Country Risk Trend June 2008
The scenario calling for a marked economic slowdown this year seems to be holding true with annualised first-quarter growth of 2.2 per cent for the euro zone and 0.9 per cent for the United States. The statistics available for emerging countries notably bear out the continuing strength of the BRIC economies in 2008: China posted 10.6 per cent annualised growth in the first quarter, India 9.0 per cent, Russia 8.5, and Brazil 5.8. There has thus been little change in the scenario we presented for the full entire current year three months ago with a one-point loss of GDP growth suffered not only by industrialised countries, down from 2.5 to 1.5 per cent, but also by emerging countries down from 7.3°to°6.3 per cent. We still expect world economic growth of three per cent for the full year.
Although there may be little change in the overall growth scenario, several risk-aggravating factors warrant particular attention:
More difficult access to bank credit has been the main driver of the credit crisis
Central Bank surveys since mid-2007 reflect the much tougher attitude adopted by banks in extending credit to companies and households in both the United States and Europe. The results of these surveys are notably borne out by higher financing costs with the spreads on long-term rates between risk-free loans and those granted to companies growing wider. The ECB compared the trends on spreads in Europe and the United States, showing that at equivalent levels of risk interest rate spreads have widened substantially more in the United States, up 140 basis points for a BBB rated risk, than in Europe, up 115 points.
According to available statistics on the supply of bank credit to companies, however, there was no observable slowdown in the first quarter this year in either the United States or Europe with bank credit continuing to expand at annual rates of 20 and 15 per cent respectively. This persistent dynamism may nonetheless be deceptive and cloak contrasting situations: Experiencing difficulties in obtaining financing on financial markets, companies have been turning to banks and thereby replacing the "poor risks" no longer enjoying access to loans due to the more selective screening criteria applied. With the tightening of credit conditions only taking place in recent months moreover, companies can continue to draw on credit lines granted at an earlier date. And there is customarily a lag between decisions to tighten credit conditions and the moment when the resulting impact on lending shows up in available statistics.
Statistics published on borrowing by non-financial companies in the euro zone in the first quarter this year reflect the shifting of corporate debt from the market to banks: While the borrowing continued to grow, bank loans were up 4.5 per cent but bond issues only 0.4 per cent. And total corporate debt now represents 78 per cent of GDP according to the European Central Bank.
Like in Europe, the debt of non-financial companies grew further in the United States according to the Fed, up an annualised 9.5 per cent in the first quarter this year after a 10.8 per cent increase in the fourth quarter last year. And non-financial corporate debt now represents 74 per cent of GDP. Even household debt is still growing albeit at a slower pace — 3.5 per cent down from 6.1 per cent in the fourth quarter last year — with household debt representing nearly 100 per cent of GDP.
Rising energy prices have increased the pressure on companies with an easing of raw material prices appearing moreover unlikely this year or next.
Raw material prices posted a spectacular increase early this year. From 1 January through mid-June the average price of oil was 107 dollars against 72.5 dollars for 2007. The accelerating price rise complicates matters in developing a hypothesis on barrel prices. We foresee an average price of 118°dollars for 2008, up 63 per cent from last year. Unlike previous scenarios, we no longer envisage a price decline in 2009 with the average price reaching an estimated 123 dollars.
Price trends for other raw materials will vary widely: While gold prices will continue to rise, up 27 per cent this year, price increases for commodity metals like aluminium and copper should be limited to about six per cent. Nickel and zinc prices, however, should fall respectively 27 per cent and 32 per cent. Prices for food raw materials will continue to soar, especially for grain and sugar as a result of reallocation of arable land to more profitable crops as well as an apparent increase in the livestock population in the United States
A decline in staple commodity prices seems very unlikely amid persistent problems with supply: prices levels have depended on both strong demand from emerging countries — expected to continue unabated — and a range of constraints affecting demand. The price rise is primarily attributable to a lack of investment in raw material production operations (farm as well as fuel products) in the 1990s. Until 2000, new technologies attracted a high proportion of new investment with staple commodities not considered to have good growth prospects. Since prices began to rise again — from their low-point early 1999 — the efforts made by producer countries have been insufficient: the more prices rise the less they feel a need to increase production capacity. In the case of oil, the 500.000 barrel increase in daily output announced by Saudi Arabia for June/July notwithstanding, barrel prices have continued to rise. Just before that announcement, Saudi Arabia had declared a freeze on production capacity beyond 12.5 million barrels per day for 2010. This new strategic orientation adopted by the world's leading oil producer constitutes a deliberate move that the country justifies by the objective of preserving the oil wealth for future generations. But government officials doubtless have another line of reasoning: if demand remains price inelastic there will be little need for costly investments to increase the short-term profitability of the oil export income.
Beyond Saudi Arabia's strategic "about-turns", production declines or slowdowns have developed in many producer countries. The logic underlying that trend varies widely from country to country (besides a lack of investment, political tensions or maintenance problems can affect supply) and is rarely as deliberate as in the case of Saudi Arabia, which cut production by four per cent in 2007: In Russia, Venezuela, Mexico, Cameroon, Nigeria, Iran, and Algeria production stagnated, slowed, or even declined in 2007. The latest statistics published by BP show a production decline last year for eleven major oil producing countries representing 40 per cent of world production. Besides these supply issues, other factors argue in favour of high and volatile prices. The weakening of the dollar — the invoicing currency for oil transactions — has prompted producer countries to push up prices. The market considers available production reserves insufficient to cope with an interruption of production whatever the cause (maintenance, cyclones, sabotage, and so on), which tends to make price volatility sensitive to the slightest incident. Speculative investment also has a difficult to evaluate impact and constitutes demand that is insensitive to price trends.
In short, the various constraints on supply at this juncture tend to reduce the likelihood of the scenario based on a significant price decline in the 2008 second half or next year.
Inflation constrains monetary policy in emerging countries and strengthens the strong euro scenario
A troubling upsurge of Inflation — largely fuelled by rising staple commodity prices — has developed in the euro zone with prices up 3.7 per cent, substantially above the ECB's two per cent objective. In the United States prices rose 4.2 per cent in May and new rate cuts by the Fed seem less likely. In what shapes up as the most realistic scenario its key rates will remain at two per cent in the coming year. The ECB meanwhile will be likely to raise its key rates in July with European rates expected to reach 4.5 per cent by this September compared to 4.0 per cent mid-June this year. As a result of the divergent policy stances across the Atlantic, the interest rate differential between the euro zone and the United States should increase in the near term. And this will not be conducive to easing the euro exchange rates with the dollar and other currencies. The European currency has appreciated 5.4 per cent against the dollar and 2.7 per cent against a basket of currencies thus far this year. Other factors with a crucial impact on the euro strengthen the appreciation scenario: the American and European current accounts have been relatively stable despite the pace of the euro/dollar appreciation. The euro zone current account balance should be 0.8 per cent (and 0.1 per cent of GDP) in 2007 and 2008 with the United States' balance expected to deteriorate slightly to a negative 5.4 per cent of GDP down a tenth of a point.
As regards capital flows, the outstanding amount invested in euro-denominated securities continues to grow for all types of instruments: equity, debt, or monetary. The euro's international status as a reserve currency continues to grow with its share of world foreign exchange reserves increasing from 18 per cent in 2001 to 27 per cent early this year. The euro dollar scenario developed by Natixis supposes that the European currency appreciation will continue until September and ease toward year end with the euro expected to reach a still-high 1.50 dollar rate by mid-2009.
Although emerging economies continue their strong expansion, emerging Asia, Latin America and emerging Europe should nonetheless lose a point of GDP growth while Africa and the Middle East continue to grow at a steady pace buoyed by firm raw material prices.
The crisis has not, however, spared weak emerging countries, whose vulnerability it has exposed: In Turkey and South Africa, as a result of economic slowdowns and unsustainable external imbalances, the currencies have become very volatile and vulnerable to investor sentiment with the volatility heightened by political uncertainty.
That deterioration of the economic environment will generate difficulties for companies in both countries. In Vietnam and the Baltic states, corporate debt has become excessively dollarized or "euro-ised". But a sharp adjustment of the economic overheating has developed in those countries, resulting in severe pressure on the exchange rate in Vietnam and a hard economic landing in Latvia and Estonia.
Inflation has given rise to risks of social instability in some emerging countries
Inflation has become a priority issue this year in emerging countries. Rising food and energy prices have caused price indices to rise sharply in many of those countries with inflation exceeding seven per cent in the first quarter in, for example, China, India, Indonesia, Egypt, many sub-Saharan African countries, and the Gulf countries. There is a strong correlation between the poverty level and the weight of food prices in overall price indices. That correlation holds true not only by country but also by income category within a particular country.
In sub-Saharan Africa food price represent 60 per cent of the household shopping basket. And the prices for rice and wheat are up 50 per cent since December with the high cost of living sparking many violent demonstrations, particularly in Cameroon, Ethiopia, Côte d'Ivoire, and Senegal. The economic context of high growth associated with the upsurges of prices has not constituted an offsetting factor. In periods of improving economic conditions the public can be all the more disgruntled by a price shock when the fruits of the growth are unevenly distributed. On that score, the riots against immigrant populations in South Africa attest to the vulnerability of the social situation even though the rise of the black middle class has been the source of the strong domestic demand observed since 2006. Tensions could lead to unrest in Egypt, for example, where prices were up 16 per cent in April while the economy grew seven per cent in 2007. Inflation has surged in a context combining frustration of the people, a failure to economic growth into tangible progress, and uncertainties over Hosni Mubarak's succession.
Tightening credit and investor skittishness will affect weak currencies and the growth of overheating emerging economies
The external financial position of emerging countries has markedly improved as evidenced by the substantial aggregate current account surplus — nearly five per cent of GDP — they continue to enjoy in 2008. That enviable aggregate position nonetheless encompasses large disparities: Africa and emerging Europe continue to run current account deficits widened by strong domestic demand.
The economies concerned are dependent on portfolio investment and/or debt financing. They particularly suffer when investor skittishness affects financial markets through greater selectivity or a possible widening of spreads. The increase in spreads has been relatively moderate in the recent past increasing from a low of 152 basis points end May 2007 to 330 bps mid-March this year before easing to 255 bps three months later (mid-June). The increase in risk premiums thus seems limited at this juncture especially in comparison to the high of 900 basis points reached end 2002.
The weaknesses are of two very different and distinguishable types:
Countries with their financing needs covered by concessional debt: loans from bilateral and/or bilateral creditors as in the case of low income African countries as well as Nicaragua and Kyrgyzstan. Although the current crisis of confidence does not really affect that financing, the political situations of those countries can affect their access to such aid.
Countries with their financing needs covered by growing corporate and bank indebtedness as in the Baltic States, Romania, Bulgaria, Turkey, and Jordan. And these are precisely the countries that Coface has negative watchlisted or downgraded with the exception, however, of Serbia already rated at a high level of risk (C), Turkey already rated B, and Croatia (rated A4) whose prospective admission to the EU has strengthened investor confidence. The countries in this group seem vulnerable with their strong growth records often correlated with an upsurge of domestic bank credit — frequently denominated in foreign currencies — often financed itself by local banks through borrowing from their parent companies.
The banking sector in other countries is often dominated by non-resident shareholders from Western Europe (Austrian banks in Central Europe, Scandinavian banks in the Baltic States). Western European banks weakened by the subprime crisis could thus pass on any credit tightening to their subsidiaries abroad. They could also decide to reduce their contributions to subsidiaries located in countries considered "risky" where the size of current account deficits augurs marked slowdowns in 2008 and 2009.
Credit and economic slowdowns are thus likely this year in emerging Europe with a high proportion of negative watchlisted and downgraded countries — Bulgaria, Romania, and three Baltic States — located in that region.
The current credit crunch will, however, be likely to affect "only" economic growth and, to a lesser extent, exchange rates often protected by high foreign currency reserves, fixed exchange rate systems with their credibility enhanced by prospective membership — even in the distant future — in the euro zone as in the case of Bulgaria or the Baltic states. The Romanian leu governed by a floating exchange rate system will likely be among the most volatile currencies in the near term. The banking system in these vulnerable countries are solid, with the notable exception of Vietnam where bank credit underwent a vertiginous expansion from 35 per cent of GDP in 2000 to 70 per cent in 2006, without having benefitted from a thorough systemic overhaul.
United States
Rated A2 since March 2008
The subprime mortgage crisis and tighter credit conditions continue to spread to the real economy. The property downturn and the financial crisis have hit households and companies hard exacerbated by continuing and increasing inflation, up 4.2 per cent end May. Despite positive signs in the first months of the year economic growth will be weak in 2008, up 1.1 per cent with the deterioration limited by a fiscal package representing one point of GDP and an easing of monetary policy (with rates down 325 basis points between September and April) whose initial effects should become apparent this autumn.
Households will continue to significantly reduce their consumption (70 per cent of GDP) by substantially cutting back on discretionary spending and adjusting their behaviour as consumers. With their confidence at a historic low they continue to cope with the decline in value of their real property and financial assets, a shrinking job market, growing unemployment (5.5 per cent in May, an increase of nearly one per cent more in a year), the decline of their disposable income affected by higher prices for petrol at the pump (up 28 per cent between January and May) and foodstuffs. With limited savings and high debt representing 13 per cent of their disposable income they have to deal with stiffer conditions for refinancing their mortgage loans.
The continuing decline of residential construction, down 21 per cent for the year ending April 2008 will also affect economic growth with building permits and new housing starts down 30 per cent and sales down over 40 per cent. Home prices, meanwhile, fell over 15 per cent for the year ending this April. The default rate has moreover now begun to rise on borrower segments other than subprime with housing stocks (10.6 months) bloated by foreclosures, which have been accelerating. And the crisis has affected non-residential construction in turn with companies that lack good access to credit postponing investments in facilities. Buoyed by low debt (43 per cent of GDP) and high cash flow (80 per cent), companies will nonetheless likely continue — albeit cautiously — to buy equipment despite erosion of the profit rate (11.1 per cent of GDP). In such conditions, the growth of corporate investment should be limited to 2.8 per cent.
Exports (12 per cent of GDP) continue to grow at a satisfactory pace thanks to favourable exchange rates (effective real exchange rates down 9.6 per cent in the year) with Canada and the European Union and the ongoing economic dynamism of emerging regions, representing 50 per cent of sales abroad, especially China and the Middle East. Imports, meanwhile, have been at a standstill affected by the domestic consumption slowdown. Foreign trade should thus make a slightly positive contribution to GDP growth.
The economic slowdown has affected corporate payment behaviour. According to the private AACER institute, corporate bankruptcies increased 46 per cent in May 2008 compared to May 2007. That reflects the deterioration of the Coface payment experience, centred particularly on companies in sectors associated with domestic consumption. Rising costs for energy, shipping, and some inputs have affected their margins and the current credit crunch has worsened their strained financial positions. The sectors particularly affected include not only residential construction (home developers and builders, manufacturers and distributors of furnishing materials for construction, intermediaries and financial institutions) but also car manufacturing, and distribution linked to housing. Services to private individuals and leisure (restaurants, hospitality, travel), as well as the textile-clothing and Hifi-TV-video sectors have also suffered from the greater selectivity exercised by households in their spending.
Western Europe
Western Europe should lose a point of growth this year, down about a third from the expansion achieved in 2007 (1.8 per cent compared to 2.8 per cent). Contrary to expectations, economic growth was relatively satisfactory in winter and spring. The slowdown should thus mainly develop in the second half.
Households faced with rising food and energy prices and tighter credit conditions have been holding back on spending.
The residential property downturn has continued, affecting jobs and tax revenues.
Companies have also been coping with rising costs and those operating in the euro zone with unfavourable exchange rates. Although their exports have slowed, companies have nonetheless maintained satisfactory growth thanks to continuing strong demand from emerging countries and raw material producing countries. Their margins have, however, tended to shrink.
In such gloomy economic conditions, governments have elected to freeze efforts to improve public sector finances or, for those already endowed with surpluses, to use them as a growth stimulus.
Beyond this broad overview, however, it is necessary to distinguish between the few countries where the economy will slow substantially and/or growth will be weak and the great majority where the differential will be limited and/or growth will remain at a reasonably good level.
The first group of countries includes above all Spain where residential construction — the main growth engine — has been collapsing and payment behaviour has deteriorated sharply. The decline of Spain's domestic demand has had a recessive effect on Portugal, where growth was already weak and 30 per cent of exports flow to its Iberian neighbour. The slowdown has also been pronounced in Ireland and Iceland with the payment behaviour of Irish companies nonetheless only evidencing deterioration in construction and that of Icelandic companies showing no deterioration at all. In Italy, with payment behaviour traditionally below the European average, payments incidents have been perceptibly trending up. In Denmark, where growth has been weak, corporate bankruptcies have increased, especially in construction. In the United Kingdom, residential construction and consumption have lost their verve but payment behaviour continues to improve.
The second group includes Germany and Austria where exports continue to drive the economy and France, Norway, Finland, the Netherlands, and Switzerland where consumption has held up well.
Germany
Rated A1
Although slowing in the second half, economic growth should still reach 2.2 per cent this year.
Slower growth of exports to Europe and the United States notwithstanding, the foreign trade contribution to GDP growth will nonetheless remain largely positive amply offsetting the continued sluggishness of private consumption. Households will doubtless benefit from the continued easing of unemployment and concomitantly from reduction of the unemployment insurance contribution rate. But they will be prompted to exercise restraint by the rise of energy and food prices and by the weak growth of disposable income despite the significant wage increases won in certain sectors.
Benefiting from low debt and high profit margins, companies should maintain good payment behaviour, a trend borne out in the first quarter this year by an excellent Coface payment incident index and a stable bankruptcy rate. The reduction of corporate income tax in 2008 in a context of balanced public sector finances will have a positive influence. Residential construction will, however, remain a difficult sector, particularly in the eastern part of the country. The kitchen furniture sector has also exhibited a high risk profile. Automotive subcontracting has suffered meanwhile from increasing delocalisation eastward on the continent.
France
A1 rating
Economic growth should slow to 1.6 per cent this year down from 2.1 per cent in 2007. According to the official statistics agency INSEE household confidence continued to deteriorate in May. That should prompt consumers — whose debt grew from 53 per cent of disposable income in 2000 to nearly 72 per cent in 2007 — to exercise caution on discretionary spending and to replenish precautionary savings (over 16 per cent of their gross disposable income). After a first quarter slowdown household consumption (57 per cent of GDP) should thus only increase slightly for the full year, up 1.3 per cent with purchasing power suffering from the rising cost of energy and food products and a higher tax burden compared to last year.
Loans to households, particularly in relation to housing, have been gradually slowing since end 2006. Tightening conditions for granting bank credit will continue to affect residential investment. New housing starts fell nearly 10 per cent year-on-year in the first quarter 2008.
Non-residential construction should stagnate meanwhile with companies postponing infrastructure investments as a result of higher borrowing rates and greater difficulty in arranging financing. The steady erosion of their profits — down from 8.5 per cent of GDP in 2000 to 5.2 per cent in 2007 — and their cash flow ratio from 85 per cent in 2000 to 60 per cent in 2008 has made them particularly sensitive to the conditions of access to the credit on which they have relied more since 2004. The domestic demand slowdown will tend to slow import growth, which should limit any widening of the current account balance. Two main factors, meanwhile, will hamper exports: less dynamic demand from European trading partners and the euro appreciation in dollar zones undermining the competitiveness of French products. Those negative factors notwithstanding, exports will grow at essentially the same rate as they did in 2007 with foreign trade likely to make a positive contribution to GDP growth.
The corporate mark-up rate should remain stable on average this year at 31.4 per cent. That rate nonetheless masks disparities with the margins of smaller companies eroded by price increases for intermediate products, which they will not always be able to pass on in sales prices, and with access to credit particularly tightened for this company segment. Industrial sectors burdened by high debt will thus bear close watching notably in automotive and aeronautical subcontracting, paper, and metals. Vigilance is also in order for the IT sector (assemblers and distributors), the hog industry (breeders, cooperatives, slaughter houses, distributors), and cattle feed and fertilizer wholesalers and cooperatives. In construction, the decline of orders from developers may affect some subcontracting companies. Corporate bankruptcies increased over nine per cent —12-month moving average through March 2008 (source Coface Services) — a trend consistent with the growth of payment incidents recorded by Coface thus far this year.
Denmark
A1 rating
On negative watchlisting
Reason for negative watchlisting the rating : Economic growth will be weaker in 2008, up 1 .4 per cent, affected by cutbacks in consumption by households whose confidence has begun to suffer from the inflationary pressures and the value lost by their financial wealth. Companies will put the brakes on investment (up 1.6 per cent after up 8.8 per cent in 2007) highly dependent on bank credit and thus particularly sensitive to current credit restrictions. Margins should shrink, squeezed by rising wage costs amid a very tight job market and by higher prices for inputs. Bankruptcies continue to rise, up 25 per cent for the first five months of the year.
Growth slowed markedly in 2007. Households have reduced their spending affected by both a property market correction and higher interest rates. However, wage growth spurred by record employment had a mitigating effect on the slowdown. Companies suffered, meanwhile, from erosion of their productivity and a slowdown of their exports.
The economy remained flat in the first months this year with only 1.4 per cent growth expected for the full year. Deeply in debt and not withstanding the steady rise of their incomes, households continue to exercise caution on spending and their consumption (49 per cent of GDP) should dwindle further. Several unfavourable trends have eroded their confidence: growing inflation expected to reach 3.1 per cent, the value lost by their financial assets (down USD 16 billion in the 2007 fourth quarter according to the Central Bank, and tighter credit conditions. Residential construction will decline about six per cent this year with commercial construction remaining at a standstill. With investment by manufacturing and service companies heavily dependent on bank credit, it will slow substantially, a trend consistent with the tightening loan conditions. Corporate competitiveness will suffer from a range of factors: a job market expected to remain tight, increasing difficulty in recruiting skilled personnel, wage growth, and saturation of production capacity. Oil and natural gas sales will continue to underpin exports whose growth will nonetheless be hampered by production capacity constraints, the economic slowdowns affecting traditional trading partners, and by the krone's strength in some markets. Weaker domestic demand will hold imports down meanwhile, which will contribute to limiting the reduction of the current account surplus.
The government's' fiscal budget will show a surplus again this year buoyed by revenues associated with North Sea hydrocarbon prices. Spending could, however, increase more than expected due to commitments made during the autumn 2007 general elections. The government will in any event continue reducing public sector debt. In this context of weak growth, labour-intensive sectors will likely be subject to cost pressure while sectors focusing mainly on the domestic market should suffer from the domestic demand slowdown. The pace of corporate bankruptcies continued to accelerate in the first five months this year, up 25 per cent after an increase of 21 per cent in 2007. The sectors affected most include industry, construction, distribution, and hospitality-catering.
Spain
Rated A2
Reason for the rating change: Spain's A1 rating is downgraded to A2 due to deterioration of corporate payment behaviour amid weakening economic conditions with 1.6°per cent growth expected this year down from 3.8 per cent in 2007. The residential construction sector that had been the main growth driver has continued to decline with substantial negative repercussions on consumption and Investment.
The marked growth slowdown under way since the year began has continued with the economy likely to be very dull by year end.
That trend is mainly attributable to a very pronounced domestic demand slowdown affecting both consumption and investment.
Investment in residential construction, which still represented nine per cent of GDP and jobs until recently, has collapsed.
Households are contending at once with a significant increase in unemployment, price inflation for food and energy, price erosion affecting their property assets, rising interest rates while they carry variable rate debt, and the tightening of conditions for taking out loans. They have consequently sharply reduced their consumption spending.
In this unfavourable context, payment behaviour has deteriorated overall. While remaining satisfactory for households due notably to social pressure, corporate payments have deteriorated sharply a trend consistent with the decline of their profits. Smaller companies associated with the housing market — joinery and fenestration, real estate agents, developers, manufacturers and distributors of equipment and material for the home — often debt-burdened and having increased in number while the market was strong, have been the most vulnerable. Road transport has suffered from rising petrol costs while the automotive industry has to contend increasingly with Eastern European competition and slumping local vehicle sales. Only tourism seems safe at this juncture but it could suffer in turn from the slowdown grinding away in Northern European countries.
The foreseeable acceleration of the decline in housing prices, the continued rise of unemployment, the interest rate hikes announced by the ECB, and the expected slowdown of corporate investment in equipment and facilities do not augur well for an upturn any time soon.
Tax breaks representing one point of GDP — rental support for youth and low-income families, increases in small pensions, an income tax reduction of EUR 400, cancellation of the wealth tax,—facilitated by the good health of public sector finances and the public infrastructure spending continuing under the PEIT multi-year modernisation programme will only have a limited positive impact. And with imports in a more pronounced slowdown than exports the negative foreign-trade contribution to GDP growth will be smaller but barely make a dent in the massive current account deficit.
Portugal
Rated A2
On negative watchilisting
Reason for negative watchlisting the rating: Economic growth will slow in 2008 in phase with the slowdown of household consumption and exports. Deeply in debt (129 per cent of disposable income), households have experienced difficulties in getting loans to finance their spending and will likely draw less on their savings. Corporate investment will remain moderate and the process of re-specialising in higher value-added sectors will still be too shaky to enable companies to cope with the weaker demand from the European Union — which provides a market for 70 per cent of its export sales — and particularly demand from Spain (30 per cent). The activity of some companies should, however, derive support from large infrastructure projects. The upsurge in bankruptcies in 2007, up 62 per cent, is partly attributable to a legislative change.
Economic growth accelerated slightly in 2007, buoyed by domestic demand and exports. Limited wage growth prompted households to take on additional debt and draw on their savings to finance their spending. Corporate investment made a significant recovery facilitating a slight improvement in productivity and competitiveness. Exports thus developed at a solid pace without, however, winning new market share. Increased debt service notwithstanding, the government continued to pursue its public sector deficit reduction objectives.
Growth should be weaker in 2008 amid slowdowns of both private consumption and exports. Households — with their heavy debt burden reaching 129 per cent of disposable income — will reduce spending in a context of weak job growth, higher interest rates, rising prices for energy and food products, and increasing tax pressure. Tighter credit conditions should undermine the timid property investment recovery fostered by tourism and the migration of the rural population to large cities. Companies will reduce their investment in machinery with production capacity utilisation down in the first months this year. Their business activity will benefit, however, from infrastructure projects like the new Lisbon airport facilitated by community funds supplemented by domestic resources. The results of the efforts made by companies in recent years to improve their competitiveness and adjust their specialisation in favour of higher value-added products are still too shaky to enable them to cope effectively with the slowdown of foreign demand, particularly from the European Union, the outlet for 70 per cent of sales abroad. The domestic demand slowdown will slow and facilitate a slight reduction of the huge current account deficit. Despite the lagging pace of efforts to reorganise the civil service, the government will go forward with the process of growth convergence with the other euro zone countries by further reductions in its public sector deficit. Partial privatisation of Portugal's TAP airline, INAPA papermaker, and Energias electricity supplier will moreover facilitate reducing the public debt.
Application of new legislation adopted in 2005 was partly responsible for the 62-per cent increase in bankruptcies last year. Reflecting the trend toward increasing difficulties for companies in the current economic context, the Coface payment incident index has deteriorated since April 2008. The economic fabric will remain weak this year as a result of the lagging pace of efforts in many sectors to integrate new technologies and improve labour skills.
That has notably been the case in the textile-clothing and shoe industries, which have been contending with stiff competition not only from low-cost countries but also from emerging European and Euro-Med countries. The efforts to overhaul these sectors will thus continue in 2008.
Emerging Europe
The Emerging Europe region, encompassing Central Europe and Turkey, should lose a point of GDP growth in 2008, down from 5.6 to 4.6 per cent under the effect of sagging foreign demand, rising prices, and tighter monetary policy. Several factors have, however, had a mitigating effect on the slowdown: rising wages, the influx of foreign direct investment and European funds, and the growth of the region's share in Western European imports. Economic growth will moreover remain three points higher in the region than in the euro zone, its main trading partner. Except for the Baltic States, which have been contending with a marked credit slowdown, severe erosion of purchasing power, and a downturn in the property market, regional growth has mainly been trending up thus far this year.
Although steady tax revenues have facilitated reducing the public sector deficit in several countries, fiscal reforms have lagged behind schedule, and wage and social spending are up sharply.
Combating the inflation fuelled by rising foodstuff and energy prices and a tightening of the labour market has become the primary economic policy challenge. In this context regional central banks will likely continue tightening monetary policy. The high level of inflation has postponed adoption of the euro by the new member countries until at best 2012 with the exception of Slovakia, which already has approval to adopt the single currency on 1 January 2009.
The widening of current account deficits and the rapid growth of private sector debt and loans denominated in foreign currencies in conjunction in some cases with the bursting of speculative property bubbles have made many regional countries vulnerable to a currency crisis or sudden adjustment of growth. Fears of a hard landing for the Estonian and Latvian economies in particular are largely borne out by the slowdowns observed early this year. Lithuania, Romania, Bulgaria, Hungary, and Turkey remain the other weak countries in the region. Turkey notably still has the highest external financing needs of any emerging country while the procedure underway to ban the party in power has substantially increased the political uncertainties. The risk premiums for sovereign default reached high levels for those weak economies in the wake of the subprime crisis before easing substantially since mid-March this year. The Romanian leu — even if it has steadied slightly since end January 2008 — remains the regional currency most affected by that crisis.
Estonia
Rated A3
Reason for the rating change: The severity of the growth slowdown observed in the first quarter this year (up 0.1 per cent year-on-year, after up 4.8 per cent in the 2007 fourth quarter and up 7.1 per cent for all of 2007) raises fears of a hard landing for economic growth. Household confidence is affected by falling property prices and resurgent inflation (up 11.4 per cent end April this year). Continued wage growth has, meanwhile, been squeezing the margins of companies moreover faced with increasingly tight credit conditions.
That should affect investment. With domestic demand expected to decline, a slight recession is not out of the question this year even if exports remain dynamic (up 19 per cent in value terms in the first quarter this year).
Construction and sectors linked to consumption or that are labour intensive are particularly vulnerable.
The marked first-quarter slowdown may foreshadow a hard landing for economic growth for all of 2008. Tighter credit conditions, deflation of the speculative property bubble, erosion of household purchasing power, and narrowing corporate margins could pave the way to a slight recession this year. Inflation continues to grow — up 11.4 per cent in a year through end April 2008 — due to increases in food and energy prices, excise taxes, and wages. The objective of joining the euro zone in 2011 seems out of reach in this context. The expected decline of tax revenues should not, however, jeopardise the solidity of public sector finances, which have been running surpluses until now. Government debt has moreover been low, representing 3.4 per cent of GDP. The weakening of domestic demand should, meanwhile, have the beneficial effect of reducing a current account deficit that reached a difficult to sustain level in 2007 (17.3 per cent of GDP) necessitating, in the absence of adequate foreign direct investment inflows extensive recourse to borrowing abroad. The resulting increase in debt reflects in particular the credit lines granted by Nordic banking groups to local subsidiaries. In the political arena the coalition government has been experiencing its first signs of tensions. Relations with Russia have moreover remained tense since the riots triggered in April 2007 by the officially-approved moving of a statue commemorating the glory of Soviet soldiers. But the economic impact of these diplomatic tensions should remain limited to oil transit trade.
Latvia
Rated A4
Reason for the rating change: A hard landing for the Latvian economy has become a distinct possibility at this juncture. Growth fell to 3.3 per cent year-on-year in the 2008 first quarter, down from 8.1 per cent in the fourth quarter last year. Economic activity has suffered mainly from the deflation of the speculative property bubble and the tightening of credit conditions compounded by high inflation, up 17.5 per cent end April 2008. Exports have, however, been growing rapidly. GDP growth should fall to about 2.4 per cent in 2008, down from over 10 per cent these past three years. Sectors involved with construction or consumption and those that are labour intensive, which have to contend with rising payroll costs, are the most vulnerable.
The economic slowdown should be pronounced in 2008 with GDP growth down from 10.3°per°cent to 2.4 per cent under the effect of the property market downturn, tighter credit conditions, and the erosion of purchasing power. With domestic demand weakening slightly, only the positive contribution to growth made by foreign trade kept the country from falling into recession. The increases in regulated prices and in food and energy prices will keep inflation at high levels, up 17.5 per cent end April, the decline of domestic demand notwithstanding. In such conditions Latvia is not expected to adopt the euro before 2012/2013. The pronounced import slowdown should facilitate reducing the current account deficit from 22.8 per cent to 14 per cent of GDP this year. Foreign direct investment finances slightly under a third of that deficit while external debt, mostly owed by banks, has reached nettlesome levels. Although — after the virtual fiscal equilibrium of recent years — re-emergence of a slight public sector deficit appears likely, sovereign risk remains very moderate due to the low level of government debt (10 per cent of GDP). In the political arena meanwhile, corruption scandals could engender a degree of instability, but not of a nature, however, likely to jeopardise the main economic policy options.
Turkey
Rated B
After several years of strong growth in the wake of the 2001 crisis, Turkey suffered a slowdown (4.5 per cent in 2007) amid interest rates at their highest level since mid-2006 and a poor harvest. Rising inflation (slightly over 10 per cent in April 2008), tight credit conditions at the international level, and current new political uncertainties have prevented the easing of monetary policy crucial to reviving domestic demand. Middle Eastern dynamism, meanwhile, should only partly offset the European demand slowdown. Overall, growth should be relatively modest in 2008, around four per cent. A slight recovery will be possible in 2009 provided the political crisis is durably resolved and a more favourable international environment makes it possible to reduce interest rates.
In the current volatile world financial environment, the demand filed by the public prosecutor attached to the highest court of appeal to ban the party in power (AKP) constitutes a major risk factor. The likelihood of the constitutional court approving the ban is significant. In that case new elections seem inevitable, which would prolong the uncertainties, probably until early 2009.
These uncertainties in combination with a less favourable international credit environment heighten the main risk — a currency crisis — overhanging the country, especially with its external financing needs larger than those of any other emerging country. Although foreign direct investment inflows are now significant those needs are also covered by loans taken out by private companies whose debt has been growing strongly and by volatile capital. A loss of confidence by foreign creditors in this context could trigger a currency crisis that would particularly weaken companies with high foreign currency debt but with revenues denominated in local currency. Some of the firms with foreign currency debt are nonetheless exporters. Turkish companies moreover generally coped effectively with the previous — albeit relatively mild — shocks of May 2006 and summer 2007. Above all, and unlike 2001, public sector debt is now manageable and the banks enjoy solid foreign exchange positions. A crisis on the scale of that of 2001 is thus highly unlikely at this juncture.
Russia
Rated B
GDP growth reached 8.5 per cent in the first quarter and should continue to trend up throughout the current year buoyed by the dynamism of household consumption and investment, especially currently-surging foreign direct investment, On the supply side, construction (up 28 per cent), wholesale and retail commerce, transport and telecommunications, property, and B2B services should continue to expand rapidly. In the current buoyant economic conditions, the Coface payment experience on Russian companies continues to reflect the major shortcomings of the business environment.
The current surge of inflation (15.1 per cent in the first quarter this year) will moreover bear watching. Inflationary pressures should ease slightly for the full year as a result of the good grain harvest and tighter monetary policy with interest rates raised in June for the third time this year. Inflation will nonetheless remain high: 12.6 per cent expected for all of 2008).
The financial position remains sound. Although external debt ratios have improved, massive recourse to borrowing abroad by companies and banks has kept credit risk at appreciable levels in a context marked by a lack of transparency. Liquidity crisis risk remains limited, however, thanks especially to the Russia's large foreign exchange reserves. The emergence this year and next of financing needs only partly covered by foreign direct investment contribute to increasing the country's dependence on financial markets and increasing its vulnerability to a loss of investor confidence.
Although benefiting from the buoyant economic conditions, the banking sector still has significant weaknesses. Besides being too fragmented, it suffers from shortcomings on risk management and the transparency of financial information. With bank intermediation relatively limited, however, systemic risk is very small.
In the political arena, relations with Georgia deteriorated early 2008 over the Abkhazia and South Ossetia issue. A risk of conflict remains a plausible scenario. Domestically, the coming into power of Dmitri Medvedev could mark a more liberal shift and facilitate progress on political liberty and the campaign against corruption.
Emerging Asia
GDP growth should lose slightly over a point (7.6 per cent expected for 2008 down from 8.9 per cent in 2007) due to the slowdowns in the United States, Japan, and Europe in the wake of the subprime crisis. Emerging Asia will thus prove relatively resilient thanks to the growing influence of domestic demand on the growth dynamic and the financial solidity of most regional countries. The good regional performance moreover substantially reflects the excellent results achieved by China and India, which represent 55 per cent of emerging Asian GDP. The regional countries with the most open economies — Hong Kong, Singapore — should suffer most, however, and could lose two to three points of growth due to the slowdown of their exports. Taiwan also remains vulnerable with its dependence on the United States' economic cycle.
China's economic development meanwhile is pregnant with risks as evidenced by the disquieting signs of overcapacity — especially in steel, the automotive industry, distribution, and property — and overheating. After reaching 6.5 per cent in 2007, inflation surged again in the first half this year (8%). With government officials concerned about the resulting social repercussions, they will likely step up the monetary tightening, the pace of the yuan appreciation, and measures that are administrative in nature (like price freezes, and so on). Surging inflation has also prompted India to tighten monetary policy, which should ultimately undermine growth.
In the financial area, external over-indebtedness risk has remained limited throughout the region. Large current account surpluses have, however, tended to flood stock, property and credit markets with liquidity. After rising sharply in 2006 and 2007, Asian stock market indices have fallen thus far this year reaching levels comparable to those observed in summer 2007. Despite the downturns, price earnings ratios have remained high, which tends to suggest the continued presence of speculative bubbles. In China, the PER for section A on the stock exchange still exceeds 60. The ratios also remain high in India (20 times earnings) and Indonesia (21). In this context of overvalued stock exchanges the increased volatility observed in the first quarter this year is expected to continue throughout the year.
China
Rated A3
After peaking at 11.9 per cent in 2007, China's economic growth is expected to ease slightly in 2008 to 9.5 per cent. In the first quarter this year it reached 10.6 per cent. With domestic demand the main growth driver, the impact of the American slowdown should thus remain limited. Inflation, meanwhile, accelerated to 6.5 per cent in 2007 and reached 8.0 per cent in the first quarter this year, fuelled mainly by rising food and energy prices. It is likely to remain high throughout the year with officials having decided in June this year to raise diesel and petrol fuel prices by 18 per cent as well as electricity prices. Underlying inflation nonetheless remains below two per cent. Concerned over the social repercussions, the government will likely continue to tighten monetary policy — with increases in interest rates and especially mandatory reserves (five increases since the year began) — even if the tightening has had little effect thus far. Targeted administrative measures, like price freezes, may moreover be taken in 2008. The yuan appreciation has been accelerating, meanwhile, up 9.3 per cent year-on-year in May 2008 compared to up 6.9 per cent for all of 2007. Even if the yuan appreciated 10 per cent a year, however, it would take twelve years to shed its undervalued status with the IMF evaluating the equilibrium exchange rate for the Chinese currency against the dollar at just 1.96 yuan compared to 7.39 yuan in 2007.
Despite the expected export slowdown, meanwhile, China will continue to run large current account surpluses. The excess liquidity generated not only by those surpluses but also by the massive influx of capital ultimately ends up flooding the stock market evidenced by the 110 per cent increase in the Shanghai Stock Market index in 2007. Despite the price corrections that developed between January and May 2008 (down 35 per cent), the price earnings ratio remains a very high 60 showing that the attendant risks of speculative bubbles and volatility remain substantial.
Organisation of the Olympic Games will mark 2008 and the infrastructure investments made in consequence constitute an opportunity for the country. The results of a study by JP Morgan showed, however, that the Olympic Games only had a very marginal impact on the economy in Korea in 1988, Spain in 1992, the United States in 1996, Australia in 2000, and Greece in 2004. The aftermath of the Games could moreover — by causing sharp cuts in investment and consumption spending, — be a contributing factor to the economic slowdown.
Meanwhile, the social and political upheavals linked to growing inequality between urban and rural areas as regards the effects of rising prices will bear watching.
Vietnam
Rated B
On negative watchilisting
Reason for negative watchlisting the rating: Vietnam's strong growth — eight per cent on average since 2003 — has given rise to economic overheating with inflation reaching 12.6 per cent end 2007 and surging 25 per cent year-on-year this May. The current account deficit, meanwhile, widened significantly in 2007 and could reach 13.6 per cent this year. In the context of a Vietnamese currency — the dong — pegged to the dollar and a banking system highly dollarized, foreign exchange risk has increased. A major dong depreciation could thus be accompanied by a marked growth slowdown — with a 5.0 per cent expansion expected for 2008 down from 8.5 per cent in 2007— and an increase in corporate default risk.
Vietnam has enjoyed growth of over eight per cent since 2003 thanks to development strategy (inspired by the Chinese model) based on trade liberalisation and marked by admission to the WTO in January 2007 and a high rate of investment. That economic dynamism has engendered signs of overheating, especially since 2007. And with the dong pegged to the dollar and the banking system highly dollarized the overheating has given rise to increased foreign exchange risk. A major dong depreciation could thus be accompanied by a marked growth slowdown — with a 5.0 per cent expansion expected for 2008 down from 8.5 per cent in 2007— and an increase in corporate default risk.
After accelerating to 12.6 per cent in 2007, inflation has surged thus far in 2008 reaching 25°per cent this May year-on-year. That acceleration is attributable to the rapid expansion of credit (up 54 per cent in 2007), rising prices for food and oil (with Vietnam a net oil importer since early 2007), soaring housing and construction prices, and increases in wages have fuelled the inflationary spiral.
Monetary policy has become tighter with mandatory reserves higher and interest rates increased from 8.0 per cent to 14 per cent. These measures notwithstanding inflation will likely remain high throughout the year, reaching 18.3 per cent.
The current account deficit meanwhile has continued to widen. It represented 9.6 per cent of GDP in 2007 and could reach 13.6 per cent this year — compared to just 0.4 per cent in 2006 — amid strong growth of imports, especially capital goods needed for the many investment projects notably in construction. The widening current account deficit prompted the government to devalue the dong by two per cent in June. But foreign exchange risk has nonetheless remained substantial with the dong converted on the black market at rates below official parity with a 7.0 to 15 per cent discount. The forwards market has similarly discounted a 30 per cent-depreciation. And the banking system is very sensitive to exchange rate risk as a result of its extensive dollarization with 30 per cent of deposits and the appreciable proportion of bank intermediation resulting in dollar-denominated loans.
Vietnam's banking system remains weak in general despite some recent reforms that resulted in a more straightforward opening of the market to foreign banks and privatisation of three state-owned banks. Seven state-owned banks controlling 70 per cent of total bank assets nonetheless continue to dominate the sector. The high proportion of non-performing loans — one in four — associated with the rapid expansion of credit constitutes a major vulnerability. The lack of transparency and the failure to apply international risk management standards are additional sources of weakness.
The growing risk of a liquidity crisis due to the country's limited foreign exchange reserves will also bear watching. The government's decision to stop publishing information on the banking system and the level of foreign exchange reserves has moreover resulted in a lowering of expectations on Vietnam's financial outlook.
Vietnamese risks have thus been sharply downgraded — with Standard and Poor's and Fitch notably reducing the outlook for Vietnam from "stable" to "negative" — and a hard landing may be looming for the economy.
India
Rated A3
Tighter monetary policy notwithstanding, economic growth was higher than expected in the first quarter this year (up 8.8 per cent) driven by industry (up 10.9 per cent) and services (up 13 per cent). Domestic demand nonetheless remains the main growth engine with consumption and especially investment still strong in the private sector. And GDP growth rests on sound fundamentals: high savings and investment rates and moderate external debt ratios. With a more self-contained economy than the other emerging major powers, India is less dependent on international economic conditions and should thus be largely spared the effects of the American slowdown. In these circumstances the Coface payment incident index for Indian companies remains below the world average.
The main source of concern at this juncture is an inflation rate that reached 11.05 per cent for the year ending 7 June 2008. That inflationary surge is partly attributable, however, to the 12°per°cent increase in fuel prices decided by the government and by rising prices for food, which represents high proportion of the household shopping basket. Further interest rates hikes by the central bank are nonetheless likely, which could affect growth in the second half this year.
The deterioration of external accounts is less troublesome since it remains moderate and inflows of long-term capital largely cover India's external financing needs. The continuing presence of speculative property and stock market bubbles will continue to bear watching, however, in the currently more unstable world financial context.
Latin America
GDP growth is expected to slow to 4.3 per cent in Latin America this year down from 5.5 per cent in 2007 amid a less buoyant international environment and an economic slowdown in the United States, even with domestic demand still making a decisive contribution. Although still strong, world demand for staple commodities, especially in Asia, could decline in 2009, as could the high prices for raw materials, and deepen the economic slowdown. Most regional countries have, however, been able to reap the benefits of a previously favourable world context that facilitated cleaning up external accounts, building up substantial foreign exchange reserves, and continuing to reduce foreign debt. The resurgence of inflation — under relatively good control until now except in Argentina and Venezuela, — constitutes a challenge to continuing to pursue the generally appropriate monetary and fiscal policies that have contributed to the steadiness of local currencies and facilitated cleaning up public sector finances. With the region's stronger macroeconomic foundations and the greater credibility of the economic policies pursued, the international financial turbulence should have limited impact there with the region's large economies unlikely to experience major financing difficulties, tightening credit conditions at the world level notwithstanding. Although radical tendencies continue to mark the politics of some countries (Venezuela, Bolivia, Ecuador), the political options of most of the other countries are moderate. In general, however, the institutional and business environments leave room for improvement. In this context, corporate payment behaviour has deteriorated slightly but nonetheless remains relatively satisfactory although some sectors, like textiles, continue to be faced with competitiveness problems with others, like agriculture, remaining subject to weather conditions.
Mexico
Rated A3, negative watchlist status since mars 2008
The economy is likely to slow this year with 2.6 per cent growth in the first quarter and 2.3°per°cent for the full year down from 3.3 per cent in 2007 due especially to the economic slowdown in the United States on which Mexico remains dependent as a market for its exports. The fiscal stimulus through measures intended to buoy domestic demand, the main economic engine, should produce a slight upturn in 2009. Tight monetary policy meanwhile should ease inflationary pressures notably attributable to rising food and energy prices and limit the overall rise in prices to 4.5 per cent for the year. The economy's relatively solid foundations will likely mitigate the effects of international financial turbulence.
The process of improving public sector finances, which depend on oil revenues, will stall, however, as result of the fiscal stimulus programme. With a decline in oil production, slumping exports to the United States, and a slowdown in emigrant worker remittances, the foreign trade deficit will begin to widen from 2009. Foreign direct investment is expected to cover half of external financing needs, however, with Mexico's already moderate external debt ratios likely to decline further.
Efforts to modernise the economy, and particularly to reform the state-owned oil company Pemex, have come up against stiff resistance on political and social grounds with President Calderon lacking a parliamentary majority.
In this context, the business environment still leaves room for improvement with the Coface payment experience on Mexican companies deteriorating somewhat although remaining acceptable. The difficulties experienced in the textile, clothing, and shoe industries reflect their problems in meeting foreign competition, especially Asian, while the problems in the food industry are more cyclical in nature.
Brazil
Rated A4
With domestic demand still the main growth engine, the economy is expected to remain relatively strong this year — after a 5.8 per cent expansion in the first quarter, 4.6 per cent is expected for all of 2008 and slightly less (4.1 per cent) in 2009 compared to 5.4 per cent in 2007 — but without reaching, however, the five per cent growth targeted in the government's priority Growth Acceleration Programme. The country has shown a noteworthy capacity to cope with the volatility of international financial markets. Inflationary pressures, with the rise of prices accelerating this year and likely to reach six per cent by year end, have prompted the central bank to begin another cycle of increases in its already high key rate.
The underperformance of exports but especially the dynamism of imports and a widening services deficit should cause a current account deficit to emerge this year and increase in 2009. Foreign direct investment will likely cover, however, most of Brazil's external financing needs. The country's external vulnerability is expected to ease, moreover, thanks to the improvement in the external debt ratios. And the record level of foreign exchange reserves constitutes a very solid safety net even if a widening current account deficit in 2009 could contribute to a weakening of the currency.
Public sector debt, meanwhile, is still too high (with the gross amount outstanding expected to represent 64 per cent of GDP this year and the net amount 41.5 per cent), which notably tends to impede investment and infrastructure modernisation. But the adoption of the structural reforms needed to sustain stronger growth is impeded, however, by the governing parliamentary coalition's lack of homogeneity and the government's lack of commitment in the run-up to municipal elections late this year and presidential elections in 2010 with the constitution denying President Lula da Silva the right to run for a third term.
In this context, the Coface payment experience on Brazilian companies has only deteriorated slightly while remaining relatively satisfactory. Corporate creditworthiness is expected to remain good in growth sectors including oleaginous production, sugar, mineral extraction, construction, steel, and, to a lesser degree, aeronautics, and the automotive industry. Some sectors — like the distribution of pharmaceutical products and fertilisers — continue, however to contend with difficulties that are specific in nature while others — like clothing and shoes — have to cope with foreign competition that benefits from the strength of the real.
North Africa and Near & Middle East
Oil prices, which virtually doubled in the space of a year, have provided the region's producer countries with the resources to ensure the perpetuity of major infrastructure projects whether in the Gulf Monarchies or Algeria. But the rising cost of rent, construction materials, and, subsidies notwithstanding, fuel and food products, have created inflationary pressures exacerbated by the depreciation of the dollar to which the currencies of most Gulf monarchies are pegged. The price surge could cause delays in some projects and severely reduce consumer purchasing power, limiting nonetheless strong growth outside the oil sector. That is especially the case in the United Arab Emirates and Saudi Arabia. After two years of reduced hydrocarbon production in the Arabian Kingdom, an upturn is expected this year with growth reaching about six per cent.
Although foreign debt has been growing in the region — except in Algeria, which has pursued tight policy on that score — any over-indebtedness risk has to be put into the perspective of the extensive and growing asset holdings abroad. Fiscal expansionary policy in Iran has spurred growth but at the expense of stoking inflation that exceeds 20 per cent. The country's inflexible positions on the nuclear issue has prompted the United Nations and the United States to impose sanctions that make economic and financial transactions more complicated and costly.
Petrodollars from the Gulf Monarchies have indirectly benefited the other countries in the region via investments, tourism, and emigrant worker remittances. Coping with the oil bill will be particularly painful for Jordan and Lebanon, which already run high external deficits, respectively 20 and 12 per cent. Soaring foodstuff prices have triggered riots, particularly in Egypt. Remedial measures taken to offset subsidy reductions and rising prices for food products have widened public sector deficits in Egypt, Jordan, Syria, Lebanon, and Yemen. Israel, meanwhile, has withstood the slowdown in the United States relatively well, achieving 5.4 per cent growth in the first quarter, driven by household consumption and investments. The international credit crunch has, in general, had little effect on the region.
Geopolitical tensions continue to run high in that corner of the world, spurring Islamist movements in opposition to governments that in general enjoy good relations with the United States. The chaos reigning in Iraq remains a source of regional destabilisation and the Iranian nuclear issue continues to be a major factor of uncertainty. Perceptible signs of easing tensions have nonetheless emerged. Qatar's mediation in Lebanon notably led to the election of a president paving the way for restoring the normal functioning of institutions paralysed since autumn 2006. The resumption of talks between Hamas and Fatah and the truce between Israel and Hamas augurs a possible revival of the Middle East peace process that could include Syria.
Saudi Arabia
Rated A4
Adjusting oil production to foreign demand contributed last year to a new growth slowdown with the economic expansion limited to 3.5 per cent. The non-oil sector, meanwhile, continued to grow at a strong, steady pace of 6.5 per cent with the revenues generated by high barrel prices spurring domestic demand and both public and private investment in large industrial and infrastructure projects. The oil sector's contribution to growth is expected to rebound this year and next — an estimated six per cent in 2008 and four per cent in 2009 — in view of the programmed increases in oil and gas production and the buoyant demand from emerging countries. And high oil prices and large projects in progress will continue to underpin non-oil economic activity. The rising cost of commodity material and labour could, however, delay some projects and undermine economic growth. Increasing inflation has moreover affected purchasing power and could deter household consumption. The non-oil sector is thus expected to maintain about six per cent growth. The overall economy will grow an estimated six per cent in 2008 and five per cent in 2009. Petrochemicals, construction, and transports will be the sectors likely to outperform. Corporate earnings have been good and the Coface payment incident index for Saudi companies has remained below the world average. With the country's admission to the WTO end 2005, the business climate improved. The investment rate is, however, still below the country's potential amid continuing governance weaknesses and high geopolitical risk.
Egypt
Rated B
With the liberal policy options adopted by the government since 2004, the business climate has improved. The boom conditions in oil producing countries have moreover benefited Egypt's economy through investments and emigrant worker remittances. The strength of domestic demand and the increases in staple commodity prices in conjunction with subsidy reductions have, however, caused a surge of inflation estimated at 14.5 per cent on average for the year ending June 2008. Although the marked increase in prices has undermined household purchasing power, investment and private consumption continue to drive the economy. Sharply higher demand for imported products has, however, made a negative contribution to GDP growth estimated at 6.5 per cent this year, or somewhat slower than the 7.1 per cent expansion achieved in 2006/07. The manufacturing, tourism and communications sectors performed particularly well. In construction, bottlenecks and higher material and wage costs have delayed some projects. Inflation targeting policy should facilitate keeping the rise of prices under control with an average increase of 9.3 per cent estimated for the 2008/09 financial year.
Underpinned by the good trend on foreign currency revenues and dynamic foreign direct investment spurred by privatisations, Egypt's external financial position is not a source of difficulty at this juncture. Debt service is low. The country continues to build up foreign exchange reserves. The fiscal deficit and public sector debt continue, however, to give cause for concern. With rising food prices having triggered riots, the government took compensatory measures — wage and subsidy increases — intended to keep a lid on the social climate. The planned clean-up of government finances was postponed in consequence and the public sector deficit could represent between 7.0 and 8.0 per cent of GDP for the current financial year, after easing to 5.7 per cent in 2006/07.
Lebanon
Rated C
Reason for the removal from negative watchlist status: The Doha Accords that made the election of a President in May 2008 possible have paved the way to restoring the functioning of the country's institutions to normal. Despite the difficult economic conditions, corporate payment behaviour has held up well.
After Raffik Harriri's assassination in 2005 and the war with Israel in 2006, insecurity and political instability exacerbated by the prospect of presidential elections supposed to be held late 2007 impeded an economic rebound. After pro-Syrian members of parliament and the government resigned, the ensuing blockage of normal institutional functioning stalled progress on reforms and implementation of the USD 7.6 billion promised in international aid at the Paris Conference in January 2007. That situation affected household consumption, investment, and tourism. Notwithstanding the difficulties, however, companies maintained good payment behaviour.
In 2007, after two years of virtual stagnation, economic growth failed to rise above four per cent, underpinned by construction despite the slowdown of investment by Gulf countries in this sector and by a dynamic banking sector redeployed to other regional countries. Government finances remain marked by the cost of the reconstruction in the 1990s with public sector debt reaching 170 per cent of GDP. The government moreover ran a fiscal deficit of 12.4 per cent in 2007. With a large current account deficit that represented 12.5 per cent of GDP in 2007, the external financial position is also still shaky, remaining exposed to a crisis of investor confidence. The country's banks are its strong suit. Well capitalised, liquid, and profitable, they are nonetheless vulnerable due to their exposure to sovereign risk.
Mediation by Qatar made President Michel Suleiman's election in May 2008 possible, paving the way for institutions, paralysed since autumn 2006, to resume their normal functions even with the political situation remaining shaky in the run-up to general elections in 2009.
Iran
Rated D
Buoyed by social policy based on redistribution of oil export revenues, the economy remained strong in the 2007/08 financial year with 5.8 per cent growth, which constitutes a slight slowdown compared to the 6.2 per cent achieved in 2006/07. The non-oil sector derived support from several sources: public spending, social incentives, and the easing of bank interest rates. Services and manufacturing performed well. For the second straight year construction was particularly dynamic, spurred by public infrastructure spending, and private savings, which have been turning away from stock market investments. Oil sector production rose just one per cent with the decline in capacity of old fields partly offsetting the production start-up of new facilities. Expansionary fiscal policy and accommodating monetary policy have kept inflation at high levels, between 25 and 30 per cent, undermining purchasing power in a country where incomes remain relatively low compared to the region's other oil producing countries.
For 2008/09, economic growth is estimated at 5.3 per cent. The government will continue to support the economy through public spending in the run-up to presidential elections in 2009 and in view of the continuing strong growth of oil prices. The inflation rate is expected to remain above 20 per cent.
The external financial position presents no particular difficulty. Iran will likely maintain large foreign exchange reserves, which will limit liquidity crisis risk. Public sector finances, however, give substantial cause for concern, however, with the sector's limited surplus despite the excellent oil market conditions reflecting the extensive redistribution of oil export revenues.
The business climate has suffered from the government's populist policies and sanctions imposed on the country in the absence of a settlement of the nuclear issue. The World Bank's governance indicators moreover continue to place Iran at critical risk levels.
Sub-Saharan Africa
The growth outlook for sub-Saharan Africa's remains bright with a 6.5 per cent expansion expected this year and 6 .3 per cent in 2009, underpinned by firm raw material prices, particularly hydrocarbons and ores. Risks have nonetheless been growing in a context of soaring foodstuff prices and persistent structural imbalances.
Oil importing countries, with growth (five per cent) below the sub-Saharan average, have suffered from the widening of their twin deficits. In this context, improvement in their financial positions resulting from debt relief granted under the HIPC and MDRI programme could prove largely unsustainable. Soaring prices for foodstuffs, which represent 60 per cent of the household shopping basket in sub-Saharan Africa, exacerbate social and political risks. The 50 per cent increase in wheat and rice prices between December 2007 and April 2008 triggered violent protests over the cost of living in Cameroon, Burkina Faso, Ethiopia, and Senegal. The upsurge of inflation has moreover led the central bank of South Africa — which represents 40 per cent of sub-Saharan Africa's GDP — to adopt monetary policy options not very favourable to growth, affected meanwhile by an energy crisis likely to become chronic over the next five years. In a context where the markets have less confidence in emerging countries, South Africa (downgraded to A4) has also been contending with tightening conditions for financing its current account deficit.
On a more general level, there continue to be many structural weaknesses: Producer countries still do not sufficiently re-invest the oil wealth. With diversification of the productive fabric still embryonic the region remains vulnerable to a downturn of raw material prices. The weight of the farm sector gives rise to a dependence on weather conditions. Poor transport and energy infrastructure impedes productivity improvement. The high poverty level limits development of human capital. The difficult business environment deters foreign direct investment inflows. And political and social risks remain high with the many domestic or sub-regional uncertainties susceptible of compromising otherwise brighter outlooks (Côte d'Ivoire, South Africa).
South Africa
Rated A3
On negative watchlisting
Reasons for the rating change: Economic growth is likely to slow markedly and fall below three per cent in 2008 amid an increasingly severe energy crisis that has prompted realignment of major energy intensive investment projects. The central bank's tight monetary policy, meanwhile, has proven completely ineffective in stemming surging inflation that originates abroad and that reached 10.2 per cent this June. The monetary tightening has nonetheless affected the economy (household consumption and private investment). The risk of a currency crisis has moreover remained acute in a context of stiffening conditions for financing a large current account deficit. With social risk increasing sharply amid insufficient redistribution of wealth, the emergence of a new leader of the ANC stokes uncertainties over South Africa's future economic options
The economy held up well in 2007 under the tightening of monetary policy with growth climbing to five per cent, underpinned by investment and dynamic household consumption. The growth rate is expected, however, to drop below three per cent in 2008 with South Africa contending with an energy crisis attributable to a shortage of production capacity in relation to growing demand. This critical energy situation, which could drag on for the next five years, has already prompted a reassessment of energy intensive investment projects crucial to expanding South Africa's capacity for economic growth. The tighter monetary policy, which resulted in a 450-basis point increase in the repo rate between June 2006 and June 2008 and in stiffer credit conditions (National Credit Act), has begun to have a significant impact on companies and households — with defaults on debt contracted by households noticeably increasing in consequence. And continuing inflationary tensions (10.2 per cent this June) could further undermine consumer purchasing power especially with South African Reserve Bank's tight monetary policy proving ineffective in combating inflationary pressures with exogenous causes. In this context, the country's external financial position remains shaky. A current account deficit that exceeded seven per cent in 2007 will likely remain large this year despite the growth slowdown. The oil bill is expected to continue to weigh on the deficit as will capital goods imports needed for infrastructure projects. External financing needs are covered by volatile portfolio investments very sensitive to swings in confidence with respect to emerging markets. Exchange rate risk has increased in consequence. The rand thus depreciated 20 per cent against the dollar between December 2007 and March 2008. Exchange rate variations observed since April 2008 attest to the greater volatility of the South African currency.
Besides, the social context is tense amid an insufficient distribution of wealth. And the xenophobic violence that broke out this June in the Johannesburg and Cap townships, causing nearly one hundred deaths and displacing tens of thousands of people was also a reflection of deep currents of frustration. The naming of a Jacob Zuma backed by the Communist Party and the unions to lead the ANC South Africa's main political party increases the uncertainty over the country's future economic and social policies.
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