Thursday, December 1, 2011

FT: Romania: junked by S&P

Here we go again: another CEE rating gets junked. Standard & Poor’s downgraded Romania’s local currency sovereign rating on Tuesday after markets had closed. S&P lowered both the long and short term local currency ratings to BB+/B from BBB-/ A-3. Anything below BBB- is considered ‘junk’ or speculative grade investment material.

The main reason? Romania’s banking sector is massively exposed to its Greek and Austrian parents. We have seen this story before.

S&P said in a statement that the ratings move was a result of both methodological change and Romania’s vulnerability to external shocks given its high, albeit declining, external debt and the prevalence of Greek and Austrian banks in its finance sector.

Historically local currency debt is seen as a safer bet than private foreign denominated debt. However, S&P argues that when a country’s level of foreign debt hits 50 per cent of overall debt, a lack of monetary flexibility calls for the ratings to be equalised.

In Romania’s case, foreign denominated debt now exceeds 60 per cent and represents a “high level of euroization (sic) of the economy.”

In other words, Romania’s amount of foreign debt has reached levels which leave the local debt more vulnerable to the possibility of a default because the government will be less inclined to use monetary policies to inflate away its local debts.

From the report:

Under our revised methodology, the gap between the local- and foreign-currency ratings on most of our rated sovereigns is narrowing. This is because we believe governments are likely to have fewer incentives to differentiate between their local- and foreign-currency debt in the event of a debt restructuring, given the increasing globalization of markets. In accordance with our criteria for sovereign ratings, the local-currency rating on Romania is equalized with the foreign-currency rating. This is based on our view of the high level of euroization (sic) of the economy.

While S&P was relatively upbeat about Romania’s economy noting that its stable outlook was driven by an improving fiscal position and its government’s commitment to implementing the reforms agreed with the International Monetary Fund under its current program – real weaknesses remain. As S&P noted:

Foreign institutions own 85 per cent of total banking sector assets. Austrian banks dominate, holding around 40 per cent of total market share, while Greek banks’ subsidiaries account for 24 per cent of capital and 14 per cent of the assets of the banking sector. These subsidiaries are autonomous from their parents, which we believe will likely limit spillover effects if confidence in the Greek banking sector weakens further. In our view, however, there is a risk that if foreign parent banks run into difficulties they may significantly reduce cross-border exposure to their subsidiaries, thereby reducing credit activity.

According to a recent report by rival ratings house Fitch, 31.5 per cent of Romanian banking assets are owned by Austrian banks while another 15.8 per cent are in Greek banks’ hands. As Greek and Austrian banks suffer losses, they will be forced to pull in their horns and deny their subsidiaries credits – all bad news for the Romanian economy.

Elsewhere, S&P is concerned that Romania’s commitment to reform may be tested by a darkening economic picture, particularly as there is an election scheduled for the end of 2012. S&P pointed to the threat posed by a European slowdown which could further weaken Romania’s balance of payments performance and increase external vulnerabilities.

Thus, S&P is expecting the government to reduce its deficit to just below 5 per cent of GDP in 2011, from 9 per cent in 2009. However it remains nervous about the government’s projection of a 3 per cent deficit in 2012 – particularly if there is an election to be won.

S&P sign off with this warning:

If, against our expectations, the government fails to adhere to its fiscal consolidation and structural reform strategy, or should Romania’s external deficits widen significantly without improving the country’s long-term growth potential, the ratings could come under pressure.

Conversely, if the government continues to push through with structural measures to improve competitiveness and potential growth, while building a sustained track record of fiscal prudence, we could raise the ratings.

Moody’s Investors Service rates Romania Baa3 while Fitch has the country at BBB-, the lowest investment grades at both companies.

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