Hungary among the weakest links in CEEMEA, no EM is immune - City analysts

Hungary at a very high risk

Ratings agency Standard & Poor’s announced on Friday night that it had downgraded the U.S. credit rating one notch - from AAA to AA+ - because "political brinkmanship" had made the government’s ability to manage its finances "less stable, less effective and less predictable."

The other two main rating agencies, Moody’s and Fitch have not followed suit, although the former warned today that it could join S&P by downgrading the U.S. credit rating within the next two years if the U.S. fails to address its USD 14.5 trillion deficit.

The US has enjoyed an AAA rating from S&P since 1917.

On 2 August, Moody’s reaffirmed the US triple-A rating but adopted a negative outlook. Fitch has not formally reaffirmed its AAA rating, and is expected to announce the outcome of its rating review late August or early September.

"Over time, this status could be threatened if further measures to address the long-term fiscal situation are not adopted, but it is early to conclude that such measures will not be forthcoming," Moody's analyst Steven Hess wrote in a report Monday morning, according to Reuters.

“While the initial impact of the US rating downgrade will grip CEEMEA markets in an indiscriminate fashion, we think that some degree of differentiation will begin to develop, particularly between the strong and weak credits of the region," CEEMEA strategists at BNP Paribas said in a research note today.

They believe the commitment by the European Central Bank (ECB) to expand the Securities Markets Program (SMP) to include Spanish and Italian bonds as well as the announcement by the G7 nations that they would intervene in FX markets should there be a disorderly move, “suggest that after the reflex risk-off reaction across the CEEMEA space, we may see spreads begin to tighten again, particularly in those countries where economic fundamentals warrant a better risk assessment."

“In this respect, SovX CEEMEA will likely tighten in the coming days, supported by the ECB’s expanded bond purchasing programme."

The authors of the note argue that in the ‘strong credits’ group that includes South Africa, Israel, and the Czech Republic, “a sell-off should be treated as an opportunity to establish long positions, particularly on longer duration papers given that the yield curves of these three countries are already fairly steep."

The other side of the spectrum consists of those countries which can be classified as ‘weaker credits’, which are more heavily concentrated within the ‘CEE’ part of the acronym and consist of countries such as Hungary, Poland, and Turkey, and to a certain extent, Russia and Ukraine.

“In this group of countries, central banks generally do not have the luxury to cut interest rates in order to boost domestic demand as it might lead to sizeable currency losses. This is particularly the case in Hungary and Poland, assuming the CHF enjoys more safety bid."

The analysts said Hungary is “at a very high risk", adding that last week's news that local governments would seek to "reprofile" their CHF obligations was badly received by markets and moves in xccy basis (as well as 5y5y rates) were “worrying".

“The HUF curve has so far been steepening along with the risk-off but if the HUF comes under any further pressure, we could see an increase in expectations that the NBH may take action on0020rates as it has done in the past," BNP Paribas said.

Little cause for optimism from the budget data

On a cash-flow basis, Hungary’s general government deficit (excluding local governments) widened to 217% of the annual goal in July. Excluding the impact of the MOL purchase, the deficit is "only" 126% of the annual target. Total revenues fell further, down 1.6% yr/yr, better than the previous months but remaining very weak. Spending instead rose 4.6% yr/yr, the strongest increase this year after three months of improving spending control.

“The latest release confirms our view that notwithstanding the returning pension assets and the crisis taxes revenues due at the end of the year, the government is at risk of undershooting the 2% of GDP budget surplus goal (2.9% of GDP deficit plus the returning pension assets)," commented Raffaella Tenconi, anlayst at Bank of America Merrill Lynch in a daily note to clients on Monday.

“Rising risk aversion and concerns about the budget outlook in coming years will continue to weigh on Hungarian assets in coming weeks," she added.

Read more about BofA/ML’s not too optimistic view on Hungary at the links below.No EM is immune

Although emerging markets fundamentals are generally better, “no EM is immune from the deepening problems in the US and Europe," commented Capital Economics in a note to clients today.

Neil Shearing, Senior Emerging Markets Economist at Capital Economics in London, believes growth everywhere is likely to slow over the next year and, while Asia should continue to outperform, he is sticking to his below-consensus forecast for growth in Emerging Europe.

While there “seems to be a growing consensus" that once the initial panic subsides emerging economies “should be resilient in the face of deepening debt crises in the US and Europe" but based on what we learned from the 2008-09 crisis “it would be complacent to downplay the risks to EM growth posed by economic shocks in the West," he said.

“Indeed, if growth in the emerging world has somehow ‘decoupled’ from that of the developed world it is only in a relative (as opposed to an absolute) sense."

While Shearing believes that the initial impact of the S&P downgrade on US markets should be short-lived, he warns that growth in the world’s largest economy “is likely to remain sluggish at best for some time."

“Meanwhile, the problems in the euro-zone pose an even greater threat to global stability."

He expects growth to slow sharply to just 0.5% next year and remains of the view that “the current crisis will ultimately result in some form of break-up of the single currency."

Twofold impact

In Shearing’s view the impact of such scenario on EMs will come via two main channels: weaker demand for exports and a disruption to global capital flows.

He sees four main reasons why economies of Emerging Europe look most vulnerable:

1. they rely more heavily on exports to the troubled euro-zone
2. they are more dependent on foreign capital to finance spending (particularly Turkey) and roll over external debt
3. high budget deficits (if not debt) mean that there is limited scope for policy stimulus, if needed
4. the region’s largest economy, Russia, will be hit hard if oil prices fall back, as he expects.

Fundamentals will not matter much once the going really gets tough

Elisabeth Andreew, analyst at Nordea Bank, shares Shearing’s view, saying that while fundamentals do look better in Emerging Markets, if panic really hits developed markets, “fundamentals will not matter much" and “all EM currencies will be hit".

“Up until the end of last week, Emerging Markets currencies were relatively stable, cushioned by generally better fundamentals, but the US downgrade that prompted the G7 and central banks to act with the ECB purchasing Italian and Spanish government bonds, has pushed volatility markedly higher also in Emerging Markets currencies generally today," Andreew said in a research note today.

Nordea has ranked its EM currency universe from the factors they believe are the most important at the moment. Starting with a glance at the 3-month correlations with Nordea’s Emerging Markets Risk Perception Index, we can see that the TRY, the ZAR and the INR have the highest correlation, that is, they are most sensitive to a change in risk perception, while the CZK and the RUB have the lowest correlation.

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