Archive for the ‘Rating agencies’ Category

Russia: Is the sovereign rating useful?

September 8, 2010


Does Russia’s sovereign rating tell us any more than the oil price?

Fitch Ratings today published a press release revising the “Outlook” on its “BBB” rating of Russian government bonds to positive from stable (see a Fitch press release below).  Rating agencies – Moody’s, Standard & Poor’s and Fitch – have been under fire since their high structured real estate ratings were downgraded rapidly during the recent financial crisis, suggesting that these ratings were wrong and therefore not a useful guide to investors.  Over the last two years, financial regulators have had their plates full preventing a 1930s-style banking collapse.  As a result, though they would like to kick the rating agencies in the pants to shake out the mediocrity, they haven’t had the time.  Are credit ratings useful? 

Yes and no.  Sometimes rating agency analytical reports are good, comparatively unbiased guides to the safety of bonds from sovereign governments and corporations, especially relative to investment bank reports.  However, the ratings themselves are sticky and often follow changes in creditworthiness (sudden ones anyway) rather than lead them.  Rating agencies don’t want to stick their necks out.  Conflicts of interest (agencies are paid by the bond issuers) are not to be dismissed, though somehow there is a more arms-length analytical relationship between bond issuers and the agencies than between the same and the investment banks, who fall over themselves to extol the virtues of clients that issue debt or equity.

Furthermore, sometimes a bond issuer’s profile is so tied to the price of a commodity (say, oil) that an investor is better off tracking the commodity price than bothering with ratings.  This is the case with “Rising Power” Russia.  Russia’s economy has long been dominated by energy exports.  Little has been done to diversify the economy in the way that its BRIC peers — China, Brazil and India — are diversified.  Energy prices rise and Russia’s ratings improve, and vice versa.  Yet the agencies go to great lengths to spell out the details of Russia’s credit profile in their reports.  As I said, sometimes the reports are good, especially for an econ nerd; but, the rating actions themselves – the reason agencies are paid so handsomely — can be of little use.

With oil prices rising rapidly over the last decade, Russia’s sovereign ratings rocketed from near-default levels (CCC) in 2000 to investment grade levels (BBB) today.  The ratings peaked at BBB+ from 2006 to 2008, when the price of a barrel of oil topped out at around $140 before collapsing to near $50 during the dog days of the global economic crisis in the fall of 2008.  That’s coincidentally when Fitch put Russia’s ratings on a Negative Outlook, before lowering the ratings to BBB in February 2009.  Since then, oil prices have clawed back to around $75 per barrel, and Fitch has again moved the Rating Outlook, first to Stable and then today to Positive.  This is all well and good, but the oil price was nearly as useful a guide as the ratings over this time frame, just as it was in 1998 when Russia defaulted on its bonds amid oil prices in the neighborhood of $10 a barrel.  Yes, the rating reports are informative, but if the agencies are to be more useful to investors (and society), they should try harder to predict financial developments and have their ratings lead, rather than follow, these developments.  And, they should show some skill at this before the regulators get around to kicking them in the pants.   


  Fitch Affirms Russia at ‘BBB’; Revises Outlook to Positive   
08 Sep 2010 8:04 AM (EDT)

Fitch Ratings-London-08 September 2010: Fitch Ratings has today affirmed Russia’s Long-term foreign and local currency Issuer Default Ratings (IDRs) at ‘BBB’. The Outlooks for the Long-term IDRs have been revised to Positive from Stable. At the same time, Fitch has affirmed Russia’s Short-term foreign currency IDR at ‘F3’ and the Country Ceiling at ‘BBB+’.

“The Russian economy is recovering after being hit hard by the global financial crisis. The outlook revision to positive reflects Fitch’s belief that the decline in inflation, shift to a more flexible exchange rate policy, sizeable repayments of private sector external debt, stabilisation of the banking sector and rising foreign exchange reserves should serve to reduce the country’s financial vulnerabilities,” says Ed Parker, Head of Emerging Europe in Fitch’s Sovereigns team.

Real GDP grew by 5.2% year-on-year in Q210, having contracted by 7.9% in 2009. Fitch forecasts growth of 4.3% in 2010 GDP and 4% in 2011 and 2012 – broadly in line with estimated potential. Recovery appears to be fairly balanced, and is supported by the rebound in oil prices, rising real incomes and stabilisation of financial confidence and capital flows.

The private sector has strengthened its balance sheets, where vulnerabilities had built up in the boom years. It repaid a net USD80bn in external debt in the two years to June 2010, including USD51bn of short-term debt, reducing its refinancing requirements and foreign currency exposures. Banks are liquid and have high reported capital ratios of around 19%. Asset quality appears to have stabilised, though Fitch estimates total problem loans at about 25% (including restructured loans at extended maturities and off-balance sheet exposures). A sizeable current account surplus, which Fitch forecasts at 4.6% of GDP in 2010, is helping Russia to rebuild its foreign exchange (FX) reserves, which have risen by USD92bn from their low in Q109 to USD476bn – the third-highest in the world – providing a formidable buffer against shocks. Russia is a large sovereign and overall net external creditor, the latter equivalent to 24% of GDP at end-2009, compared with a net debtor position for the ‘BBB’ range median.   

Inflation has declined to 6.1% in August, from double-digit rates 12 months previously. The Central Bank of Russia has shifted to a more flexible exchange rate and independent monetary policy regime, with positive real interest rates, which has the potential to help reduce inflation, dollarization and the risk of financial instability. However, the Central Bank of Russia has yet to build up a track record in this area.

Russia’s public finances have deteriorated over the past two years, though remain a rating strength. Fitch forecasts the budget deficit at 4.7% of GDP in 2010. Moreover, the budget balances at an oil price of around USD100pb, highlighting its vulnerability to a severe and sustained oil shock. However, general government debt is low, at only 10% of GDP at end-2009, compared with the 10-year ‘BBB’ range median of 35%. Moreover, the government has USD127bn (9% of GDP) in its sovereign wealth funds (1 September 2010), providing substantial financing flexibility, as demonstrated in 2009.

Weaknesses that weigh on Russia’s sovereign rating include its poor governance, institutions and corruption; a weak business climate that constrains investment, diversification and growth; exposure to commodity prices (and therefore the global economy); and a history of high and relatively volatile inflation.

In terms of potential triggers for future rating actions, a tightening of fiscal policy that significantly reduces Russia’s non-oil and gas budget deficit and its vulnerability to oil price shocks could lead to an upgrade. Material structural reforms that improve the business climate, banking sector and governance could also lead to an upgrade. A longer track record of implementing a more flexible exchange rate policy and anchoring inflation at the mid-single digit rate could put upward pressure on the ratings; as could a material strengthening in the external balance sheet. Conversely, a severe and sustained drop in oil prices could lead to negative rating action.

Hotspots for sovereign credit risk: Fitch report

June 1, 2010
What Greece needs is a thunderbolt from Zeus, not a bailout from Frankfurt.  Source:
What Greece needs is a thunderbolt from Zeus, not a bailout from Frankfurt. Source:


Like a thunderbolt from Zeus, financial markets are struck by the perils of a sovereign debt default.  In financial crises, markets and policy makers fight the last war.  In the Great Depression, countries made the mistake of balancing budgets instead of offering a Keynesian stimulus; in today’s crisis, they are spending like crazy by issuing debt (like crazy).  Sovereign balance sheets are in a woeful state. 

Fitch Ratings explains what is going on in Greece, what countries like the US must do to keep their AAA ratings, and what Latin America’s outlook is.  Fitch delivered its annual Sovereign Hot Spots seminar, which I used to run in New York.  Read the summary below and access the powerpoint presentations and the video of the conference to bone up on sovereign credit risk, which preoccupies global markets these days, as it well should.

Fitch belatedly downgraded Mexico, which lacks a dynamic economy and resists reforms to the oil sector and taxes that could improve creditworthiness.  These factors have long been at play in Mexico.  In addition, Fitch highlights Mexico’s dependence on the US market, as opposed to peer countries such as Brazil that export increasingly to China.  This factor is discussed as a weakness for Mexico these days, whereas for years it was alluded to as a strength.  (Who better to export to than the US, went the argument.) On the other hand, Brazil’s ratings are being held down because of its woeful fiscal accounts, in spite of its strong external balance sheet (which Mexico lacks).  I won’t quibble with the importance of public finances to sovereign creditworthiness; I will just point out that time and time again, analysts have let sovereigns off the hook that had strong public finances and weak external finances (e.g. Asia crisis countries and some countries today in Eastern Europe).  This has caused lots of Wall Street analysts to get it badly wrong in the past. (Did they call the 1998 Asia crisis or the problems Eastern Europe is currently having? No.)  Brazil has the reverse profile — strong fx reserves and weakening (though not fragile) public finances.  By penalizing Brazil too much for Lula’s loosening of the fiscal purse, analysts may miss the boat on Brazil (or may already have).

Finally, it might not be enough to say, as Fitch does, that AAA countries remain AAA because of their financial flexibility, but must find an “exit strategy” from all the rising debt over the medium term, as the US and others sure need to do.  This is ratings stickiness again, folks.  Rating agencies have a difficult time adjusting their ratings because it suggests their analysts might be wrong.  Maybe some AAA countries should have already lost their stellar ratings.  Economists are always good at finding powerful intellectual arguments to explain their current positions — remember Alan Greenspan before Congress on low interest rates.  Have a read of the Fitch summary below — it is chock full of good sovereign credit analysis. 

From Fitch:

“Sovereign Hotspots: Diverging Trends” began Tuesday, 2 March, with a conference in New York discussing the divergence of fiscal prospects between high-grade advanced economies and emerging markets. The conference focused on recent credit pressures and bond market volatility in Europe, as well as credit trends in Latin America. Additionally, Fitch distributed a press release commenting on Chile’s sovereign ratings following the country’s catastrophic earthquake and aftershocks. The event concluded with an analyst panel providing more details on specific countries in Latin America and an investor panel debating recent developments and prospects for the global economy and emerging markets in particular.

Below are some highlights of the conference, followed by links to each presentation. If you would like to hear a replay of the event, please click here. For information on next week’s events in London, Frankfurt and Paris, which will include presentations on Emerging Europe, the Middle East and North Africa, please click on or contact Katie Donnelly at 1-212-908-0828.
New York Conference Highlights:
High Grade and Euro Area Sovereign Risk      
Diverging Trends – ‘Advanced’ and ‘Emerging Market’ Sovereigns

Emerging markets (EM) have weathered the global economic and financial crisis relatively well due to their generally strong balance sheets.  Foreign exchange reserves for EM excluding China have shown a strong recovery since February 2009 and are now near pre-crisis levels.  In addition, lower public debt ratios, combined with less sensitive tax bases have led to more solid fiscal positions in EM relative to developed markets (DM).  Over the next two years, Fitch foresees a continued divergence in public debt paths, with government debt/GDP declining in EM and increasing in DM.
High Grade Sovereigns and the Meaning of ‘AAA’

Countries with high financing flexibility are better positioned to withstand economic/financial shocks than countries that are less flexible in terms of funding, with financing flexibility largely depending on the size of the economy (i.e., the amount of real & financial assets to absorb sovereign liabilities) and the depth of demand for a country’s currency (reserve currency status implies strong underlying demand for assets in that currency).  However, while high-grade sovereigns have the capacity to maintain solvency and the cost of debt service is still below mid-1990s levels, Fitch views these sovereigns’ fiscal exit strategies as key to their ratings outlook, with the urgency among the larger AAA-rated countries being greatest for the UK, Spain and France. 
Greece and the Euro Area

With Greece’s greatest problem being its non-credible statistics and poor track-record, Greece needs to bolster credibility and investor confidence in the long-term solvency of the state in order to gain market access at an ‘affordable’ price. At present, the EU is playing a game of “constructive ambiguity” aimed at stabilizing markets and reducing liquidity risk while putting additional pressure on Greece to restore fiscal discipline.  However, it should be noted that at this stage it is not clear that contagion risk is that severe, as so far spread widening has been ‘rational’, focusing on large deficit countries.
View full presentation
Latin America Overview

Although the average rating continues to be higher for Emerging Europe than for Latin America, the change in the average regional rating has been much better for the latter, with five positive rating actions taking place since July 2009.   Thus, while Latin America has been a mixed bag, with the number of negative rating actions exceeding the number of positive rating actions since the onset of the crisis, the region has generally been quite resilient to the global economic storm.  After an estimated 3% decline in GDP in 2009, Fitch anticipates overall GDP to grow by 4% in 2010, aided by supportive monetary and fiscal policies, a renewed credit cycle and stronger domestic demand (particularly in Brazil, Chile, Panama and Peru), as unemployment rates (which rose only modestly during the crisis) are declining, real wages are recovering and consumer confidence is increasing across the board.  In addition, both domestic and foreign direct investments are expected to rebound, general government debt is anticipated to stabilize and current accounts to remain resilient in 2010, with further accumulation of international reserves taking place.

Nonetheless, Latin America still faces important challenges as it copes with a sluggish global economic recovery as well as significant budgetary rigidity, which may hinder fiscal consolidation.  Additional challenges for the region include sustaining prudent policies through a sluggish recovery and avoiding election-related market uncertainty as presidential elections approach in Colombia (May 2010), Brazil (Oct 2010), Peru (Apr 2011), Guatemala (Aug 2011) and Argentina (Oct 2011).  Thus, while Latin America’s economy will rebound in 2010, the pace of the recovery will differ across countries and growth will still be below the rates observed in 2006-2007.  Since Fitch is currently not seeing a strong reform momentum throughout the region, sovereign creditworthiness trends are likely to remain stable to slightly positive.
Mexico: Explaining the Downgrade

Mexico was downgraded to ‘BBB’ with Stable Outlook in November 2009 primarily for structural reasons, including its low non-oil tax base and high oil dependence, combined with uncertain oil prospects (in fact, oil production has been declining in recent years despite an increase in capex, indicating the need for further reforms at Pemex).  In addition, the 2009 tax package, while in the right direction was insufficient, demonstrating the reluctance of political parties to come together to implement major fiscal reforms to improve tax revenues.  Other factors that led to the downgrade include a relatively modest fiscal buffer (the commodity stabilization fund is small compared with Chile’s, Russia’s and Kazakhstan’s), a limited external cushion (i.e., a weak international liquidity ratio compared with ‘BBB’ peers) and Mexico’s historical growth performance, which has been lagging that of its peers.  While Peru, Chile and Brazil have increased their trade links with China and reduced their ties with the US, Mexico still exports over 70% of its products to its North American neighbor.  As a result, the sluggish rebound of the US economy will continue to constrain Mexico’s growth in 2010.  Factors that led Fitch to change its Outlook on Mexico from Negative to Stable include the country’s well capitalized banking system and low balance of payment risk, as well as its track record of disciplined macroeconomic policies, its smooth external debt profile and its demonstrated ability to tap international markets under difficult external conditions.
Brazil: Beyond the Economic Resilience

Investor confidence towards Brazil is supported by the country’s strong external balance sheet, its robust external solvency ratios (Brazil has long been a net external creditor) and the healthy economic rebound anticipated for 2010, with the expected 5.5% growth in GDP being the strongest in Latin America and only behind India’s and China’s.  However, Fitch has not taken a positive rating action as the agency considers that Brazil’s resilience is already captured in its current ratings to a certain degree and that its stronger external balance sheet has been at a fiscal cost.  In fact, the deterioration in public finances and high government debt burden due to double-digit current spending and significant budget rigidity are dampening the country’s upward credit trajectory.  Moreover, Brazil’s domestic debt composition needs to improve further, as a large proportion of its debt is still contracted at floating rates and 2010 maturities are on the higher side when compared to those of its peers.  Finally, with 2010 being an election year, needed reforms are likely to stall until the next administration takes over.  Fitch will observe how the next administration will handle challenges such as the realization of expenditure reforms, the definition of BNDES’ role and the simplification of the tax system, as well as the management of oil sector development given recent discoveries, among other things.
View full presentation 
The presentations will be available free of charge for three months. If you have problems accessing these presentations or for more information, please email Frank Laurents at, or telephone +1 212-908-9127.

Additional information can be found on the Fitch Ratings website,

If you know others who would like to receive this e-mail, please forward this to a colleague.

Image: What Greece needs is a thunderbolt from Zeus, not a bailout from Frankfurt. Source:

(from a blog post of March 5, 2010.)

President Obama: Masterful politician

March 28, 2010


Soaring the fray.  Source:  Google Images
Soaring above…well…in the fray. Source: Google Images

I don’t agree at all with the Economist’s leader this week, which suggests that Barack Obama’s presidency was headed for failure until his health care victory last week.  The health care victory was the icing on the cake, coming fourteen months into Obama’s first term, after he rescued the planet from an economic meltdown in a cooperative effort with other G-20 leaders, pulled the Security Council behind him in a tougher stance toward Iran, negotiated nuclear arms reductions with the Russians, and improved America’s image in the world.  Bravo, Mr. President!

Politically, this fella is no slouch.  Obama may well avoid what happened to Bill Clinton in ’94, a massive mid-term reversal, with the likes of Newt Gingrich snickering in the hall, John Boehner today looking  like a dim photocopy of the Newt.  Sure, the president has been aided by the Republican victory in Massachusetts.  Yes, that’s right — aided by the Republican victory, a wake-up call that came ten months before the mid-term elections, just in time to deflate the egos of many in the West Wing, to cobble together a realistic health care victory, and to lay the foundation for a multi-month comeback to a mid-term election victory, or at least a less-nasty defeat.   Such a Democratic upset this November seems more likely now, given the current state of the know-nothing Republican Party, as hamstrung by their defunct ideology and mediocre leadership now as they were in October 2008 when they couldn’t understand that capitalism would be saved by government intervention.

Let’s not underestimate the dimensions of this political success.  I, not knowing much about Barack Obama in 2008, underestimated the mettle of this (at the time) inexperienced, leftish, mediocre legislator with barely any time outside the Illinois legislature.  He is one of those lucky bets that is paying off.  

Obama, his advisers, and dare I say it, the Democratic leadership of Congress, played this thing like a symphony.  Right on the heels of the Mass. election, which I wrote about in January, it would have been highly unpopular to ram health care reform through, utilizing the funky procedures they are employing right now.  Steny Hoyer had to button his lip in January.  Now, the country has barely noticed how the Democrats are passing this thing.  The Dems realized that not passing health care reform would be worse than stealing it in the middle of the night.  President Obama can claim that he has done something for the American people, something big, and yes, controversial.  But this accomplishment will be remembered as such, and everyone will forget how it was done.  Brilliant insight on the part of the Democratic leadership.

Even better, the president held that mock-bipartisan discussion with the Republicans right after the Mass. election, providing fodder for his future argument on the hustings, that “I reached out to them and they bit my hand.”  Now, he can dispense with the facade of bipartisanship (something he has never really exhibited), just when you want to dispense with bipartisanship, that is, in the run-up to an election.  The gloves are off, folks, and the Democrats are towering over a party in disarray, drifting to the right, and sipping tea.

Now, what do you do with this victory?  This is the question the Economist asks.  Undoubtedly, the Obama people will answer, “Get re-elected.”  And for starters, this means doing as well as possible in the mid-terms, to allow for a legislative foundation to pass more of the Obama agenda, though no one is quite sure what that is.  Then, run in 2012 as the early 21st century’s FDR, the remnant of the right quivering in their jack-boots.

To keep up the momentum, the President just jaunted off to Afghanistan, to underscore his key foreign policy priority and to make indelible his new-found image of toughness.  Having sustained criticism for dithering and allowing others to lead him, whether Democrats in Congress or foreign leaders, Obama is in pursuit of a victory abroad to match the massive, bloody victory he just won on the homefront.

I opposed health care reform in this blog.  Not that I oppose health care reform per se.  In fact, I am for it.  It is the fair and right thing to do in America, and one of those important actions, so intangible yet so necessary, that underpins social peace and the fabric of our society. However, I oppose health care reform, an expansion of government entitlements, at this time.  I still feel that America’s gravest fiscal crisis in history — the one we are in, which is set to get worse —  is no time to expand entitlements.  Entitlements — unemployment insurance, medicare, medicaid, social security, health care, etc. — could undermine America’s finances, if a medium-term fiscal plan is not put forward that puts government debt (now approaching an unhealthy 90% of GDP) on a downward trajectory.  On this, I concur with the Economist.

I was impressed that the CBO found a way to fully fund health care reform, albeit with uncertainty that the revenues will be there.  Cost containment is another uncertainty.  Hats off to the Democrats for seeking a way to expand entitlements without further busting the budget.  I do feel that some credit for this is due to those of us who put pressure on the party in power to respect fiscal rectitude, including many in the party of “no”.  Democracy works.  

I was a country risk analyst for fifteen years.  Country risk analysts are a breed that understands what is at stake with a deterioration in America’s public finances.  Country risk analysts assess the likelihood that a sovereign government will pay back its debts in full and on time.  Rating agencies, where I was a managing director for sovereign ratings for much of the past decade, assign letter ratings — AAA, BBB, BB, etc. — that rank countries by their sovereign credit risk.  Alas, the US is now in danger of losing its cherished AAA rating — the highest rating, the lowest risk — if the deterioration is not reversed in public finances (not to mention the trade deficit, which is driven in part by government deficits).  I wrote on these matters last fall — a piece on fiscal policy and one on trade — and earlier this year on the prospect of the US losing its AAA.

Americans are spoiled.  Never having experienced a real sovereign debt crisis, similar to what was experienced in Mexico after 1994, in Thailand, Korea, Indonesia and Russia after 1997-98, and in Argentina after 2001, Americans don’t worry about their governments’ finances.  Most argue today that the US, wealthy as it is, can afford health care reform.  But they don’t want higher taxes to pay for it.  There has never been a worry about the safety and soundness of US government bonds.  There have not been lines in America outside of defunct banks of depositors seeking their money since the Great Depression.  This is why the backlash against the bank bailout last  year was so strident…and so ill-informed.  Country risk analysts know better and understand that America has bought some time with its stimulus package and bank rescue, but had better balance its books in short order.  My worry is that the president and his inner circle are not as on top of these risks as the average country risk analyst is.  Hopefully, Geithner and Summers and others will bend the president’s ear regarding fiscal rectitude, if they are allowed to remain in power.

America’s economy remains strong and large.  The US dollar remains the world’s reserve currency. American competitiveness in high-technology, education, services, agriculture, defense and other industries remains intact.  It would take some serious further mismanagement for the US economy to lose its position of number one.  In 1905, Argentina had one of the leading economies in the world.  Through over a hundred years of mismanagement, Argentina became the number one sovereign financial pariah, with a massive sovereign bond default in 2001.

The US has a ways to go before becoming Argentina, or even Greece or Britain, the latter more likely to lose its AAA than the US.  But, such intangibles as credibility of the US dollar and US assets could evaporate quickly.  Right now, those with cash in the world do not have a lot of options better than US dollar investments — euro investments look dodgy at best, yen investments are not so attractive, and other currencies do not provide the depth and safety to handle multiple trillions of investment dollars that pour into US, European and Japanese markets.  Not yet at least.  Watch this box on the Rising Powers to learn more about the risks and opportunities in the major Emerging Markets. 

The US economy and US power are in decline, for sure.  Don’t gnash your teeth or get panicky.  We’re talking about relative decline, which is inevitable.  With $45,000 in per capita income, versus China’s $3,500, America will not grow as fast as China.  The Chinese economy will overtake America’s in a matter of decades.  US power too — that is, America’s ability to influence events in the world — will also decline in relative terms. 

It is not time to move to Beijing.  What is critical is the manner and speed of America’s decline.  If America ensures that the Rising Powers remain cooperative members of the liberal interational world order — characterized by free trade, currency convertibility, market economies, democratization, the generally peaceful resolution of disputes, and cooperation among the world’s great powers — then America can decline with peace of mind.  Moreover, if America’s declining economic position does not occur suddenly and rapidly, producing dislocation and popular anger at home, then America can maintain its still-powerful, yet diminished position in the world with grace, proud of having led the most prosperous, fairest, least-bloody world order since humans stopped swinging from trees.

The surest way to protect the world’s liberal institutions and to co-opt the Rising Powers is for America to stay strong.  So, American policy makers must see every policy option through the lens of American power.  Balance must be sought between achieving a more equitable American society and reinforcing the pillars of American power.  That is why I opposed health care reform at this time, while I fully understand the political imperative of doing it now.  Those Democratic majorities won’t last forever.   

Flush with his health care success, President Obama’s first priority no doubt will be to win elections — first in 2010 and then in 2012.  To that end, he will attempt to chalk up victories in his chosen priorities.  He will seek tangible victories in Afghanistan, some movement in the Arab-Israeli conflict, and progress on jobs and financial re-regulation.  Nothing wrong with these priorities.  The only thing missing perhaps is this lens of American power.  Will such-and-such a policy bolster American power over the longer-term or not?  If not, do not expend political capital on it.  Is there anyone in the White House looking through this lens?  I hope so.    

Restoring fiscal soundness, which means cutting spending and raising taxes, should be priority number one, Mr. President.  The president, who has sought to recast his leftish record as a centrist, should embrace centrism — and its centerpiece, sound finances — wholeheartedly.  But he won’t.  No one believes that centrism wins elections.  I suspect if he did embrace centrism, he might be surprised that it could win elections.  As the first truly centrist American president, Barack Obama would be on his way to achieving another first, following his most recent first — health care reform.

USA could lose its AAA this decade

January 12, 2010
Obama OMB Director Orszag: oversees US budget.  Source:  Google Images
Obama OMB Director Peter Orszag. Source: Google Images

Planet Earth’s critical issue this decade will be whether American power will erode — and if so, what the implications will be for the liberal world order we erected after WWII.  The Obama administration’s fiscal stimulus package cum bank bailout, building on the Paulson-Bush-Geithner-Bernanke efforts of 2008 and the unprecedented coordination of economic policy globally, constituted a brilliant, stage-managed rescue of our planet, nothing less.  However, such a Herculean effort has created its own problems — huge debts, gaping goverment deficits, and a government intrusion in the economy that will be hard to reverse.  As yet, no plans to solve these problems have been offered.

Students of power and prosperity from Paul Kennedy on down know that imperial overextension accelerates the decline of great powers.  From this dynamic, the US is not immune.  While the relative decline of the US has been in place since the 1950s, its rapidity and consequences are far from inevitable.  A too precipitous, disorderly, angry decline that would occur if America does not right its fiscal ship soon would not only injure American prosperity, but would also put at risk our global institutions — the UN, the IMF and World Bank, NATO, the WTO, the G-20, etc.  These institutions have fostered cooperation and peaceful solutions to the world’s problems. 

The symbolic end to this Pax Americana, which has raised billions out of poverty and offered countless millions broader political participation, could be the loss of the AAA rating on US government bonds.  According to Brian Coulton, head of Global Economics at Fitch Ratings, this could occur later this decade if an aggressive fiscal consolidation program is not implemented by the Obama administration (see note below).  A narrow tax base, low discretionary spending (the kind of spending that is easiest to cut) and huge entitlements — including the $900 billion health “reform” up on Capitol Hill, the continued current account deficits in spite of sluggish GDP growth, and our dependence on foreigners for financing together spell a potentially rapid decline of America’s place in the world. 

So, who will fix this?  President Obama has chosen the nerd pictured above.  He is reportedly a bright, driven man.  I am not sure how hard it is to preside over the most massive expansion of entitlement spending in history and to oversee the distribution of hundreds of billions of dollars of stimulus spending to groveling constituencies.  But that was just his first year.  The president’s chief of staff Rahm Emanuel was reported in the New York Times to have said that Office of Management and Budget Director Orszag has “made nerdy sexy,” perhaps with some jealousy.  The Times article this Sunday highlighted Orszag’s loose love life and questions about his commitment to his families.  I am all for keeping a public servant’s private life out of politics in principle, but one wonders how so extravagant a player can be entrusted with the most difficult fiscal consolidation in human history.  I don’t think rating agencies take into account the social life of a sovereign’s budget director in making their rating decisions, but one wonders sometimes if they should.    This seems to be part of the hubris we have seen sometimes in this White House.  I hope he knows what he’s doing, because the stakes couldn’t be higher.

Fitch Affirms United States at ‘AAA’; Outlook Stable   

11 Jan 2010 8:31 AM (EST)

Fitch Ratings-London/New York-11 January 2010: Fitch Ratings has today affirmed the United States’ (US) Long-term foreign and local currency Issuer Default Ratings (IDRs) at ‘AAA’, respectively. The rating Outlook on the Long-term ratings is Stable. Fitch has simultaneously affirmed the US’ Country Ceiling at ‘AAA’ and the Short-term foreign currency rating at ‘F1+’.

“The near-term risk to the United States’ ‘AAA’ status is minimal given its exceptional financing and economic flexibility and the US dollar’s role as the world’s predominant reserve currency. However, difficult decisions will have to be made regarding spending and tax to underpin market confidence in the long-run sustainability of public finances and the commitment to low inflation,” said Brian Coulton, Head of Global Economics and the Primary Analyst for the US at Fitch.

“In the absence of measures to reduce the budget deficit over the next three-to-five years, government indebtedness will approach levels by the latter half of the decade that will bring pressure to bear on the US’ ‘AAA’ status,” added Coulton.

The US government remains exceptionally creditworthy – supported by its pivotal role in the global financial system and a flexible, diversified and wealthy economy that provides its revenue base – despite an unprecedented deterioration in fiscal performance. The government’s unparalleled financing flexibility enhances debt tolerance even relative to other large ‘AAA’-rated sovereigns, and has allowed the government to take aggressive counter-crisis and counter-cyclical policy measures, which now appear to be working in terms of restoring stability to the US financial sector and the economy.

However, the government faces significant medium term fiscal challenges with a sizeable structural deficit, a narrow tax base, limited expenditure flexibility and exposure to potential interest rate shocks due to the short duration and maturity of US government debt and a heavy reliance on foreign investors. Public debt on a general government (i.e. consolidated federal, state and local) basis is expected to rise to 89% of GDP in 2010 and 94% in 2011 from 79% of GDP in 2009, which would mark the highest level among ‘AAA’-rated sovereigns. Public debt was just 57% at end 2007.

The general government deficit – estimated by Fitch at 11.4% of GDP in 2009 and forecast at 11% in 2010 and 8.5% in 2011 – contains, in Fitch’s opinion, a sizeable structural component that will not be eliminated by the economic recovery and the unwinding of stimulus measures. Corporate taxes, in particular, collapsed in 2009 having been boosted by artificially strong financial sector profits and asset price gains in the years before the recession began and are unlikely to show a strong recovery. Fitch anticipates the economic recovery will be weak by the standards of previous recoveries and less dynamic than assumed in the latest official medium term fiscal forecasts. Deleveraging will continue to weigh on private sector demand, while rising long-term unemployment and the fall in investment through the recession could adversely affect supply side performance. In addition, while TARP related fiscal outlays have been lower than anticipated, fiscal risks relating to the financial sector remain, particularly with regard to Fannie Mae (‘AAA’/’F1+’/Outlook Stable) and Freddie Mac (‘AAA’/’F1+’/Outlook Stable).

Public debt levels compare particularly poorly with ‘AAA’-rated peers when expressed relative to fiscal revenue. General government debt was equivalent to 330% of revenues at end 2009 (even higher at 437% on a narrower central government basis), the highest among ‘AAA’-rated sovereigns and compared to a long-run ‘AAA’ average of 118%. Amongst high grade sovereigns, only Japan (‘AA’/’F1+’/Outlook Stable) and Ireland (‘AA-‘/’F1+’/Outlook Stable) have higher debt-to-revenue ratios. Debt interest payments are expected to rise to nearly 11% of revenue by 2011 and nearly 13% on a central government basis. Fiscal flexibility is also reduced by the limited scope for sizeable structural reductions in public expenditure, given low discretionary outlays and pressures on entitlement spending.

Both the dollar’s role as the predominant global reserve currency and the benchmark status of US Treasuries significantly reduce the scope for destabilising interest rate shocks. But the economy’s high external debt burden, the ongoing current account deficit and the high share of non-resident holdings of government debt (close to 50%) increase the potential for volatility in US asset prices if foreign investors were to become concerned about public debt sustainability or risks to the credibility of the monetary policy framework. With the average maturity of federal debt having shortened sharply over 2008 and 2009, rising interest rates would feed through to the budget relatively quickly.

Applicable criteria available on Fitch’s website at ‘Sovereign Rating Methodology’, dated October 16, 2009.

Contact: Brian Coulton, London, Tel: +44 (0) 20 7682 7497; David Riley, + 44 (0) 20 7417 6338; Shelly Shetty, New York + 1 212 980 0234.

Israel’s economy: weathering the storm

November 10, 2009
Source: Google Images
Source: Google Images

Much news and commentary you hear about the State of Israel has to do with geopolitics and the Arab-Israeli conflict (see my colleague Ben Moscovitch’s blog on this site for a nice selection.)  Settlements, will Abbas run or not, Iran’s plans to wipe Israel off the map, Israel’s thoughts about taking military action against Iran, the Goldstone Report on the war in Gaza, films about the war in Lebanon, and on and on. 

Not that this hyper-news about Israel is not important and interesting.  But, let’s step back and look at Israel from a “rising power” perspective — half highly indebted socialist country/half cutting-edge hi-tech and health sciences capitalist upstart.  Its economy has proven itself resilient to the intifada, to the tech bust of nearly a decade ago, and now to the US-led global meltdown. 

How so?  It’s about policy, stupid.  Sound economic policy, begun in the 1980s with a classic monetary stabilization program that reduced inflation, and deepened only a few years ago, by none other than Benjamin Netanyahu, as finance minister, with his Thatcherite restructuring of the economy (e.g., increasing the labor force participation rate by creating incentives for the religious to work) and his shift to a rules-based fiscal policy.  Israel still has a high government debt burden — above 80% of GDP.  But that is down from above 100% not long ago.  Meanwhile the rest of the world has caught up to Israel’s debt levels (with the U.S. now surging higher). 

On the external front, the country couldn’t look better — $60 billion in foreign exchange reserves, a current account surplus, and “net external creditor” status, that is, Israel’s claims on foreigners exceed foreigners’ claims on Israel (oh, how the U.S. would love to have that balance sheet!)

So, in spite its modest size, constrained by the country’s small population, the Israeli economy dwarfs those of many of its much poorer and poorly run neighbors.  Have a look at the Fitch press release below referencing a recent report on Israel and its sovereign credit outlook.

Fitch Affirms State of Israel at ‘A’/’A+’; Outlook Stable   
06 Nov 2009 8:22 AM (EST)

Fitch Ratings-London-06 November 2009: Fitch Ratings has today affirmed the State of Israel’s Long-term Foreign and Local Currency Issuer Default Ratings (IDR) at ‘A’ and ‘A+’ respectively with Stable Outlooks. The Short-term Foreign Currency IDR is affirmed at ‘F1’ and the Country Ceiling at ‘AA-‘.

“Israel has fared better than many other small, open economies in the recent global economic and financial downturn, suffering only a mild recession compared to rated peers in Europe and Asia,” says Paul Rawkins, Senior Director in Fitch’s London-based Sovereigns team. “Nonetheless, the downturn has exposed Israel’s key vulnerability to shocks, namely a high public debt ratio that looks set to exceed 80% of GDP in the wake of wider fiscal deficits in 2009-10.”

Fitch says an improved macroeconomic policy framework, coupled with structural reforms since the last recession in 2001-02, laid the foundations for strong growth in 2004-08, in line with the ‘A’ median of 5%, rendering the economy markedly more resilient to shocks. With the exception of Bahrain, China and Poland, Fitch expects Israel to be the only country in the ‘A’ range to escape an outright recession in 2009. This performance is attributed largely to aggressive monetary and exchange rate policies, aided by a relatively trouble-free banking sector and an absence of asset price bubbles. Structurally, Israel’s high-tech manufacturing and services sectors have proved unexpectedly resilient to declining global investment demand, presaging a near record current account surplus in 2009.

Israel’s high public debt ratio remains the key constraint on its sovereign ratings. The adoption of rules-based fiscal policy in the wake of the last recession has served Israel well; limits on the growth of public expenditure and a ceiling on the state (i.e. central government) deficit facilitated a contraction in general government debt to 78% of GDP at end-2008 from a peak of 100% in 2003. Even so, this ratio remains high relative to the peer group median of 37%, although it is not the most extreme (‘A-‘ rated Greece exceeds 100% of GDP). Moreover, considering the mildness of its recession and an absence of financial sector-related support, the current external shock has taken a heavy toll on the public finances, chiefly on the revenue side. Fitch expects Israel’s general government deficit to widen to 6%-7% of GDP in 2009-10, on a par with rated peers Malaysia and the Czech Republic, which have experienced much steeper recessions, while pushing general government debt up to over 84% of GDP by end-2010.

While Israel’s experience with fiscal rules has been mixed, the current framework has entrenched fiscal discipline and together with signs of a strong economic recovery, suggests Israel’s powerful public debt dynamics could reassert themselves by 2011, forestalling any further deterioration in the public debt/GDP ratio. The government envisages a sharp narrowing in the state deficit to 3% of GDP in 2011 (from 6% in 2009), but still hopes to adhere to tax cuts over the medium term. Fitch expects some revision to the fiscal rules, with greater prominence being given to the Maastricht public debt/GDP ratio of 60% of GDP. From a rating standpoint, a positive rating action would require a decline in the debt/GDP ratio to a level nearer to the ‘A’ median. Conversely, a prolonged rise in the debt/GDP ratio and/or sustained fiscal easing would prompt a negative rating action.

Externally, the Government of Israel became a net external creditor for the first time in 2008, although it still falls short of ‘A’ norms on this measure. Burgeoning international reserves – these have more than doubled to USD60bn since end-2007 – have been the key factor behind this status change for the sovereign, facilitated by a strong current account surplus and buoyant net capital inflows. The economy as a whole also passed a new milestone in 2008, registering a surplus of external financial assets over liabilities for the first time. Israel expects its standing on the international stage to be further enhanced by OECD membership in the near future.

Contact: Paul Rawkins, London, Tel: +44 (0) 20 7417 4239; Richard Fox, +44 (0) 20 7417 4357

Media Relations: Peter Fitzpatrick, London, Tel: + 44 (0)20 7417 4364, Email:

Additional information is available on

Emerging Europe has fiscal problems, says Fitch

October 29, 2009
Emerging Europe: Fiscal woes  Source:
Emerging Europe: Fiscal woes Source:

Fitch Ratings published a report this week analyzing the fiscal deterioration taking place in 21 countries in what it calls “Emerging Europe,” which includes three sizable economies — “rising” power Russia’s nearly $1.7 trillion economy, struggling Turkey’s $745 billion economy, and Poland’s nothing-to-sneeze-at $525 billion economy. Like much of the rest of the world, Emerging Europe juiced its economies with fiscal stimulus packages due to the Great Recession, and therefore, needs an exit strategy over the medium term to this fiscal deterioration. 

Fitch rates Russian sovereign debt at BBB with a Negative Outlook (likely to be downgraded within two years); Turkey’s BB- with a Rating Watch Positive (likely to be upgraded, albeit from a low level, within the next three months); and, Poland’s debt A- with a Stable Outlook.

Fitch expects Polish GDP growth to languish before rebounding to about 3% in 2011; Russian growth to creep back above 3%; and, Turkey’s to move back to around 4% per year.  Government deficits in all three will remain sizable at between 3-6% of GDP per year, though quite small next to America’s 10% this year.  Poland’s government debt will rise to nearly 60% of GDP by 2011; Russia’s government debt remains very, very small (at below 15% of GDP); and Turkey’s will rise to nearly 50% of GDP before plateauing.  These levels are still modest relative again to U.S. levels approaching 90% in the coming years.  Poland’s and Turkey’s current account balances (a measure of trade) are in deficit, though forecast by Fitch to be below U.S. levels, which should exceed 3% of GDP in the coming years.  Russia, of course, as an energy exporting powerhouse, remains in surplus on its current account.

Central European economies, including Poland’s, are expected to move out of recession nicely, driven by links to the euro area, especially to the reviving German economy.  Baltic and Balkan states are rebounding less nimbly, according to the Fitch report.

A number of countries have been assisted by sizable IMF financing, including Turkey, Hungary, Armenia, Georgia, Latvia, Romania, Serbia and the Ukraine, not to mention that Poland obtained a $20.5 billion Flexible Credit Line with the IMF.    

Have a look at the Fitch Press release on the report below. 

Fitch: Public Finance Concerns Move to the Fore in Emerging Europe
29 Oct 2009 4:00 AM (EDT)

Fitch Ratings-London-29 October 2009: Fitch Ratings says in a new report that although external financing risks have eased somewhat for many countries in emerging Europe (EE) during recent months, rising government deficits and debt ratios mean that sovereign rating dynamics remain negative.

“Worst fears of a systemic economic and financial meltdown in emerging Europe have receded as global output has started to recover and financial conditions have eased, driven by the massive global fiscal and monetary policy stimulus, rescue packages led by international financial institutions and, in many countries, impressive economic resilience,” says Edward Parker, Head of Emerging Europe Sovereigns at Fitch.

“However, major challenges remain due to the scale of the negative shocks to hit the region; the costly legacy of the crisis, notably rising public debt ratios; and the uncertain “exit” from the crisis, recession and accommodative policy settings; while a relapse in one of the more vulnerable countries could trigger ripples across the region,” says Mr Parker.

Concerns over public finances have moved to centre stage. Fitch forecasts the impact of the recession – in some cases augmented by fiscal stimulus measures, lower oil prices and bank bail-outs – to widen the average budget deficit to 5.9% of GDP in 2009 from 1.1% in 2008, before narrowing to 4.6% in 2010. It expects the average government debt/GDP ratio to rise to 36% at end-2010 from 23% at end-2007. Failure to implement credible medium-term fiscal consolidation could lead to rating downgrades. In many countries, social pressures and elections will make it harder to implement austerity measures. This is fertile territory for political shocks. For countries reliant on IMF-led programmes for fiscal and external financing and for underpinning economic confidence, failure to stick to programme conditions poses additional risks to macroeconomic stability.

Fitch has revised its forecast for 2009 EE GDP to -6.1% from -4.6% in its June forecast round, owing to an even steeper drop than anticipated in output in H109. This contrasts with just -0.1% forecast for emerging markets as a whole. It forecasts only Azerbaijan and Poland will avoid recession, while Armenia, Estonia, Latvia, Lithuania and Ukraine will suffer double-digit declines in GDP. However, it has revised up its 2010 growth forecast to 2.6% (from 1.5%), owing to the unwinding of the deeper 2009 contraction and more supportive global conditions. Indeed, it estimates EE GDP rose by about 1% q-o-q in Q209, after plummeting 7% in Q109, led by a rebound in Turkey. But weak investment, rising unemployment, moderate capital inflows and credit growth, fiscal consolidation and a rebuilding of balance sheets point to a subdued recovery.

External financing and currency risks, which were the primary vulnerability of many countries in EE in the initial phase of the crisis, have eased somewhat, though remain material. This reflects a rapid reduction in current account deficits (CADs), substantial multilateral assistance, a boom in sovereign external issuance (USD19bn year to date) and relatively resilient private-sector roll-over rates. Fitch estimates the region’s gross external financing requirement (CAD plus medium- and long-term (MLT) amortisation) at USD304bn in 2009 and 2010, down from USD363bn in 2008.

In contrast to the rally in EE government bond prices, sovereign ratings dynamics remain negative, albeit at an easing pace. Following 11 notches of downgrades of foreign-currency Issuer Default Ratings in Q408, there were two downgrades in Q109, three in Q209 and only one in Q309. The balance of Outlooks and Watches has improved slightly since August 2009, but 12 countries are on Negative and only one on Positive. Fitch expects future rating actions to be driven more by country-specific developments than general trends.

The full report, entitled “Emerging Europe Sovereign Review: 2009”, is available on the agency’s website at

Contacts: Edward Parker, London, Tel: +44 (0) 20 7417 6340, David Heslam, +44 (0)20 7417 4384; Eral Yilmaz, +44 (0)20 7682 7554.

Turkey: the harder they come…

October 7, 2009
Turkish Prime Minister Recep Tayyip Erdogan  Source: Google Images
Turkish Prime Minister Recep Tayyip Erdogan Source: Google Images

Sovereign risk in Turkey was once talked about in the same breath as Brazil’s.  Not so anymore.  One is going hat in hand to the IMF, likely to get $45 billion in the coming weeks; the other is largely self-financing.  What went wrong in Turkey?  Always keep your eye on the current account deficit, folks, even when Wall St. analysts tell you its nothing to worry about because it’s financed by FDI, or some such Bernanke-esque bunk.  Current account deficits mean borrowing from abroad.  And that means vulnerability.  Turkey went into the global crisis with a 5-6% current account deficit, while Brazil went in with small surpluses.  Keep your eye on America as well and its sovereign credit risk — current account deficits there have been nearly halved to 2-3% from 5-7% a couple of years ago, largely due to the US recession.  But the U.S. still can’t kick its foreign borrowing habit, Obama’s protectionism notwithstanding.  Likewise, watch out for “twin deficits.”  That’s when government deficits move in tandem with current account deficits (the former often driving the latter).  The US has these, as does Turkey (where government deficits are in the range of 5-7% of GDP, versus Brazil’s 3-4%).  Turkey’s overall government debt burden remains modest at under 50%, versus Brazil’s near-70%; however, Brazil’s government debt burden is headed down, while Turkey’s is rising.  Hence, Fitch moved Brazil up to investment grade not long ago, while Turkey languishes at BB-.  They both were BB- only a few years ago.  Sometimes the rating agencies get it right, even though it often takes them some time to do so.

So, the Turkish prime minister shows up hat in hand at the IMF’s doorstep, while President Lula’s Brazil is considered a rising power.  Have a look below at the CreditSuisse report from today on Turkey’s negotiations with the IMF.  Deputy Prime Minister Babacan, whom I met with in the past and perceive as smart and wily, is thankfully in charge of these negotations.

From CreditSuisse:

Berna Bayazitoglu
+44 20 7883 3431
Prime Minister Erdogan denounced yesterday the claims in the local media that the IMF has offered a sizable financing package to the Turkish government which it cannot turn down. As we reported in the Emerging Markets Economics Daily yesterday, Erdogan told the Wall Street Journal on Monday (5 October) that the Turkish government has resolved one of the sticking points with the IMF, namely the IMF’s request for an independent tax revenue administration, and added that “he would like to see a new IMF program for Turkey agreed soon.” This was the most upbeat assessment that Erdogan has offered on the subject in a long while. Looking for an explanation for the change in Erdogan’s tone about an IMF agreement, the Turkish media claimed yesterday morning that the IMF might have offered a large financing package to Turkey (amounting to $45bn) which Erdogan cannot turn down. However, at a reception later in the day, Erdogan denounced local media stories that the IMF has made a new offer to Turkey.

Nevertheless, Erdogan’s statements in the Wall Street Journal add strength to the possibility that the government might invite an IMF mission to Turkey soon. As we noted in the Emerging Markets Economics Daily yesterday, speaking at various conferences in the last few days at the IMF/World Bank annual meetings in Istanbul and somewhat in contradiction to Erdogan’s statements in the Wall Street Journal, Deputy Prime Minister Babacan (who is the senior policymaker in charge of policy discussions with the IMF) had said that the discussions on the tax revenue administration and local governments’ spending were still continuing and that the IMF was studying the government’s medium-term economic plan and fiscal program.

The Statistics Office will release the industrial production data for August tomorrow. We forecast that industrial production was down 4.7% yoy in August, slowing from a contraction of 9.1% yoy in July. Our forecast is more optimistic than the consensus forecast (according to Bloomberg) of a 5.2% yoy contraction.

Mexico proposes sound fiscal plan, says CSFB

September 9, 2009

I discussed Mexico’s fiscal woes and compared them to Brazil’s in a previous post.  Today, financial market analysts reacted positively to the Mexican government’s fiscal plan, set to limit the widening of the federal deficit in 2010.  Like Barack Obama’s unwillingness to confront Congress on the cap-and-trade carbon emissions plan or health care reform, Felipe Calderon’s government once again skirted the issue of expanding Mexico’s narrow VAT tax to cover food and medicines.  Instead, the government will tax income more heavily.  CreditSuisse’s Alonso Cervera applauds this move because of the virtual impossibility of moving a budget through the Mexican legislature with a VAT expansion in it.  Calderon faces a congress in which his PAN party is dwarfed by the opposition PRI party, unlike the commanding position of Obama’s Democrats in both houses of the U.S. Congress. Nevertheless, Mexico’s budget, if passed, is a step in the right direction, especially since it controls spending and raises the share of non-oil taxes in government revenues. 

Read Alonso Cervera at CreditSuisse and Alfredo Thorne at JPM below:  

 From CreditSuisse’s Emerging Markets Economics Daily, Sept 9, 2009

“The government presented an ambitious budget proposal for 2010 that seeks to limit the widening of the deficit to 0.4% of GDP mainly by strengthening non-oil tax collections. The government released the comprehensive documents last night. Our first impression is a positive one, in that the government will seek to gain congressional approval for tax hikes equivalent to 1.4% of GDP, and for spending cutbacks equivalent to 0.5% of GDP. By applying an additional 0.7% from non-recurring revenues (those

currently existing in stabilization funds as well as projected ones), the government seeks to limit the widening of the fiscal deficit to 0.4% of GDP, from 2.0% this year to 2.4% of GDP next year. The government will also seek to strengthen the fiscal responsibility law by, among others things, eliminating the maximum reserve levels for stabilization funds so that the government can capitalize on the materialization of a revenue windfall.

The government presented in its policy guidelines document relevant comparisons that make it clear that non-oil tax revenues in Mexico are particularly low. The government made the comparison versus other OECD countries, Latin American countries and Brazil in particular. The government’s proposal to enhance non-oil tax revenues does not rest on the introduction of a value-added tax on food and/or medicines. We view this as a wise decision, given the strong opposition that both the PRI and the PAN had voiced in recent days regarding this potential proposal. Instead, the government is seeking to

achieve a combination of higher excise and income taxes, as well as the introduction of a new tax that has been labeled the “anti-poverty tax”.

Specifically, the government’s proposals on the tax front include: 1) the introduction of a 4.0% excise tax on telecommunication services that use a public network (excluding services in rural areas as well as public telephones); 2) increasing the excise tax on tobacco by 10.9 percentage points in 2010; 3) increasing the excise tax on beer from 25%to 28% in 2010-2012 and then reducing it back to 25% by 2014; 4) increasing the excise tax on lottery games to 30% from 20%; 5) hiking the maximum income tax rate on individuals and corporations to 30% in 2010-2012 from 28% at present, and then reducing it gradually back to 28% by 2014; and, 6) increasing the tax on cash deposits from 2% to 3% and broadening its application to cover smaller transactions.

Finally, the so-called antipovertytax would be a “2% tax on revenues generated by all types of economic activities, applied in all stages of production  in a non-cumulative manner”, according to the document. The proceeds, estimated at 72bn pesos (0.6% of GDP), would be applied to selected anti-poverty  programs. The government estimates that non-oil tax revenues could increase from 9.2% of GDP in 2009 to 10.8% of GDP next year. The bulk of the increase would come from income taxes, which would increase from 5.0% of GDP in 2009 to 5.6% of GDP next year. The government is also proposing some changes to the taxation of Pemex. Specifically, one of the proposals is to create a new flat tax rate of 15% for natural gas and crude oil extraction activities in selected fields, as opposed to taxing them based on a variable rate that is capped at 20%.

On the spending front, the government is seeking a reduction of 0.6% of GDP in programmable expenditures as well as the re-allocation of other expenses in favor of pension payments, health coverage and overall anti-poverty measures. Some specific measures to cut spending include the closing of three major government offices, 5% headcount reductions for high ranking officials and administrative staff, and 10% cutbacks in Mexico’s representative offices abroad. On the debt financing front, we highlight that the government will seek a net domestic indebtedness ceiling of 340bn pesos, which compares favorably to the ceiling it requested (and got from congress) of 380bn pesos for 2009. We think that this should be a relief for the local market, as the government will seek more actively than usual non-market financing sources abroad (mainly IFIs and other non-traditional sources). As for market debt issuance in external markets, the government’s plan is to simply issue an amount equivalent to market amortizations coming due in 2010 ($2.9bn).

Finally, the government’s outlook on the global economy in 2010 is somewhat cautious. The government’s documents presented to Congress yesterday state that the global situation continues to show a significant degree of fragility and that the global economic recovery will be moderate. Mexico’s real GDP is projected to expand at an average rate of 3.0% in 2010, with average annual growth seen at 4.2% in 2011-2015. This is partly based on the Blue Chip survey that puts US real GDP growth at 2.3% in

2010 and US industrial output growth at 2.5%. The government’s oil price assumptions are based on the formula set out in the budget responsibility law. Taking historical and projected prices, the formula yields an estimate of $53.9 per barrel for Mexico’s crude oil export mix in 2010 (roughly $60 for the WTI mix), which increases gradually towards $64.6 by 2015, which we view as conservative. Finally, in terms of oil output, the assumption is that it will average 2.5mn barrels per day in 2009 and in subsequent years, down from slightly over 2.6mn barrels per day in 2009. This assumption may be on the optimistic side, in our view.

In the remainder of this week we will expand our analysis of the comprehensive documents issued by the government last night. We reiterate that our initial reaction is positive, in that the government is putting on the table several measures that seek to close the gap created by falling oil and non-oil prices due to structural and cyclical factors. We also view the decision to keep off the negotiating table any proposal to introduce a valueadded tax on food and medicines as a good move by the government, one that may make negotiations smoother with the main political parties.

Finally, and on a separate note, the central bank will publish today at 10:00 am EST the inflation results for August; we estimate headline inflation was 0.28% last month (relative to July). If our estimate proves accurate, annual headline inflation will drop to 5.1% from 5.4% in July. Meanwhile, we estimate that core prices rose by 0.24% last month, which would put the 12-month reading at 5.1%, down from 5.3% in July. These would be the lowest 12-month readings since May 2008 in the case of headline inflation,

and since July 2008 in the case of core inflation. Market expectations are generally in line with our own. The latest survey released yesterday showed average forecasts of 0.26% and 0.25% for headline and core inflation, respectively. The survey also showed that the overwhelming majority of analysts (19 out of 24) thought that the central bank will keep the overnight rate unchanged at 4.5% in the remainder of the year.”

From JPMorgan’s Emerging Markets Today, Sept. 9 2009

“President Calderón yesterday announced the 2010 economic

package, calling for an austere budget with changes in the

public sector’s administration structure. To reduce expenses,

Calderón presented four administrative changes for next year

to be discussed by Congress. First, the Ministries of Tourism,

Agricultural Reform, and Public Ministry will be eliminated.

The first two entities will be reallocated to the Ministry of

Economy and Ministry of Social Development and

Agriculture, while the third will fall under executive powers.

Second, the federal government will reduce the large number

of civil servants and freeze salaries and compensation. Third,

spending on embassy, councils, and foreign activities will be

reduced. Fourth, other administrative expenses will be

reduced. The measures together are expected to reduce

budgetary expenses by MXN80 billion. Calderón

estimated that these expenditure cuts, combined with the

fiscal package (still pending at the time of writing), will

narrow the fiscal gap to MXN180 billion (1.4% of GDP).

Calderon also reiterated the government’s commitment to

reducing poverty noting that none of these expenditure cuts

will include social programs.”

Alfredo Thorne (52-55) 5540-9558

Brazil: Fitch Ratings not happy about fiscal deterioration

September 8, 2009
"G-2": Brazil's President Lula and Mexico's President Calderon: Whose fiscal ship faces calmer seas?  Source:  Google Images
“G-2”: Brazil’s President Lula and Mexico’s President Calderon: Whose fiscal ship faces calmer seas? Source: Google Images

Fitch Ratings published a report this month analyzing Brazil’s fiscal deterioration this year (see press release below).  Brazil’s public finances have slipped just like in just about every country in the world.  Fitch highlights Brazil’s heavy government debt burden relative to its emerging market peers.  Brazil’s fiscal deterioration — characterized by rising spending, tax cuts, and a poor tax intake — will at the very least slow any upward movement in Brazil’s credit rating, currently at BBB- for foreign currency debt, and could in fact lead to a downgrade if a fiscal consolidation is not forthcoming over the medium term, suggests Fitch. 

Yet Fitch rates Mexico fully two notches above Brazil (BBB+), albeit with a Negative Outlook (meaning the rating should go down within two years).  Brazil’s government debt to GDP ratio is nearly 70%, whereas Mexico’s is below 40%.  What they don’t highlight is that Brazil’s debt to tax revenue ratio is lower than Mexico’s (nearly 170% in South America’s largest economy vs. Mexico’s nearly 200%).  Mexico’s woeful tax performance is a perennial problem gone unfixed for decades.  Moreover, the Mexican government relies on oil-related revenues, even though oil production south of the Rio Grande is declining.  The Mexican government won’t allow private investment in the energy sector as a way to increase production (and can’t, due to popular opposition).  Mexico is a mess (not least because of its heavy dependence on one country, eh-hem, eh-hem, the United States), and Fitch acknowledged as much in July when it said it will monitor fiscal measures in the wake of the mid-term legislative election to decide whether or not to downgrade.  Signs are that an austere budget may be in the works.

Debt is measured against both GDP and revenues to indicate a country’s ability to grow out of its debt burden, i.e. to raise enough revenues to pay future debt obligations.  The debt to revenues measure is arguably a better proxy for this capacity, even though most analysts look at debt to GDP because GDP is more standardized…and perhaps out of laziness  Sure, Mexico has a vast untaxed portion of the economy it  could draw on to service its debt.  But it hasn’t ever done so and it won’t.  An owner of a Mexican trucking company once told me, he doesn’t pay any taxes.  So, Mexico’s fiscal picture is at least as bad, if not worse, than Brazil’s.  What’s more, Brazil’s external balance sheet is stronger than Mexico’s, with lower net external debt to exports and a stronger sovereign net external creditor position.  Its economy appears more resilient, not least due to its diversification.

Yet Mexico still remains two notches above Brazil due to sticky credit ratings and the inability of the rating agencies to take dramatic action.  Such dramatic rating action would suggest that rating agency analysts have been wrong for some time.      

Fitch: Brazil’s Fiscal Deterioration – A Slippery Slope
03 Sep 2009 2:05 PM (EDT)

Fitch Ratings-New York-03 September 2009: Fitch Ratings believes that Brazil will need to begin the process of fiscal consolidation, as an expected economic recovery begins to take hold, in order to preserve its fiscal credibility. Fitch has published a special report on Brazil’s deteriorating fiscal situation and the potential impact on its credit profile.

The degree of fiscal deterioration in Brazil’s public finances is quite evident when comparing the fiscal outturn of the first seven months of 2009 with the same period a year ago. The central government primary surplus has declined by 60% in the first seven months of 2009 compared with the same period in 2008 as a result of fast-paced spending growth and weak revenue performance.

‘The structure of Brazil’s public spending is deteriorating as a significant part of the increase is related to personnel and pension benefits, which will be harder to adjust in the future and cannot be classified as strictly ‘counter-cyclical’ in nature,’ said Shelly Shetty, Senior Director in Fitch’s Sovereign Group.

On the positive side, the scale of Brazil’s counter-cyclical fiscal stimulus package is modest by international standards, and the expected deterioration in the country’s fiscal balance is somewhat less than its rating peers. In addition, the government has domestic and external market access to fund the higher deficit. However, Fitch notes that the country’s starting fiscal position is weaker when compared with its peers. Brazil’s general government debt burden is significantly higher than the ‘BBB’ median (66% of GDP compared with 27% for the ‘BBB’ median) and will increase further this year.

Fitch recognizes that Brazil has a good track record in delivering and surpassing fiscal targets even when economic conditions are difficult, such as in 2002-2003. Across the globe, 2009 has been a challenging year, and many emerging markets have seen deterioration in their fiscal balances. However, the sharp increase in spending growth observed so far in 2009 needs to be curbed for the authorities to achieve even the reduced primary surplus target for this year, and more importantly, to return to the higher primary surplus target of 3.3% for 2010, as set under the Budgetary Guidelines Law.

‘Given the uncertainty in the pace of economic recovery and thus revenue growth, greater resolve to contain spending growth (especially current) would be positive for the credibility of fiscal targets,’ added Shetty.

While Brazil’s external finances remain strong and the country has weathered the global financial crisis relatively well, the deteriorating fiscal picture could potentially dampen the upward momentum of Brazil’s credit trajectory. On the other hand, persistent and significant deterioration of public finances and debt dynamics could undermine fiscal credibility, increase investor risk premia, and adversely affect investment and growth prospects, which in turn, could weigh on Brazil’s creditworthiness.

Fitch currently rates Brazil’s Long-Term Issuer Default Ratings at ‘BBB-‘ with a Stable Rating Outlook.

The full report ‘Brazil’s Fiscal Deterioration: A Slippery Slope’ is available on the Fitch Ratings web site at ‘’

Contact: Shelly Shetty +1-212-908-0324 or Erich Arispe +1-212-908-9165, New York.

Media Relations: Kevin Duignan, New York, Tel: +1 212-908-0630, Email:; Sandro Scenga, New York, Tel: +1 212-908-0278, Email:

Russia: Fitch Ratings Pessimistic on Sovereign, Banks

August 18, 2009

Fitch Ratings, one of the three global rating agencies, published reports this week on the state of play in Russia.  The government of Russia’s BBB rating was affirmed, but the Outlook for the rating (i.e., where the rating is likely to go in the next two years) remains negative.  Russia has been more negatively affected by the global downturn than other Emerging Markets (with GDP down over 10% annualized in the first half of this year).  Fitch quotes these reasons why:

“First, it [Russia] was highly exposed to the shocks to global commodity prices and cross-border capital flows, which were of the order of 25% of GDP. Second, monetary policy was overly loose, external borrowing and domestic credit growth was excessive, and the economy was overheating prior to the crisis. Third, vulnerabilities were exacerbated by structural weaknesses including an undiversified economy, a weak banking sector, high inflation, FX mismatches on private sector balance sheets, weak institutions and a difficult business climate – which the authorities failed to address sufficiently during the boom years.”

In addition, Fitch banking analysts expect non-performing loans at Russia’s banks to top off at 25% of total loans, up from 14% in June.  Under its “pessimistic” scenario, Russia’s NPLs rise to 40% and losses amount to 24% of total loans.  Press releases on the Sovereign and the banks are below.

” Fitch Affirms Russia at ‘BBB’; Outlook Negative   04 Aug 2009 7:12 AM (EDT)

Fitch Ratings-London-04 August 2009: Fitch Ratings has today affirmed the Russian Federation’s Long-term foreign and local currency Issuer Default ratings (IDR) at ‘BBB’ with Negative Outlooks. At the same time, the agency has affirmed the Short-term foreign currency IDR at ‘F3’ and the Country Ceiling at ‘BBB+’.

“The Russian economy and sovereign balance sheet have been severely affected by the global financial crisis and, despite signs of economic and financial stabilisation since March, risks to creditworthiness remain on the downside,” says Edward Parker, Head of Emerging Europe in Fitch’s Sovereigns team.

Russian GDP contracted 10.1% y-o-y in H109, a far worse performance than in other larger emerging markets, and foreign exchange reserves (FXR) have fallen by around USD200bn over the past 12 months. The severe impact of the global crisis on Russia reflects three sets of factors. First, it was highly exposed to the shocks to global commodity prices and cross-border capital flows, which were of the order of 25% of GDP. Second, monetary policy was overly loose, external borrowing and domestic credit growth was excessive, and the economy was overheating prior to the crisis. Third, vulnerabilities were exacerbated by structural weaknesses including an undiversified economy, a weak banking sector, high inflation, FX mismatches on private sector balance sheets, weak institutions and a difficult business climate – which the authorities failed to address sufficiently during the boom years.

Fitch forecasts Russia’s real GDP to decline 7% in 2009, before increasing 3.5% in 2010, helped by the inventory cycle, base effects, higher oil prices and a large fiscal stimulus. However, the length and depth of the recession is a downside risk and will have implications for bank asset quality, public finances and, potentially, political pressures on the Russian authorities. Fitch views the banking sector as a key credit weakness. In its base case, the agency projects impaired loans to increase to 25% of total loans by end-2009, requiring recapitalisation of at least USD22bn in addition to the USD24bn injected since Q308. The central bank faces a challenge in providing sufficient liquidity to the banking sector, while reducing inflation to single-digits and avoiding excessive rouble volatility.

The Russian private sector faces maturing external debt payments of USD137bn this year, which may be difficult to refinance in current market conditions. Fitch estimates the roll-over rate was 64% in Q109. Capital outflows and the dollarisation of household bank deposits have eased since the completion of the rouble devaluation process in February, but could re-emerge in the event of renewed financial stress. Nevertheless, overall the country has a strong external liquidity position, with FXR of over USD400bn, and it is a net external creditor to the tune of 17% of GDP at end-2008, compared with a net debtor position for the ‘BBB’ range ten-year median of 13%.

Public finances are a key sovereign rating strength. General government debt was only 8% of GDP at end-2008, well below the ‘BBB’ range 10-year median of 35%. Moreover, Russia has an aggregate USD184bn in its Reserve Fund (RF) and National Wealth Fund (at end-June, equivalent to around 15% of projected 2009 GDP) providing a strong liquidity position to finance budget deficits and to run counter-cyclical fiscal policy. However, Fitch forecasts the recession, fall in oil prices and anti-crisis measures to cause the federal budget to swing from a surplus of 4.1% of GDP in 2008 to a deficit of 8.5% in 2009 and 6% in 2010. Even with a return to the eurobond market next year, this will cause the RF to be depleted in 2010 and require significant fiscal consolidation over the medium-term.

A renewed deterioration in global economic prospects, oil prices and risk appetite leading to a material weakening in the sovereign balance sheet or macroeconomic instability could result in another downgrade (Fitch downgraded Russia’s ratings by one notch on 4 February 2009). Negative shocks from the banking sector or elevated financial pressures from low roll-over rates on external debt or large-scale capital flight would also be negative for the ratings. Furthermore, a failure to narrow the budget deficit, and a consequent rapid increase in government debt and depletion of the sovereign wealth funds could lead to downward pressure on the ratings in the medium-term. In contrast, a material easing of a combination of these risks could see the Outlooks revised to Stable.

Contacts: Edward Parker, London, Tel: +44 (0)20 7417 6340; David Heslam, +44 (0)20 7417 4384.

Media Relations: Peter Fitzpatrick, London, Tel: + 44 (0)20 7417 4364, Email:”

“Fitch Ranks 57 Russian Banks by Loss Absorption Capacity  
14 Aug 2009 5:07 AM (EDT)

Fitch Ratings-London/Moscow-14 August 2009: Fitch Ratings released a report today ranking 57 rated Russian banks based on their loan loss absorption capacity. Fitch considers this capacity to be currently weak at 10 of the banks reviewed, although most of the 10 could likely rely on capital support from shareholders, and moderate at a further 14.

The extent of Russian banks’ asset quality deterioration, their loss absorption capacity and contingency recapitalisation plans are likely to be the main drivers of rating actions over the next 12 to 18 months. Fitch-rated banks reported an average 14% impaired loans (5% non-performing and 9% restructured) at 1 June 2009, up from 10% (3% and 7%) at 1 March.

“However, management figures prepared at a still relatively early stage of the credit downturn are unlikely to fully capture the eventual full extent of asset quality problems,” says Alexander Danilov, Senior Director, Fitch’s Financial Institutions group in Moscow. “The gradual deterioration of banks’ asset quality metrics is likely to continue during the second half of 2009 and into 2010.”

Fitch had previously stated that it expects impaired loans at Russian banks to reach 25% in a base case scenario, resulting in ultimate loan losses of 12.5%. Under a more pessimistic scenario, impaired loans could reach 40% resulting in loan losses of 24%.

Fitch ranked the loan loss absorption capacity of the 57 rated Russian banks to demonstrate their relative vulnerability to loan losses. The agency assessed the banks’ loss absorption based on the maximum reserves to loans ratio they could have sustained at 1 June 2009 without breaching minimum regulatory capital requirements. However, Fitch notes that a lower or higher loss absorption capacity, as defined by this measure, does not automatically mean that a bank is more or less vulnerable to potential loan impairment, as credit losses at individual banks may significantly diverge from Fitch’s average sector assumptions.

For 10 of the 57 banks – VTB24, Rossiya, Bank of Moscow, Swedbank (Russia), VTB, Moscow Bank for Reconstruction and Development, AK Bars, Rosbank, Orgresbank and Unicredit (Russia) – the maximum reserves/loans ratio is below 10%, and Fitch thus regards these banks’ loss absorption capacity as currently weak. However, Fitch notes that the capacity of two of these banks – Bank of Moscow and VTB – should strengthen significantly as a result of upcoming equity injections, and that most of the other eight banks also have relatively strong shareholders, which the agency would expect to contribute new capital in case of need. Fourteen of the banks reviewed had moderate loan loss absorption capacity (a maximum reserves/loans ratio of 10%-15%), while capacity was significant at 14 banks (15%-20%), solid at 11 (20%-32%) and strong at eight (more than 32%).

Banks’ loss absorption capacity has increased significantly in recent quarters as they have received new capital, albeit mainly in the form of subordinated debt, and cut back on loan growth. However, this capacity still remains moderate on a sector basis relative to potential credit losses.

“The recently approved government programme to support banks’ tier 1 capital, if successfully implemented, could help to make recapitalisation a manageable process,” says James Watson, Managing Director, Fitch’s Financial Institutions group, “Defaults would still be possible, in particular at banks with major asset quality or corporate governance failures, although recent government actions suggest a determination to avoid destabilising, unmanaged failures at larger institutions.”

The report, entitled ‘Russian Banks: Measuring Their Loss Absorption Capacity’, focuses mainly on asset quality deterioration trends and banks’ loss absorption capacity. It follows and expands on the July 2009 presentation, entitled ‘Asset Quality Problems Weigh on Russian Bank Ratings’, which provided a summary of Fitch’s sector wide credit loss expectations and recapitalisation requirements. The report and presentation are available at

Contacts: Alexander Danilov, James Watson, Moscow, Tel: +7 495 956 9901.

Media Relations: Marina Moshkina, Moscow, Tel: +7 495 956 9901, Email:; Hannah Warrington, London, Tel: +44 (0) 207 417 6298, Email:”