Smoke On Europe’s Eastern Horizon?
By Edward Hugh
“The market is pricing these sovereigns at much wider levels than where their agency ratings would imply,” said Diana Allmendinger, a director at Fitch Solutions. CDS on Italy imply a rating of BBB, five notches below its agency rating of AA-minus. And Spain’s implied rating is BB-plus, nine notches below its agency rating of AA-plus.
With so much emphasis being placed on what has been happening farther to the South, economic realities on Europe’s Eastern periphery have largely been escaping the close scrutiny of media and analyst attention. In the wake of the belated recognition of the region’s vulnerability which followed the bout of acute stress experienced during the post-Lehman crisis, a new consensus has now emerged (for an in-depth study of the Latvian example see this piece) that the IMF-guided programmes put in place at the time have essentially set things, if not entirely straight then at least on the right track. In particular, as a result of the extensive fiscal discipline and willingness to sacrifice shown a much brighter future now awaits these countries well to the sidelines of all those horrible Greek debt concerns.
Certainly this is the picture you get from looking at the way the ratings agencies have been treating many of the countries in the region. Only last week Fitch upgraded Estonia to A+, citing the country’s solid economic growth performance, exceptionally strong public finances, declining external debt ratios and increasing stabilization in the banking sector. But since many reservations have been expressed in Europe of late about the validity of rating assessments, I thought it might be interesting to seek out an alternative opinion, and take a look at what the financial markets have been saying, at least as far as the recent evolution of Credit Default Swap prices go.
The recently upgraded Estonia, for example, was being valued as recently as just two years ago as having the third-riskiest sovereign debt in the European Union. But the country is now trading in quite another league, and finds itself included among the European “top ten” sovereigns in terms of price. As reported by Bloomberg on 20 June, Estonian credit-default swaps were trading at 87 basis points, while France was being quoted at 83.7, the Czech Republic at 83, Austria at 68.7 and the U.K. at 66, according to data provided by CMA. By way of comparison Polish CDS stood at 159.6. Effectively, Poland was being considered as almost twice as risky as Estonia. The big question, of course, is whether this kind of realignment in valuations makes any kind of economic sense? Is contagion risk being reasonably priced in, and if it isn’t, do we face the risk of a sudden (and destabilising) adjustment in the not too distant future?
Obviously, it is clear that the Estonian Sovereign was never, even during the worst moments of the financial crisis, and under the most severe of worst case scenarios, the third riskiest that was to be found within the frontiers of the EU (Estonia was the only EU country to have a budget surplus last year – worth 0.1 percent of GDP – while public debt totaled a mere 6.6 percent). On the other hand it is the case that Estonia faced an extremely challenging crisis in 2008/09, and had the Euro peg collapsed in one of the four East European countries who had one at the time then the pressure of private debt could certainly have confronted the country with some very complex and difficult choices. So, if we all stop being emotional about CDS for a moment, and start to consider that they might be a traded instrument which can tell us not who is about to default but rather something about the perceived levels of country risk at a given moment in time then they might offer us some sort of yardstick for following how market sentiment is moving, and even (the case in point for my argument here) whether market pricing of relative risks is in line with economic fundamentals.
So, following the argument along a bit, it is far from clear that the current level of Estonian CDS prices risk in in any more satisfactory way than they did at the height of the crisis, since as we will see there are rather curious anomalies in the way in which some of the countries in the region are being priced, while an excessive short term emphasis on fiscal deficits has perhaps misled observers about real risks in Europe whether these lie to the South (Italy) or to the East.
It is not my intention here to single out Estonia for special – negative – treatment (that would not be warranted) but the value being placed on the CDS really is incredibly low for a country that just entered the Euro Area with an outlook which could, at the very least, be considered as reasonably uncertain. It is being priced as part of core Europe, when in reality it forms part of Europe’s periphery. Arguably, were the Euro to break in two, Estonia would incline towards riding with the German lead group, but given the fact that the country now has a totally export dependent economy (this is the part that I feel is least understood) , and a currency which was arguably over valued at the time of Euro entry (and the country now has ongoing above-Eurozone-average inflation) it is not clear how prepared the country would be to handle the challenges of being attached to the new, and ultra-high value currency which would be created. Of course, some are going to argue that the risk of this happening is slim. But, is this risk – small as it may be – currently being priced in? That is the question. I would suggest the risk is not being priced in, and this creates the possibility of a dangerous surprise in the markets in the event of a disorderly Greek default.
Strangely, as a country which has recently entered the common currency, country risk seems to have followed a path which is rather nearer to that of its Baltic peers that equivalent Euro Area countries.
This disparity becomes even more striking if we look at the evolution of Baltic CDS with those of the two countries in Eastern Europe who entered the Eurozone before Estonia. The spread on Slovenian and Slovakian CDS has surged in recent months, not because short term risk of sovereign default in either of these two countries has increased notably, but simply because these two countries as members of a Eurozone with known problems, and real contagion dangers, are now seen as being more risky. So why isn’t this the case with Estonia?
Yes, Slovenian and Slovakian CDS are still comparatively low risk priced (Slovenia at 109 and Slovakia at 102) but it is the direction and velocity of the movement which is striking, and especially in comparison with Euro Area peer Estonia. Why are these two countries considered to be more at risk than Estonia, especially given the size of the latter’s recent historic legacy?
Moving beyond the Baltics, risk in a number of other East European countries seems quite mispriced, unless we think that only being pegged to the Euro (rather than actually being a member of it) is a less risky mode to live in. Bulgarian CDS (currently around 225) have been steadily moving down all this year, and in sharp contrast to what happened in June last year, have so far not responded to the Greek crisis, despite the fact that Bulgaria’s banks are quite dependent on their Greek parents for funding.
The picture in Romania is rather similar, with the current price of 250 being well off last years highs of around 415, which means that markets are currently perceiving risk in Spain and Italy as more pronounced than those in Bulgaria and Romania. Certainly I would not want to argue that risk in both the aforementioned countries is high, but I am not at all convinced that contagion risk in the latter two is anything like as low as is being suggested, which is presumably why Nomura was recently advising clients in a research note to sell South African CDS and buy the wrongly priced Bulgarian and Romanian ones (also see here). Looking at the macro economic fundamentals of the respective cases, I can’t help feeling that in this case the analysts are right.
And if we move over to Hungary, then we find that as of last Friday CDS stood at around 285, well below the highs of over 400 seen as recently as last November in the wake of the Irish crisis.
Arguably the Hungarian case is the most glaring one, since it is the East European country with the highest debt to GDP levels (around 80%). It has very high gross foreign debt (around 135% of GDP, of which 45% is forex denominated), and it is a country where institutional quality is a constant cause for concern. In many ways Hungary is the Italy of the East. Apart from the presence of a strong trade surplus there is not that much to commend in Hungary’s recent economic performance. Yet its CDS has fallen into line with a regional pattern, and there is little in the way of what is happening in Spain and Italy to be seen in the spread, let alone what is going on in Slovenia and Slovakia.
Both Hungary and Romania were the object of IMF/EU rescues during the height of the financial crisis, and as a result their financing problems subsided. Both countries have made substantial progress in reducing their fiscal deficits, and have carried out a number of structural reforms. But both countries still have high levels of external indebtedness coupled with economies which are now extraordinarily export dependent for growth. In addition the demographic outlook for many of these countries is absolutely dire, and you will continually have smaller and older workforces trying to pay down increasing quantities of debt.
This underlying reality constitutes an unstable combination which make the countries concerned highly vulnerable to both a renewed deterioration in sentiment and an external economic slowdown of the sort we could see following a disorderly Greek default. Yet markets in general seem to be shrugging off the risk as almost non existent. “Smoke on the horizon” the admiral said as he lowered the telescope from his blind eye, “I see no smoke on the horizon”.
This post first appeared on my Roubini Global EconoMonitor Blog “Don’t Shoot The Messenger“.