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Monday, March 30, 2009

Moody's Cuts Slovakia's Outlook

by Edward Hugh: Barcelona

Now here's an interesting story. Slovakia has just joined the eurozone, a status most of the rest of the EU's East European members would badly like to attain. But just to remind us that joining the zone, while offering considerable support and protection in times of trouble, is no panacea, Moody's Investors Service have last Friday cut their outlook on Slovakia’s government bonds rating (to stable from positive, implying their is no likelihood of an upgrade in the near future, a possibility which was implicit in the earlier positive outlook).

Moody's justify their decision on the grounds that future investment in Slovakia is at risk due to a combination of factors: the recession in the euro-region, the country’s dependence on the car industry and its falling competitiveness compared with other eastern European nations, many of whose currencies have fallen sharply during the crisis. In fact the Slovak Finance Ministry forecast only last Friday that foreign direct investment into Slovakia will be much lower this year than originally expected - with the Minister stating he expected a decline in FDI to 0.6 percent of gross domestic product in 2009, compared with a 2.7 percent forecast before the economic and financial crisis hit the country.

The worrying thing for me about all this, is not the immediate short term pressure which Slovakia will undoubtedly be under due to the regional crisis, but rather the loss of competitiveness issue, becuase it is ringing bells in my head about what previously happened in the case of Portugal (see my lengthy post on this here). The danger is that eurozone membership gets to be seen as a target you strive to achieve, and then relax into once it has been attained. The Southern Europe experience generally is not encouraging in this regard, and as they are finding out now, the hardest work begins after adopting the euro, since there is no currency left to devalue should loss of competitiveness prove severe.

So I really do wish Jean Claude Trichet would exercise some of that famous "vigilance" on what to do about this issue too, since the long term future of the currency zone undoubtedly depends on getting this one right.

In fact investors are already positioning themselves for a future weakening in the country's creditworthiness. Slovak five-year credit default swaps have been falling back recently, after hitting an all time high of 133.1 earlier in the month, according to CMA Datavision prices. (A basis point on a credit-default swap contract protecting 10 million euros of debt from default for five years is equivalent to 1,000 euros a year).

But the spread on Slovak government bonds has also been rising (see chart below), and the spread with the 10 year government bond vis a vis the German equivalent was 136.7 on Friday. The chart presents a pretty preoccupying picture, since while bond spreads have all been under pressure since the onset of last October's crisis, it is unusual to see investors perceiving credit risk rising in a country which has only just joined the "gold-digger" club. And Friday's warning shot from Moody's needs to be understood in this context.

The country has seen a huge increase in its car manufacturing capacity in recent years, fueling double-digit economic growth in the quarters before the financial crisis, but amid waning western European demand for Slovak-made cars - including brands Volkswagen, Audi and Peugeot - the country now faces a stalling economy and rising unemployment. Slovak unemployment data for February showed the jobless rate reaching its highest level in more than two years, rising to 9.7% from 9% in January.

Over 75% of the country's EUR332 million stimulus has now been spent, largely giving tax breaks to low-wage earners to encourage them to reenter the work force, and with a fiscal deficit ceiling of 3% of GDP to defend, spending cuts rather than stimulus cannot be ruled out, since VAT returns are falling fast.

So while Slovakia's total public debt only equals around 30% of GDP, pressure on the spread could increase if the country is forced to increase its borrowing. Slovakia only expects to need EUR 5 billion in borrowing this year, and EUR 2.5 billion has already been secured in the first few months of the year.

Strong Economic Slowdown Underway

The Slovak economy slowed further in the fourth quarter of last year with real GDP growing by 2.5 percent year on year. Whole year GDP for 2008 was 6.4 percent with total GDP reaching €67.33 billion. Economic growth had been 6.6 percent in the third quarter, and while there is no official data for seasonally adjusted quarter on quarter growth, I estimate the economy may well have contracted by around 1.5%.

Part of the problem is the drop in export demand for Slovakia's car driven economy, and the country posted a trade deficit in January, as drop in demand was made worse by the suspension of gas deliveries from Russia. Exports slumped 29.9 percent on the year in January, the fourth consecutive monthly decline, and the biggest drop at least since 2006 when the statistics office began compiling data under the current methodology. Imports were down 22.4 percent.

The trade deficit totalled 279.5 million euros ($361 million), following a revised deficit of 341.6 million euros in December. Slovakia posted a trade surplus of 42.3 million euros in January 2008.

The drop in the demand for exports has obviously hit industrial production which decreased by 27 % year-on-year in January reach the biggest drop since the statistics office began compiling data in 1999. Manufacturing output fell 32,7 %.

Construction output was also down sharply in January, falling by 25.6% year on year, although seasonal factors can obviously be playing a part here.

Slovak retail sales fell by 3.3% year on year and totalled €1.3bn in January 2009. The largest contributing factor to this overall decrease was from the category of ‘other household goods in specialised shops’ retail which dropped by 24%. In addition sales of fuels ‘in specialised shops’ retail (15.6%) and the category of ‘retail sales realised not in stores’ (4.8%) experienced significant drops. Retail sales of electronics fell sharply (42.5%), and drops were also witnessed in the categories of: ‘food in specialised shops’ (15.8%); recreation and entertainment (12.7%); other goods in specialised shops retail (5.9%); and retail in non-specialised shops (4.5%).

Worry Now, So As Not To Pay The Price Later

In the short term the Moody's decsion really doesn't mean that much, since Slovakia only had 28.6% (of GDP) in gross debt in 2008, but it is the mid and longer term dynamic we need to think about. Slovakia is about to issue a 2-year zero-coupon bond for an unspecified amount today, but the government debt agency is unlikely to have problems. However, as we have already seen in the cases of Ireland, Greece, Portugal and Spain, simply becoming a member of the eurozone is not a guarantee of anything in economic performance terms (although it does provide almost automatic protection from short term balance of payments crises). So it is important that Slovakia takes the appropriate measures to restore competitiveness now, otherwise we could see the horrifying spectacle of the eurozone's newest member steadily moving over to stand alongside countries like Greece, hovering around near the exit door, struggling desperately to avoid being rocketed out.