COMMENT: CEE credit quality is starting to weaken

By bne IntelliNews July 28, 2008

Ruth Stroppiana and Christine Li of Moody's -

In the second quarter, Moody's changed the ratings of eight issuers domiciled in Central and Eastern Europe, including Russia, announcing three upgrades and five downgrades. CEE borrowers in some sectors are starting to feel the impact from the credit crunch and slowing growth. Credit quality, however, remains in better shape than in Western Europe.

In the second quarter, Moody's changed the ratings of eight issuers domiciled in CEE, including Russia, announcing three upgrades and five downgrades. A surge in the number of downgrades and a fall in upgrades put the ratings gap into negative territory, coming in at -2. This is the first quarter since the first quarter in 2007 that the ratings balance has moved into negative territory, suggesting that CEE credit quality is weakening. The cycle reached a peak in the fourth quarter of 2005 when the ratings balance was at 47, with 48 upgrades versus one downgrade. The credit cycle has been weakening since the third quarter of 2007 when the financial turmoil began.

CEE borrowers in some sectors are starting to feel the impact from the credit crunch and slower growth. The downturn in the Eurozone, a key trading partner, and appreciating currencies in the region have slowed export demand. However, credit quality remains in better shape than in Western Europe, which has been on a downward trend since the third quarter of 2007. Most of the region is likely to continue to benefit from strong domestic demand and wage growth.

The corporate sector in the second quarter saw no upgrades and three downgrades, resulting in a negative gap of -3. This is the first time since the first quarter of 2001 that the ratings gap for the corporate sector has moved into negative territory. The three downgrades all occurred in the speculative-grade sector. Speculative-grade credit quality has weakened since the credit crunch in the third quarter of 2007, when there was a positive ratings gap of 5.

The downgrades in the corporate sector were due to two issuers from the metals and mining sector. Kremikovtzi, a Bulgarian issuer, was downgraded twice in the second quarter, once in April and then in May. The issuer defaulted on its bond in May with a total of $505m worth of debt. However, this was due to company-specific and structural weaknesses, rather than external or industry-wide factors. So far, steel companies have been able to pass on surging costs of raw materials such as metallurgical coal and iron ore. Steel prices such as hot rolled coil have risen by 63% since the beginning of this year as a result of rising raw material costs, whilst demand remains robust, driven by emerging countries such as China. Another downgrade, namely Zlomrex, a Polish issuer in the same sector, was downgraded due to its level of leverage and over-reliance on short-term financing.

The CEE financial sector is faring better than the corporate sector. Most financial issuers appear to be weathering the credit crunch well as the second quarter saw three upgrades and two downgrades, resulting in a positive gap of 1. The upgrades were mainly due to an improvement in the three issuers' bank financial strength ratings. Also, the ratings of Promsvyazbank, a Russian issuer, were upgraded due to business growth, adequate asset quality and a proven ability to support its business growth by maintaining the necessary capitalisation levels.

Despite the financial sector being still in good shape, as the ratings gap remains in positive territory, credit quality is on a downward trend as the gap has narrowed 4 in first quarter to 1 in the second. Also, not all issuers are immune. One issuer, Temirbank from Kazakhstan, was downgraded due to increasing pressures on its liquidity profile as a result of the recent outflow of customer deposits and a heavy reliance on international funding. In the CIS region, Kazakhstan banks are most vulnerable, since they have approximately $40bn worth of international borrowing, equivalent to one half of their total non-equity funding. A lack of international funding is likely to put pressure on short-term funding.

Another downgrade came from an Estonian issuer, AS Hansapank, due to weakening asset quality and concerns over the bank's exposure to the real estate sector in the Baltic countries. The Baltic region has benefited from rapid growth in recent years. However, global economic developments and the current financial crisis have presented short-term risks. The Baltic countries currently have large current account deficits and are most vulnerable should sentiment change and investors pull money out of emerging countries. Most recently, rapid inflation and monetary tightening have resulted in slumping growth and contracting housing prices. The Baltic region's high vulnerability is likely to result in an impact on credit quality.

Overall, CEE credit quality is likely to weaken. Despite strengthened currencies, issuers in the region are struggling with inflation, and central banks across the region are tightening their monetary policy rates. The central banks in Hungary, Poland and the Czech Republic have all tightened their interest rates as a result of surging inflationary pressures. Tighter monetary conditions are likely to weaken growth and slowdown corporate activity, putting pressure on profit margins.

Ruth Stroppiana is Chief International Economist and Christine Li is Economist at Moody's Investors Service

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