The world country risk index((*)The world country-risk index represents an average of Country @ratings weighted by each country's contribution to world gross production. The index is based on the world average risk level in 2000.) deteriorated slightly (up 0.3%) amid a slight aggravation of risk on emerging countries (up 0.6%). That deterioration is essentially attributable to the consequences of a less certain international financial environment mainly affecting the countries most dependent on foreign capital like Turkey (B rating removed from positive watchlist status), Hungary (downgraded to A3), the Philippines, (B, removed from positive watchlist), and Jordan (B, negative watchlisted).

Financial market skittishness marked the second quarter this year. Operators reacted strongly to the interest rate hike by the Fed last 10 May with a possible resurgence of inflation influencing their expectations. The scenario of a halt to monetary tightening in the United States from the second half this year has thus become more uncertain.

- As a result, the major stock markets registered sharp declines in both industrialised and emerging countries. The sharpest declines occurred in Tokyo, Istanbul, Sao Paulo, Mexico, and Moscow as well as in the main emerging Asian financial centres like Bombay and Bangkok.
- The currencies of the emerging countries most vulnerable to exchange rate risk, above all the Turkish lira and Hungarian forint, depreciated.
- Some raw material prices declined (copper, nickel), sometimes from speculative levels.

Although those movements can of course be considered salutary adjustments after a period of excessive exuberance, they underscore the persistent imbalances in the world economy.

The size of the American current account deficit (6.5% of GDP expected in 2006 and 7% in 2007) precludes rejection of the hypothesis of a sharp dollar depreciation followed by accelerated raising interest rate increases. Growth could then slow under the influence of concomitant monetary and fiscal tightening in all industrialised countries (Japan, Europe, and United States) and sagging confidence in financial markets.

With those new tensions developing in an environment where commodity prices are still high, the impact on economic activity will be all the more pronounced. During the first five months this year, oil prices thus rose another 20% compared to their average level in 2005.

A geopolitical context marked by persistent uncertainties has compounded that constraint. After the escalation of tensions linked to the Iranian nuclear issue, the situation has been relatively calm since the United States demonstrated its willingness to negotiate directly with Iran. However, a policy of small steps and hedging remains the most probable scenario. Meanwhile, tensions between Fatah and Hamas in the Palestinian Territories have raised the spectre of civil war and the United States has remained mired in difficulties in Iraq.

In that context, and despite continued robust demand, the environment could prove less favourable for companies. Their inability to pass on the numerous cost due to international competitive pressure should persist — which explains the still limited level of inflation. But that situation may have reached a threshold. The growth of sales volumes and productivity gains should slow. As a result, the record earnings of large groups should sag and the weakest companies (less internationalised and largely dependent on still-costly raw materials) may have to contend with increasing financial difficulties.

That tenser situation has prompted changes in the ratings of several emerging countries considered vulnerable (downgrade of Hungary's A3 rating, negative watchlisting of Jordan's B rating, removal of the B ratings for Turkey and the Philippines from positive watchlist status). And greater vigilance seems in order with emerging countries vulnerable to capital flight like Thailand (negative watchlisted A2 rating maintained), Indonesia (B rating unchanged), and South Africa (A3 unchanged). For the latter two countries, improved fundamentals explain why their ratings have remained unchanged at this stage.

Rising interest rates, marked decline of stock prices, and still-high raw material prices constitute a less favourable environment for companies, which could ultimately exacerbate the pressure on their margins. In that context, the risk index for industrialised countries has stopped improving with the upgrading of Italian export companies from A3 to A2 constituting the only rating change.

In the United States (rated A1), economic activity has remained robust. However, the high cost of energy, the slowdown of property prices, and rising interest rates should accompany a slight downturn in the second half. The household spending slowdown should continue in 2007. Company investment should also stall due notably to slower earnings growth. Only exports should remain very dynamic without, however, sufficing to offset a current account deficit representing 7% of GDP.
The company financial situation has in general remained very satisfactory as evidenced by the continued good level of the Coface payment incident index. Earnings have increased sharply amid the simultaneous improvement of sales volumes and margins in many sectors. Continued strong sales performance and the reduction of unused production capacity have made it easier for companies to set their prices. However, competition has been fierce with the situation remaining particularly difficult in sectors like the car industry, air transport, toys, and even furniture. In coming months, company earnings should grow much slower amid smaller productivity gains and rising energy and raw material costs. The company financial situation should nonetheless stabilise at a good level.

In Japan (rated A1), the economic impact of the sharp stock market declines should be limited. Buoyant domestic demand continues to underpin economic growth. Bolstered by the reduction of overcapacity and renewed profitability, companies now generally enjoy substantial financial leeway to increase their investments. Household consumption has moreover begun to grow again amid an improved employment and wage picture as well as the expected summer bonuses. Exports have also been registering strong growth still driven by Chinese and American demand. A slight economic slowdown is expected in 2007. With the Bank of Japan dropping their zero-rate policy, company investment should slow. Moreover, the likely hardening of fiscal policy (increased VAT, for example), made necessary by the disastrous public sector financial situation could affect household consumption. Finally, the yen appreciation, the American economic slowdown, and the high stock levels of electronic consumer products should cause an export slowdown.

In Europe, a broad-based phase of moderate recovery is under way. That is the case in Germany, France, Italy, Benelux, and the alpine countries. Conversely, Portugal's economy has remained sluggish. Meanwhile, Spain, Ireland, and Scandinavia continue to register growth rates above the European average fuelled by still-dynamic domestic demand. Finally, the United Kingdom has resumed satisfactory growth after a brief pause. Economic activity is expected to sag overall in 2007.

In Germany (rated A1), the economy has continued to recover. Exports, the unflagging economic engine, has benefited from the improved economic conditions in Europe and robust demand from emerging countries. Companies whose production capacity is substantially absorbed by foreign orders have made further increases in their equipment purchases. Moreover, consumption has been showing signs of recovery. Although all the economic policy decisions planned for 2007 (VAT rate increases, retirement reform, and health-system financing reform) will contribute to reducing the fiscal deficit, they should, however, put pressure on household spending and thus undermine dynamism across the economy. Furthermore, exports should slow reflecting the world investment downturn and expected euro appreciation

In France (rated A1), still underpinned by domestic demand, growth has been recovering thanks to exports. Although wages only rose slightly and despite the increasing cost of energy, household consumption is still buoyed by abundant and inexpensive credit, job growth (particularly publicly aided employment), and a price decline for imported products. Furthermore, exports have benefited from more dynamic European demand and especially from the German and Italian recoveries. However, the foreign trade contribution to growth has remained negative due to the increase in imports spurred by household spending. Despite that moderate economic recovery, some economic sectors have remained very weak. Plastics processing, metalworking, and smelting have been suffering from the car industry slowdown and rising raw material prices, road transport from the upsurge of fuel prices, and textiles from Asian competition.

In Italy (rated A2, negative watchlisted), the moderate recovery registered in the first half this year should continue in the second half. Exports have benefited from the more buoyant economic conditions in Europe even if competition from emerging countries and a lack of price competitiveness have limited their expansion. Household consumption has tentatively begun to grow again and the return of confidence coupled with generous wage agreements should spur a more robust upturn in the second half. As a result, and with a decline in social charges, companies have been investing more. The economic growth should continue in 2007 although remaining below the euro zone average. Exports should benefit from improved competitiveness linked to productivity gains, a further reduction of social charges, as well as smaller wage increases. Private consumption, meanwhile, should continue its moderate growth. In that context, private investment will also continue to increase. However, consolidation of public sector finances, which have been running large deficits, will remain a major constraint on public spending.
After the sharp deterioration registered in 2004, payment incidents have gradually resumed their earlier trend. Their frequency is nonetheless still much higher than the world average.

In Spain (rated A1), economic growth is still robust despite persistent imbalances. It has depended mainly on domestic demand with foreign trade making a largely negative contribution. Several factors have been fuelling both household consumption and activity in the construction sector: an abundance of low-cost credit, job growth, and the enthusiasm of foreigners and nationals for holiday dwellings. However, exports are still suffering from a loss of competitiveness resulting from inflation exacerbated by rising energy costs and from weak productivity gains. In this generally favourable context, a slight slowdown should nonetheless develop in the second half this year and continue throughout 2007. Despite the continued decline of unemployment and a trend toward expansionary fiscal policy, the gradual rise of interest rates in conjunction with a high level of household indebtedness should ultimately affect private consumption and residential investment. Exports meanwhile will continue to contend with the recurrent loss of competitiveness.

In the United Kingdom (rated A1), the economy has registered a moderate recovery with private consumption likely to improve in coming months amid the property market recovery. However, record household debt and continuing increases in unemployment should limit the extent of the improvement. Exports, meanwhile, have benefited from the recovery registered in Europe and the pound sterling depreciation against the euro. That improved demand trend has not, however, led to a significant increase in investment.

► The risk index for CENTRAL EUROPEAN COUNTRIES deteriorated (up 2.1%) due to the downgrade of Hungary's rating to A3 (after its negative watchlist status since the first quarter last year) prompted by the country's weak fundamentals in a context of market skittishness notably affecting emerging countries. The rating of the region's principal countries now range from A2 for the Czech Republic, A3 for Hungary, Poland, and Slovakia, to A4 for Romania and Bulgaria, which constitute the next wave in the enlargement process.

The worldwide upturn of interest rates worldwide in conjunction with the internal weaknesses of some economies (deteriorated public sector financial situations, less buoyant political environments) has significantly affected regional financial markets. Since 11 May 2006, all stock market indices have declined with the pressure on exchange rates increasing, especially in Hungary and Poland. Except in Hungary where substantial external account imbalances compound the fiscal deficit, exchange-rate risk should remain limited because of the consolidation programmes undertaken, increased production capacity, and steady capital inflows.

In Hungary (rating downgraded from a negative watchlisted A2 to A3), economic growth continued in the first quarter this year (up 4.6% year-on-year) thanks to a strengthening of investment and exports. Those favourable economic conditions should not obscure, however, the increase in macroeconomic imbalances. The public sector deficit could reach 8% of GDP this year. Hungary has also been running a substantial current account deficit (7% of GDP) amid heavy foreign debt, and a not-very-comfortable level of currency reserves. The country has become more vulnerable to a foreign-exchange crisis whose could prove very costly due to the growth of foreign currency debt carried by economic agents. In the political arena, the social democratic coalition in power emerged strengthened from the April 2006 elections. However, the austerity programme the government recently announced, based more on tax increases than on major spending cuts, does not seem to have impressed the markets very much.

In Poland (rated A3), economic growth has been recovering (up 5.2% in the first quarter 2006) thanks mainly to private consumption dynamism. Exports have benefited from substantial productivity gains. Inflation has remained under control. However, the coming into power of the conservative and nationalist right has raised fears of a slowdown on reform efforts. Government authorities will nonetheless still have to deal with two major challenges: reduce the public sector deficit and maintain an environment sufficiently attractive for foreign direct investment and thereby limit the recourse to borrowing abroad and avoid increasing the country's dependence on international financial markets.

In the Czech Republic (rated A2), which has posted impressive growth performance (up 7.4% in the first quarter), the process of delocalising European car production to the country has been driving the economy and making it possible to put external accounts back into balance. However, the easing fiscal policy has caused the public sector deficit to widen after the improvement registered in recent years. Government debt has nonetheless remained within very reasonable limits. Politically, the country has been deadlocked since the June 2006 legislative elections, with no party capable of forming a majority. That could prompt the holding of new elections.

In Russia (rated B), the Moscow stock exchange suffered greatly (down 9% on 13 June 2006 alone!) from the wave of panic selling. However, the sharp decline especially represents a necessary correction after the excessively steep rise of share prices for companies marked by major governance problems. Fundamentals are nonetheless still relatively sound with economic growth remaining robust. However, the extraction sector stagnated in 2005. In manufacturing, segments exposed to international competition (machine tools and electronic products) suffered from the penetration of imported goods. Meanwhile, the food sector fared relatively well and the construction and retail sectors posted strong growth. The country's financial situation has continued to improve. Finally, Coface's payment experience on Russian companies has been good. Financial and ownership transparency is nonetheless still insufficient. Debtor-creditor law does not work, with a vast reform of the legal system still pending.

The average risk index for Emerging Asian countries deteriorated slightly (up 0.4%) due to the removal of the Philippines' B rating from positive watchlist status. That country appears to be one of the most vulnerable to the current crisis of confidence with its high level of sovereign risk, dependence on market sentiment, and recurrent political uncertainties.

Asian countries continue to post good economic performance with their fundamentals remaining sound. Several regional stock markets of course suffered greatly from the crisis of confidence. From 10 May through 10 June 2006, the markets fell 20% in Indonesia, Thailand, and the Philippines, three of the Asian economies most vulnerable to capital flight. The skittishness could also affect the exchange rates of the weakest currencies, which have fared rather better than the stock markets thus far. However, the Thai baht, Indian rupee, Philippine peso, and Sri Lankan rupee will bear watching considering the recent massive inflows of portfolio investments into those countries.

In China (rated A3), economic activity has accelerated this year. Despite efforts to control credit, investment hardly seems under control rising 28% in the first quarter this year. Economic policy instruments have apparently not been very effective in dealing with that situation. In many sectors, like the car industry, cement, and steel, overcapacity has tended to squeeze margins thereby increasing credit risk substantially. Consolidation of the fabric of companies will thus proceed in a tense financial situation, especially for a private sector contending with stiff competition in the domestic market. Meanwhile, China's financial situation is still robust. With its current account surplus continuing to grow, foreign exchange reserves will exceed one trillion dollars this year. However, the banking sector has remained a major risk factor with the stock of non-performing loans far higher than the official figure. Moreover, a dynamic credit supply — both bank and informal credit — also seems to escape government control.

In India (rated A3), economic growth accelerated again toward the fiscal year end (31 March 2006). For the full year, growth reached 8.4%. Driven by growing middle-class purchasing power, robust domestic demand has continued to underpin economic activity. However, the likely tightening of monetary policy, prompted by fears of inflationary pressures, and the sharp stock market decline (down over 25% since early May) could undermine demand. India's growth nonetheless rests on solid foundations like its very competitive services sector. With its external debt ratios under control and currency reserves at comfortable levels, India will be able to cope with a crisis of foreign investor confidence despite the rapid deterioration of external accounts spurred by a growing oil bill.

In Korea (rated A2), the domestic demand recovery has continued thanks to buoyant private consumption since the end of the household debt crisis. Amid the high level of oil prices, investment has only increased moderately. Thanks to market share gains in China and increasing quality competitiveness in the car industry, electronics, and shipbuilding, exports have remained dynamic. In the corporate governance arena, government authorities appear determined to combat illegal practices within large groups. Several chaebol executives have been under judicial investigation. Although that phenomenon will certainly undermine the business climate in the near term, it nonetheless constitutes a sign that the quality of governance is actually improving. The Coface payment incident index has remained substantially under the world average. The won appreciation could, however, affect small export-oriented companies.

In Indonesia (rated B), political weaknesses, the exposure of public sector debt to exchange rate risk, and the low level of currency reserves have made the country vulnerable to capital flight. Indonesia's economic fundamentals have nonetheless improved and growth has been dynamic. The reduction of subsidies has provided some leeway on public spending and public sector debt has been declining. The current account is still in surplus and debt ratios have been easing. Although the anti-corruption campaign waged by President Yudhoyono has begun to produce results, governance is still a problem.

With still-significant sovereign risk and a dependency on financial markets, the Philippines (rated B) has been one of the countries most vulnerable to the current crisis of confidence, prompting the country's removal from positive watchlist status. Public sector debt — sensitive to market risks — has remained at high levels. Although the dynamism of expatriate transfers has been underpinning the economy, Philippine companies continue to suffer from Chinese competition. At this juncture, the Coface payment incident index is still below the world average. In the political arena, President Arroyo finally emerged strengthened — at least for now — from the various destabilization attempts to which she has been subjected. Despite her shaky position, her achievements on reforms have been substantial. The quality of governance is nonetheless still among the poorest on the Asian continent.

In Thailand (rated A2, negative watchlisted), the crisis of confidence also affected the stock market. The country has also been running a current account deficit partly financed by portfolio investments, which has tended to undermine the baht exchange rate. The prime minister's reluctance to withdraw from public life has moreover nurtured political uncertainties, which will not dissipate until the new elections scheduled for October 2006. Although economic growth has remained robust, industry has been contending with fierce competition from China in the electronics and textile sectors. Company balance sheets are characterised by shrinking margins and high debt levels. The continuing erosion of competitiveness could ultimately undermine company solvency. At this juncture, however, the Coface payment incident index has not deteriorated to any notable extent.

The Latin American risk index improved slightly (down 0.3%) after the upgrade of the Dominican Republic's rating from C to B. The region has not escaped the financial turbulence with all stock market indices declining since 11 May, particularly in Mexico (down 30% in one month), Brazil (down 24%), and Argentina (down 22%). For the full year 2006, however, the regional economy should continue to grow at a satisfactory pace (just over 4%) with domestic demand picking up some of the slack for foreign trade. The still-favourable prices for raw materials and farm products and continued strong world demand should be conducive to further improvement in external accounts. Moreover, several countries have continued to derive benefit from more disciplined monetary and fiscal policies, paving the way for reducing inflation and consolidating public sector finances. That context will also favour continuation of the external debt reduction process, particularly notable in Brazil. The region's ratios have nonetheless remained higher than those of the other emerging regions except sub-Saharan Africa.

The situation varies widely by country, however, and has especially depended on the economic options of the governments in power. Thus, despite certain political vicissitudes or elections dates, maintaining or restoring financial equilibrium must remain the priority for countries like Mexico, Brazil, Colombia, Peru, and the Dominican Republic.
The pragmatism of those countries has been in sharp contrast with the populist-oriented governments of Venezuela, Bolivia, or, to a lesser degree, Argentina and Ecuador. Although massive inflows of foreign currency linked to high raw material prices have allowed the latter countries to finance substantial redistributional spending, insufficient investment and vulnerability to a price downturn will continue to represent major weaknesses.

In Chile (rated A2), despite a somewhat less propitious international environment and the correction of copper prices, growth should remain robust since it also benefits from buoyant domestic demand. Public sector finances are in extremely good shape with financing needs at reasonable levels and largely covered by foreign investment. Meanwhile, with foreign debt essentially attributable to private borrowers, external debt ratios have continued to decline. The country has moreover benefited from a sound currency and very robust financial system. In that context, payment experience has been very satisfactory and company solvency should remain good.
In Mexico (rated A3), private consumption and investment will continue to drive growth amid more accommodating monetary policy with demand from the United States moreover likely to remain strong. The country also boasts solid economic and financial fundamentals. The external deficit should remain under control due notably to oil exports and transfers from emigrant workers with foreign direct investment covering the country's large financing needs and foreign debt remaining at moderate levels. Although the upcoming presidential election on 2 July 2006 has hardly been conducive to progress on reforms, there seems to be a consensus on continuing the policy of macroeconomic stability. In that context, the payment incident index has improved. In the textile sector, however, and in the case of certain maquiladoras (subcontracting export companies) payments are still subject to long delays.
In Brazil (rated B, positive watchlisted), despite the sharp decline of stock market prices registered in May, a slight economic recovery should develop this year with private consumption resuming its role as the main economic engine. Export dynamism has been responsible for current account surpluses and a sharp reduction in external financing needs. Furthermore, the country's external vulnerability has eased as evidenced by a sharp reduction in external debt ratios. Despite efforts to maintain discipline, however, public sector debt is still too high and exposed to interest rate trends. Meanwhile, the outcome of the October 2006 presidential election should not jeopardise the continuity of the current prudent economic policy. In that context, although companies currently benefit from stronger cash positions, with interest rates and the level of the real still high, they have been putting more pressure on their suppliers, which could lead to longer payment times. Moreover, some export sectors contending with competition exacerbated by the real's strength have been having difficulties.
In Colombia (rated B), President Alvaro Uribe won re-election end May this year, which implies continuation of the orthodox economic policy previously followed. However, the country's institutional weaknesses and climate of insecurity are likely to persist. Growth should sag only slightly this year. Consumption and investment should continue to be the main economic drivers with exports making a more modest contribution due notably to the downward oil production trend and pending implementation of the free-trade agreement with the United States early 2007. Although still high, external debt ratios have improved substantially with extensive fiscal reforms remaining necessary to consolidate public sector finances and reduce the high level of public debt. In that context, payment experience should remain satisfactory with companies meeting their payment obligations on time.
In Peru (rated B), the election as president in early June of former president Alan Garcia (centre-left) should result in pursuit of relatively prudent economic policy. Economic growth should remain robust, buoyed by both domestic demand and dynamic exports. Government authorities have been pursuing prudent fiscal policy with IMF backing and the country should cover its financing needs without difficulty. External debt ratios have been improving with Peru repaying its debt to Paris Club creditors ahead of schedule in 2005 and the country's ample foreign currency reserves limiting liquidity crisis risk. The country has nonetheless remained vulnerable to a crisis of confidence in financial markets or a downturn of world raw material prices with the banking system still weakened by extensive dollarisation.
In Argentina (rated C), economic activity should remain robust due notably to the stimulatory policy pursued by government authorities, but inflationary pressures have been increasing. Foreign trade dynamism, attributable to strong world demand for commodities and an undervalued exchange rate, has contributed to maintaining current account surpluses. Furthermore, the June 2005 rescheduling of Argentina's bond debt in default allowed it to replenish its currency reserves and repay the IMF in full and ahead of schedule early this year. The public sector financial trend has nonetheless remained inconsistent with external debt ratios high and the banking sector weak. Meanwhile, the prospect of a presidential election in October 2007 and the fact that the country no longer needs to rely on the IMF hardly seems conducive to progress on reforms, thus tending to undermine investment. In that context, export-oriented companies have been enjoying better financial health than have companies operating solely in the domestic market. Meanwhile, the volatility and uncertainties linked to the legal and judicial framework have persisted.

► The regional risk index for North Africa and the Near & Middle East deteriorated (up 2.3%) due mainly to the removal of Turkey's rating from positive watchlist status and the negative watchlisting of Jordan's rating. The oil economies, however, have continued to benefit from extremely favourable economic conditions for the fourth straight year. The other regional countries, which export little or no oil, have generally benefited from an upward FDI trend with some also benefiting from the petrodollars of Gulf monarchies. Geopolitical tensions, however, continued to affect risks. They continue to be the main risk factors despite the relatively calm interlude in the Iranian nuclear crisis.

After virtually doubling in two years (rising from $28.8 in 2003 to $54.5 in 2005), Brent barrel prices are still trending up with the average price per barrel reaching $65 end May — 20% above the 2005 average. Despite downward revisions of demand growth forecasts, a significant price drop will be very unlikely in the near term considering the persistence of political, technical, and weather factors of tension affecting prices and the limited margins of production available. In that context, the influx of revenues has allowed oil-exporting countries to bolster their financial situations while reducing their debt burdens (Algeria, Saudi Arabia), or financing major infrastructure programmes (as in Algeria), and/or revenue redistribution (Iran).
But the oil cash also spurred an exuberant upswing in regional stock markets these past years followed by sharp corrections since February this year whose economic impact should nonetheless remain limited in oil countries. Those corrections were inevitable since the stock markets were overvalued with price earnings ratios reaching unrealistic levels, particularly in Saudi Arabia. Although salutary, that adjustment could nonetheless hurt small investors forced to sell at a loss as well as banks that extended stock purchase loans and whose assets could deteriorate in quality when those loans fail to perform.
After tensions escalated in the first five months this year over the Iranian nuclear issue, the situation has been relatively calm since the United States expressed a willingness to negotiate directly with Iran. In those conditions, a policy of small steps and hedging will remain the most likely scenario.
Meanwhile, tensions between Fatah and Hamas in the Palestinian Territories have raised the spectre of civil war.

Two regional countries seem weakened by the crisis of confidence affecting emerging countries:
In Turkey (rated B, removed from positive watchlist status) the outlook has been more uncertain due to the lira's collapse in May this year and the interest rate hikes decided by the Central Bank. Economic growth should thus slow substantially in the second half. The lira's collapse (down over 16%) has penalised importers and foreign-currency borrowers. The substantial interest rate increase decided by Central Bank (from 13.25% to 15%) to stem inflation and reassure the markets will be particularly likely to undermine domestic demand, which has been driving growth until now. The lira's continued decline would primarily affect a private sector whose debt burden has increased. As a result of restrictive fiscal and monetary policies and radical restructuring of the banking sector, the government and banks are much more solid than they were during the 1994 or 2001 crises.
Jordan's B rating has negative watchlist status. Despite growth ranking among the most solid in the region buoyed by its role as rear base for Iraq and by the influx of regional capital, rising oil prices and the reduction of foreign aid have aggravated internal and domestic imbalances. The balance of payments will be vulnerable to a crisis of investor confidence, which would render dinar's dollar peg unsustainable. The country should nonetheless be able to rely on international aid to avoid a major crisis. With its geographic position and the composition of its population (mainly with Palestinian roots), the political scene and the economy have been very vulnerable to regional geopolitical tensions.

The ratings of the other regional countries have not changed.

Saudi Arabia (rated A4) has posted very good economic performance and the country's financial situation has strengthened markedly. With its solid external and fiscal account surpluses, the country has been able to significantly reduce public sector domestic debt, which declined from 100% of GDP in 2002 to 41% in 2005. In that context, the severe stock market corrections in February this year should have a moderate impact on economic growth. Although the regional instability and terrorist threats have had no apparent effect on the economy thus far, they have nonetheless constituted a risk-aggravating factor. They weigh on the reform programme and foreign investment and could ultimately destabilise the regime.

In Israel (rated A4), an improved climate of security, fiscal consolidation measures, and the resumption of privatisations have buoyed consumer and investor confidence. The growth of that open and diversified economy with its great potential will nonetheless remain sensitive to the climate of security and dependent on international economic conditions. In the domestic political arena, the new coalition has been shaky considering the challenges it faces (withdrawal from the West Bank, continuation of the fiscal consolidation) amid heightened social tensions. With Hamas in power in the Palestinian Territories, there will be little hope for resumption of the peace process in the near term. Moreover, the Iranian nuclear issue is perceived as a direct threat.

In Algeria (rated A4), the oil windfall has made it possible to finance a broad plan for stimulating economic growth through public spending, speed up repayment of foreign debt (which could drop to under 5% of GDP by year end), and accumulate foreign currency reserves. There are nonetheless still impediments to investment and emergence of a private sector (an outmoded banking sector, deficient public administration, corruption). Government authorities have undertaken reforms for which they enjoy substantial leeway thanks to the country's greater political stability and favourable oil market conditions. The reform process will take time, however, considering the many blocking factors (notably a shaky social climate, resistance to change, sinecures, clientelism, and corruption) that could durably impede their implementation.

In Egypt (rated B), reforms implemented since 2004 have rekindled consumer and investor confidence. The external financial situation has been good amid favourable trends on traditional sources of foreign currency earnings (oil, gas, tourism, emigrant worker remittances, and the Suez Canal), and increasing foreign direct investment, spurred by privatisations while debt service has been very limited. However, the fiscal situation has deteriorated due not only to a new presentation of the accounts but also to a rapid increase in spending (interest, subsidies, wages). The deficits should thus continue to widen, generating increasing debt. Consolidating public sector finances has become imperative. However, the need to strengthen the electoral support for the party in power (NDP) and thereby check the growth of Islamism could undermine the authorities' ability to keep spending under control.

In the absence of stiff sanctions linked to the nuclear issue, the economic situation of Iran (rated B) has continued to improve with high oil prices making it possible to stimulate growth via public spending and consolidate the external financial situation with the country's foreign debt remaining at moderate levels. Expansionary fiscal policy, intensified since President Ahmadinejad's election, has limited the public sector's financial surpluses despite booming oil prices. That policy has exacerbated the economy's vulnerability to a decline in barrel prices, has been coupled with high inflation, and has limited the accumulation of reserves in the Oil Stabilisation Fund.

The regional risk index for sub-Saharan Africa, the region that has continued to register the highest level of risk, deteriorated very slightly due to Chad's downgrade from C to D.

Sub-Saharan African countries have benefited from favourable economic conditions, linked to the level of world prices for mineral raw materials as well as to implementation of more disciplined economic policies associated with major investment programmes facilitated by debt cancellations obtained and expected under the HIPC programme for highly indebted poor countries and the MDRI (an initiative involving cancellation multilateral debt).
Although the increase in foreign currency earnings registered by oil exporting countries has allowed some of them to reduce imbalances in their public sector accounts, it has also made it possible to run external account surpluses and thus to reduce debt. Imbalances have persisted in the accounts of the other countries, however, hampered by a narrow tax base, the population's persistent poverty, the extent of the grey economy, and the tax exemptions granted to some sectors. Their foreign exchange earnings (from exports, emigrant remittances, or tourism) have moreover not sufficed to offset the increases in capital goods imports and rising energy costs. Their financing needs have thus remained substantial and covering them will continue to depend on international aid.

Finally, despite overall improvement in the region's political stability, it is still politically shaky and many uncertainties could still undermine or even reverse the apparently encouraging outlook.

South Africa (rated A3) has been relatively vulnerable to market sentiment due to a widening current account deficit partly covered by volatile capital. The South African rand has thus lost over 12% of its value since early May and the stock market over 21%. The country's fundamentals have nonetheless remained sound. Restrictive economic policy, growing economic-actor confidence, and a diversified productive apparatus have underpinned robust growth. Both public sector and foreign debt have moreover been very moderate.

Chad's rating has been downgraded from C to D. Despite Chad's improved economic conditions and solvency indicators since the Doba oil fields went into production in 2003, the outlook has worsened. The country's political situation deteriorated sharply with rebel movements growing stronger by joining forces with President Deby's former allies and seeking to topple the regime. In that context, President Deby's re-election by a wide majority in May this year in a vote boycotted by the opposition does not represent a significant firming up of the political situation. Meanwhile, the country's relations with financial backers deteriorated with government authorities calling into question the oil-resources management arrangement set up by the World Bank as a condition for its support, and thereby that of foreign investors. It is not sure that the provisional compromise concluded in April will restore relations of confidence on a durable basis.