A capital situation in Emerging Europe

By bne IntelliNews April 11, 2011

Nicholas Watson in Prague -

On April 5, Moody's Investors Service put Bulgaria's 'Baa3' rating on review for a possible upgrade, citing its healthy finances. Other emerging European countries are also in much better shape than certain Eurozone members as capital flows back into the region, prompting the question of how long it will be before the rating agencies take more action.

The main triggers for the review, Moody's said, are the Bulgarian government's strong balance sheet and ongoing fiscal caution. "The key here is that Bulgaria has a public sector debt/GDP ratio of only around 15%, while it still has a fiscal reserve of around €3bn, ie. around 10% of GDP," notes Tim Ash, head of emerging market research at Royal Bank of Scotland. "The budget deficit is modest, at only around 2-3% of GDP, while the current account deficit, which had been around 20% of GDP, has collapsed to close to balance."

However, it's not just Bulgaria that enjoys low debt levels and low current account and budget deficits, this situation is repeated across emerging Europe - and stands in stark contrast to the situation on the periphery of the Eurozone, from where Portugal became the third member to go cap in hand to the EU for a bailout on April 7.

Wasted opportunity

In the first quarter of 2009, Central and Eastern Europe suffered huge capital outflows. This caused the prices of those countries' credit default swaps (CDS) - contracts bought to insure against the default or restructuring of debt - to peak above those for Ireland, Italy, Greece, Portugal and Spain (PIIGs), who as members of the euro were not at risk of a currency devaluation. In addition, their financial sectors had access to the European Central Bank's refinancing facility, which eased the pressure on the financing of current accounts.

Unfortunately, notes Erste Group, this was a short-term fix and was provided without strict conditions, meaning the imbalances of these Eurozone countries were able to persist or even grow in 2010. Meanwhile CEE countries - some of whom had stringent conditions attached to their bailouts from the International Monetary Fund (IMF) - narrowed their current account deficits substantially during that time.

According to Erste, 2010 finally brought a reversal in those capital flows - portfolio capital as well as foreign direct investment (FDI) - in CEE. The bank calculates that after a deep slump of about 45% in 2009, FDI has picked up and was around 9% higher in 2010 in the countries it covers in the region (Croatia, Czech Republic, Hungary, Poland, Romania, Slovakia, Turkey and Ukraine). Erste also reports that since the fourth quarter of 2009, the region has experienced a rebound of portfolio investments, particularly into the Czech Republic and Poland.

This is backed up by the International Monetary Fund (IMF), which in an April report said that, capital flows to emerging market economies staged a strong comeback from mid-2009, although the rebound was more extraordinary in terms of its pace rather than the level that net flows reached. "That is true, the overall private capital flows are lower than before the crisis, but given narrower current account imbalances, the region is in less need for external financing through debt," says Juraj Kotian, Erste's co-head of CEE macro/fixed income research.

The question then arises, how long before the rating agencies - much maligned since they were found to be asleep at the wheel (yet again) when a financial crisis broke - move to align ratings to fundamentals?

The markets are already pricing in some changes. Erste notes that Slovakia (rated 'A1/A+/A+') pays a lower risk premium than the better-rated Spain and Italy. Croatia ('Baa3/BBB-/BBB-') and Hungary ('Baa3/BBB-/BBB-') - which are both at the low end of investment grade - and Romania ('Ba1/BB+/BB+') - which was downgraded to junk category during the crisis - can now borrow more cheaply than Portugal ('Baa3/BBB-/BBB-'), which is still rated higher than Romania and at the same level as Croatia and Hungary.

Rate of change

Looking at the best candidates for an upgrade by the end of this year or early next, the Czech Republic, whose 'A1/A+/A' ratings are on a positive outlook, stands out. FDI inflows to that country more than doubled in 2010, making them the highest in the region, almost 4% of GDP. "In nominal terms, they were even higher than those in 2008," says Kotian.

However, Kotian adds that he expects the rating agencies to wait until next year to see the extent of the softening in the coalition government's fiscal consolidation efforts. The three-party coalition took office last year with, for once, a decent majority in the lower house, but has since been plagued by a series of scandals that has threatened to break it up. That has also seen it water down reforms that would put the state finances on a sustainable path. "By the end of the year, beginning of next, the ratings agencies will have more information on the Czech's fiscal position," says Juraj.

Other good candidates for an upgrade, say analysts, are Turkey, Slovakia and Romania.

Turkey has been growing at a blistering pace, registering GDP growth of 8.9% last year, one of the fastest growth rates in the world, leading to calls from many, such as Turkish Finance Minister Mehmet Simsek, for the country's rating to be lifted to investment grade. Moody's last action on Turkey was in January, when the rating agency upgraded it from 'Ba3' to 'Ba2', two notches below investment grade. In March, the agency raised its outlook on that rating from stable to positive.

However, Turkey's growth has come at a cost: namely a credit boom, lots of hot money flowing into the country and a ballooning current account deficit. But Moody's was happy in April to see the central bank dramatically raise banks' reserve ratios to deflate the credit boom and curb the amount of speculative money pouring into the economy. "The Central Bank of Turkey's action is credit positive for Turkey's banking system. It will cultivate more sustainable credit growth at appropriately risk-adjusted returns and lengthen the banks' deposit maturity profile," the agency said.

Still, analysts suspect that parliamentary elections in June will prevent any action coming from the rating agencies sooner. "I doubt we will see action before the elections now. The ratings agencies know it should be investment grade already and that they are behind the curve, but they often need a strong reason to move. I think that reason was to be the fiscal rule, but that got pulled, and now with the widening current account deficit they will be reluctant to move quickly," says RBS' Ash, referring to proposed legislation that would've set fiscal targets for public debt and the budget deficit, but which was ultimately shelved in 2010.

"However, if the elections pass smoothly, and if we see fiscal and monetary policy tightened afterwards, plus some evidence of a slowdown in domestic demand, I think they will move by year-end, with Fitch going first," he adds. Ozlem Derici of Erste Securities Istanbul has similar expectations: "We expect Turkey to be rewarded with a one-notch upgrade from Moody's and/or S&P after the general elections, most likely in the last quarter of the year."

Slovakia was a magnet for FDI in the years leading up to the crisis (much of it going into the auto industry), but this slowed sharply in 2009. Even so, the country managed to get through the crisis without experiencing any severe strain on its external financing, or having to resort to a bailout from the international community, and now FDI levels are picking up again, with notable investments in the past 12 months coming from Volkswagen, KIA and Samsung. Though Ivan Miklos, Slovakia's deputy prime minister and minister of finance, told bne in February that he doesn't expect FDI to reach the dizzy heights seen before the crisis again, he nevertheless expects it to be sufficient to keep a lid on the current account deficit, which is expected to widen in 2011 to around €2.3bn, representing 2.9% of GDP, from an estimated €1.8bn, or 2.5% of GDP, in 2010.

Slovakia's ratings all have a stable outlook. Michal Musak of Slovenska Sporitelna says further improvement hinges on the success of the government's fiscal consolidation efforts. The authorities aim to cut the fiscal deficit from an estimated 7.8% of GDP in 2010 to 4.9% of GDP this year, and ultimately below 3.0% by 2013. If the government manages to get the deficit close to the 2011 target and further consolidation measures for 2012 are approved, "this could prompt rating agencies to revise Slovakia's ratings upwards," says Musak.

The Romanian economy is expected to see its first growth since the crisis struck this year, which together with the return of FDI into areas like the food industry, agriculture and renewable energy should enable the country to narrow its current account, which has previously had to be financed with help from outside. Since 2009, Romania has borrowed around €12bn from the IMF, but decided not to draw the final tranche of €1bn this year. The country also borrowed €3.65bn from the European Commission.

These funds allowed Romania to finance its external financing gap and large budget deficit, thus cushioning the effects of the deep recession. As part of the conditions attached to the loans, the Romanian authorities had to implement an ambitious fiscal consolidation plan. "Under the agreements with the IMF and the EC, Romania's government pledged to further reduce the budget deficit from 6.5% of GDP in 2010 to 4.4% this year, and to 3.0% in 2012. Most of the measures required to achieve this have been already enforced. It now rests solely with the Romanian government to stick by these measures and refrain from inflating public spending again," says Ionut Dumitru, head of research at Raiffeisen Bank in Bucharest.

Eugen Sinca of Banca Comerciala Romana says an upgrade of Romania's rating to investment grade is possible at the beginning of 2012, at the earliest. "The continuation of the fiscal consolidation efforts within the new precautionary stand-by arrangement with the IMF and EU is the key for this scenario."

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