Moody's reports: Emerging European sovereign ratings could be vulnerable to a hard landing

Despite increasing levels of macroeconomic stress in recent years, sovereign ratings in emerging Europe have remained broadly unchanged. A new Moody’s Special Comment, titled “When macroeconomic tensions result in rating changes: how vulnerable are emerging European sovereigns?” explains why this is the case, and whether any ratings may change if vulnerabilities were to materialise, said the company in a statement.rnrn”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,” explains 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 our base case scenario remains a relatively orderly reduction in growth and imbalances over time.” rnrnrnIn 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. rnrnrn”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. rnrnrn”Moody’s has identified 11 investment-grade countries in emerging Europe with significant economic imbalances, portrayed by current account deficits and a substantial increase in domestic credit in recent years,” Mr. Orchard says. “The probability of these imbalances ending in hard landings has increased with the recent turmoil in the global capital markets. Although capital flows into the surveyed countries have been maintained so far, international banks and investors have become more risk averse and capital constrained.” rnrnrn”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,” according to Mr. Orchard. “However, downgrades may 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”. rnrnrnThe 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. rnrnrnThe report identifies three groups of countries, differentiated by the potential impact of a hard landing on sovereign ratings: rnrnrn* Group 1 contains the countries whose rating would, in all likelihood, be resilient to a severe but unlikely hard landing: Iceland, Estonia, Bulgaria, Kazakhstan and Czech Republic. rnrn* Group 2 includes the countries whose rating may come under moderate pressure: Romania, Poland and Croatia. rnrn* Group 3 is comprised of the countries whose ratings would be under significant pressure: Hungary, Latvia and Lithuania. rnrnrn”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 ,” concludes Orchard. rnrn