EMERGING MARKETS REPORT
Latvia's CDS spreads soar to record after rating cut
Ratings agency warns of 'major crisis' brewing in Eastern Europe
By
Polya Lesova, MarketWatch
Last update: 3:24 p.m. EST Feb. 24, 2009
NEW YORK (MarketWatch) -- Eastern Europe's financial woes once again took center stage Tuesday, as Latvia's credit default swap spreads reached their widest levels on record after Standard & Poor's Ratings Services cut that country's credit rating to "junk" status and warned it could also downgrade the ratings of neighboring Baltic states Lithuania and Estonia.
Earlier Tuesday, S&P had warned in a separate report that "all the ingredients of a major crisis are in place" in Eastern Europe. On top of that, Moody's Investors Service placed Ukraine's ratings on review for possible downgrade, citing political uncertainty and concerns about the banking sector.
S&P downgraded Latvia's sovereign credit ratings from BBB-/A-3 to BB+/B, which is below investment grade, citing the worsening external outlook and the associated implementation risks on the government's ambitious economic program.
Latvia, whose government resigned on Friday, is mired in a severe economic crisis and has sought financial support from the International Monetary Fund.
Fitch Ratings said Tuesday that the collapse of Latvia's coalition government could delay the adoption of budget amendments to maintain its budget deficit at 5% of gross domestic product, as required by the IMF under the loan program agreed last December.
A failure to maintain budget controls could delay the disbursement of international funds to Latvia, and lead to renewed pressure on Latvia's currency peg, Fitch said.
Latvia's CDS spreads widen to record Latvia's CDS spreads reached their widest levels on record after the rating cut, according to data from Markit. A wider spread means that investors are pricing in a higher risk of debt default.
"The downgrade wasn't a great surprise given the dire state of the economy and the stratospheric level of its spreads -- just below 1,000 basis points," said Gavan Nolan, vice president of credit research at Markit.
"But it is still significant as Latvia is now only the second E.U. [European Union] country to have a sub-investment grade rating -- Romania being the other," Nolan said in a note.
The Latvian economy contracted by 10.5% in the fourth quarter of 2008, and official forecasts now suggest that the economy could shrink by as much as 12% this year.
"We believe the necessary process of private sector deleveraging is likely to continue over several years, during which time real incomes will decline, testing Latvia's commitment to both its exchange rate regime and its obligations under the 7.5 billion euro assistance program from the IMF, EU, and other official lenders," said Standard & Poor's credit analyst Eileen Zhang.
"The adjustment is made more difficult as external demand for Latvia's key exports continues to decline," Zhang said. The negative outlook on Latvia's ratings reflects the likelihood of a further downgrade later this year or in 2010, S&P said.
The agency also placed the ratings of Estonia and Lithuania on credit watch with negative implications, meaning that downgrades may be coming. The two economies are vulnerable because of weaker export performances. For Lithuania, uncertainty about its energy policy is also a concern.
Crisis in Eastern Europe
Earlier Tuesday, S&P said in a report that economic factors in Eastern Europe are similar to those leading up to the Scandinavian recession of the early 1990s.
They include the liberalization of local financial markets, leading to a boom in credit growth; a growing reliance on foreign lending, reflected in a sharp deterioration in the current account deficit; and an initial lack of response in the currency exchange rate to a growing current account deficit leading to a currency crisis.
"All Eastern European economies currently embody one or more of these symptoms, suggesting that the ingredients of a significant regional crisis are in place," said Jean-Michel Six, Standard & Poor's chief economist for Europe.
"Yet the magnitude of the problems differs across the region, leading to a diversification in the outlook for individual countries," Six said.
The Eastern European economies fall into two distinct categories, according to S&P. The Czech Republic, Poland, and Slovakia are likely to fare better in the current crisis because of their more resilient private demand and greater fiscal flexibility.
In the second group are the three Baltic countries, Bulgaria, Hungary and Romania, all of which are highly vulnerable. These countries are highly leveraged in terms of external debt and have huge current account deficits.
dalla Ue e dai Paesi Nordici.
