reserves.

Among all sovereigns rated by Standard & Poor's, eight of the 10 sovereigns with the highest current account deficits in 2007 (in relation to their GDP) or gross external borrowing needs (in relation to foreign exchange reserves and current account receipts) are located in the EMEA region. This above-average dependency on external financing makes sovereigns in the EMEA region on aggregate more vulnerable than in Latin America and Asia to an environment of sustained tight liquidity.

To date, Standard & Poor's has not taken any negative rating action on any EMEA sovereign as a consequence of the recent receding liquidity. The last time investors became deeply skeptical about emerging sovereigns as an asset class was following the Asian crisis of 1997, when the EMBIG spread temporarily trebled to over 1200 bp. Compared with that episode, the current mild tightening of risk pricing has been a walk in the park. Nevertheless, currencies and stock markets have taken a hit across the EM universe. During the Asian and Russian crises sovereign downgrades by Standard & Poor's outnumbered upgrades by a factor of 3:1, interrupting a decade of an otherwise almost continual upward trend in sovereign ratings.

While the European sovereigns are among the most exposed among the EM governments, we do expect that ratings will remain resilient and avoid the collective plunge witnessed a decade ago. On the surface, the accumulation of external liabilities in the private sector as well as a booming construction sector may bear some resemblance to the Asian accumulation of net foreign obligations during the 1990s. But in today's world financing enters most EMEA emerging economies via Western European parent banks. In times of stress they are more unlikely to rapidly withdraw their credit lines, as such behavior would have implications on the parent banks' own profitability by jeopardizing the solvency of subsidiaries, which in many cases are considered strategic. This will, in most scenarios, provide a relatively predictable flow of credit, almost akin to foreign direct investment, which in many instances finances a large part of the current account shortfall in the first place.

Public debt management techniques have also improved across the region, diversifying sources of financing by developing the domestic capital market, as well as extending tenors. These improvements reduce the probability of a sovereign default in the event of a temporary shutout from the debt markets.

Nevertheless, given the prolonged economic imbalances and overheating pressures, especially in the Balkans and the Baltics, the balance of outlooks has now shifted to a prevalence of negative outlooks (see Chart 2). Whereas in early 2006 positive outlooks in emerging Europe massively outnumbered negative ones, most positive outlooks have reverted back to stable and currently the outlooks on four sovereigns are negative (the three Baltic countries, plus Ukraine), with only one positive outlook (on the Czech Republic). All negative outlooks are based on the risks posed by excessive domestic demand fed by rampant domestic credit growth. As outlooks are a useful predictor of rating movements, negative rating actions may indeed dominate rating news in emerging Europe, but we do not anticipate anything like the torrent of downgrades among EM sovereigns 10 years ago.

 Chart 2

To assess which EMEA emerging market sovereigns are most at risk of being affected by a less forgiving international financial environment, we have constructed a simple Liquidity Vulnerability Index to provide a rough and ready yardstick. The index is an unweighted average of a sovereign's rank in the 15 country sample in five different variables, which are regarded as meaningful indicators of sovereign external financing risk:

• Sovereign debt rollover needs as a share of GDP;
• Gross external borrowing requirements as a share of current account receipts;
• Gross external financing requirements net of foreign direct investment (FDI) inflows as a share of usable official foreign exchange reserves;
• The share of a current account deficit financed through FDI; and
• The real effective exchange rate (REER) appreciation in 2007 from the average of the 1990s.

All data refers to 2007. REER data were unavailable for Latvia, Lebanon, and Egypt, and thus simply omitted. The index is then standardized with an average of zero and a standard deviation of unity. Any sovereign with a positive value is thus considered to be more at risk than the sample average. Chart 3 illustrates the result.

 Chart 3

Relatively vulnerable sovereigns (defined as an index value of 0.5 or greater) include Latvia, which tops the vulnerability index, as well as Iceland, Bulgaria, Turkey and Romania. Interestingly, with the exception of Turkey and Romania, the other sovereigns in this group all display fiscal surpluses as a result of their governments', sometimes too timid, attempts to counter overheating tendencies. Therefore, being at risk from changes in market sentiment and strong performance of the headline budget balance are no contradiction, a lesson already learnt from the Asian crisis.

At the other end of the spectrum, Russia is the least vulnerable in the sample, despite its own currently tight interbank market. If we had included other petroleum-producing economies, for example in the Middle East, those sovereigns would also have come out very well protected from any financial fallout, due to their mostly negligible or lack of external financing needs. Egypt (another oil producer), Ukraine, and the Czech Republic are also in the least vulnerable category (defined as an index value of less than negative 0.5).

Our vulnerability ranking is in line with the market's reaction: the median CDS spread of the vulnerable group increased by 114% between the end of June and the end of August this year, whereas the median spread widened by "only" 49% for the sheltered group.

The vulnerability index is a mere snapshot as it uses data exclusively from 2007. If tight liquidity conditions were to extend well beyond the current year, individual sovereigns would move up or down the scale. For example, Ukraine is still benefiting from relatively low external imbalances in the region. Ukraine is, however, very susceptible to changes in its volatile terms of trade. If, as Standard & Poor's believes, the terms of trade deteriorate markedly in 2008 and 2009, external financing needs are bound to go up, increasing Ukraine's vulnerability. Conversely, Iceland's hefty external imbalance is expected to shrink, as export capacity comes on stream and high interest rates curb economic demand. Therefore, while global credit conditions remain tight, we will update the estimate for this vulnerability index as appropriate.

The ranking is, of course, subject to the selection of variables included in the index. Nevertheless, the ranking appears quite robust when excluding individual component variables of the index. While some countries may jump a few ranks (very rarely more than two), the overall clusters remain relatively unaffected.

Standard & Poor's ratings are opinions on creditworthiness, independent of the credit cycle. Therefore, when we make decisions on raising or lowering a rating the focus is on fundamental and structural issues. The favorable financial conditions associated with the past few years, however, facilitated and, in many cases, prompted policy reforms that did genuinely improve sovereign creditworthiness. Most governments seized on the good times by modernizing their public debt management and the budgetary and monetary institutions governing economic policy making, as well as updating the regulatory environment, for example, in banking supervision. For some Central and Eastern European sovereigns, EU and eventual EMU accession led to rapid structural and institutional modernization that would otherwise have been implemented over a much longer period, if at all. Commodity-exporting nations, such as Russia and Middle Eastern sovereigns, have greatly improved their balance sheets, and Standard & Poor's expects this to carry them through even a prolonged reversal of the credit and commodity cycles. All these positive policy changes have led to many more upward than downward rating changes during the credit cycle. In emerging Europe, for example, there were 45 upgrades between 2001 and 2006 compared with only three downgrades, although this imbalance has shrunk (to a ratio of three to one in 2006) as adjustment fatigue and economic complacency set in following the 2004 EU accession wave.

But while favorable financing conditions open the path for true reform, making sovereigns more resilient to financial turbulence, they also provide opportunities for harmful exuberance and excessive borrowing, which may prove too tempting to resist. Several sovereigns, including all those European ones with a negative outlook (the three Baltic countries, plus Ukraine) are struggling with symptoms of overheating economies which directly followed the almost indiscriminate leveraging up of the private sector, increasing the risks of a hard landing. The risks associated with a sudden stop to cheap financing increases the longer the credit boom lasts and the greater the corresponding external imbalances become. It is therefore natural to expect that negative repercussions on sovereign credit quality will increase as the cycle matures and the policy response remains inadequate to balance the private consumption and investment booms. And this is exactly what we see now in emerging Europe, with negative outlooks outnumbering positive ones for the first time this decade (see Chart 2).

As should be expected, recent rating and outlook changes correlate directly with the degree of vulnerability to tightening credit as measured by our index. In Chart 3 the diamonds depict the most recent rating or outlook action for each of the 15 sovereigns (excluding affirmations; see the table below for details). A positive value of 1 indicates an upgrade, a value of 0.5 a change in the outlook in an upward direction (to positive from stable or to stable from negative); with analogous definitions for negative actions. Latvia's negative 1.5 value signifies a downgrade with the outlook remaining negative. Chart 3 shows that, with the exception of Bulgaria, the most recent action was negative on all "vulnerable" sovereigns, while it was positive for all "sheltered" sovereigns, with the exception of Ukraine. In Bulgaria's case the 2006 upgrade was related to the EU decision to allow Bulgaria to accede to the EU at the earliest possible date, locking in past reforms, as well as the country's good prospects for EMU entry, which will effectively shield it from external financing crises. In Ukraine, on the other hand, the trigger for the negative outlook was related to the simmering constitutional crisis and expectations of a negative terms-of-trade shock (which, all other things being equal, would lead to a weaker index number next year). Therefore, the two outliers are also consistent with the general conclusion that sovereign rating actions among EMEA sovereigns have been timely in pointing in the relevant cases at the increasing risks as the credit cycle draws to a close.

Latest EMEA Emerging Market Rating Actions
Sovereign	Long-term foreign currency rating	Last rating action	Date of last rating action (excluding affirmations)
Republic of Iceland	A+/Stable/A-1	Downgrade from AA-/Negative/A-1+	Dec. 22, 2006
Ukraine	BB-/Negative/B	Outlook revision from Stable	April 5, 2007
Republic of Turkey	BB-/Stable/B	Outlook revision from Positive	June 27, 2006
Arab Republic of Egypt	BB+/Stable/B	Outlook revision from Negative	March 14, 2005
Republic of Romania	BBB-/Stable/A-3	Outlook revision from Positive	April 5, 2007
Republic of Latvia	BBB+/Negative/A-2	Downgrade from A-/Negative/A-2	May 17, 2007
Republic of Hungary	BBB+/Stable/A-2	Outlook revision from Negative	Dec. 21, 2006
The Russian Federation	BBB+/Stable/A-2	Upgrade from BBB/Stable/A-2	Sept. 4, 2006
Republic of South Africa	BBB+/Stable/A-2	Upgrade from BBB/Stable/A-3	Aug. 1, 2005
Republic of Poland	A-/Stable/A-2	Upgrade from BBB+/Stable/A-2	March 29, 2007
Czech Republic	A-/Positive/A-2	Outlook revision from Stable	Nov. 30, 2005
Republic of Lithuania	A/Negative/A-1	Outlook revision from Stable	May 23, 2007
Slovak Republic	A/Stable/A-1	Upgrade from A-/Positive/A-2	Dec. 19, 2005
Republic of Lebanon	B-/Negative/C	From B-/Watch Neg/C	Sept. 11, 2006
Republic of Bulgaria	BBB+/Stable/A-2	Upgrade from BBB/Positive/A-3	Oct. 26, 2006