Latvia vs Turkey Rating Comparison

Moody’s just affirmed that their existing Baa3, i.e. investment grade, rating on Latvia already incorporates their perception of the “moderate devaluation risk” in Latvia. S&P and Fitch have both recently removed Latvia’s investment grade rating, rating it BB+ at present, and S&P even have it on negative creditwatch.

Rating agencies in general never seek to amaze me.

Take Latvia’s Baa3 rating. This puts Latvia 3 notches ahead of Turkey, which is rating Ba3/BB-. With the market pricing Latvia 5Y CDS at ~ 700bps, and Turkey at ~ 255bps, someone is clearly wrong.

Reviewing the two’s credit fundamentals, in my mind Turkey massively outscores Latvia, and I would certainly be on the side of the market in terms of pricing the two credits.

First, the Turkish lira floats, and indeed has “benefitted” from a marked nomination depreciation since last October, which have produced a ~15% real effective devaluation over this period, providing something of a soft landing for the economy. Latvia’s fixed exchange rate is a key Achilles heal in the current market environment, and indeed in real effective terms the currency has actually appreciated since last October – given currencies around it have devalued.

Second, Turkey’s flexible exchange rate regime is being reflected in the real economy impact, relative to Latvia. Thus while real GDP is expected to contract by 4-5% in 2009 in Turkey, possibly returning to growth in 2010, Latvia is expected to post a 15-20% real GDP contraction in 2009, and we simply cannot see where growth is going to come from beyond that.

Third, the weak growth outlook is massively undermining Latvia’s fiscal position, with the budget deficit ~ 10% of GDP in 2009, and likely to stay around this level in 2011. Turkey’s budget deficit has increased to ~ 6% this year (from US$15bn, with US$65bn in FX reserves (sub US$4bn for Latvia) this also means that Turkey’s net public sector debt/GDP ratio is at least ten percentage points below that of Latvia. Latvia’s PM, meanwhile, has indicated that if the IMF does not disburse the latest credit tranche by July the country is likely to be at risk of default. Remarkable, on the basis of this comment alone, then that Moody’s still keeps Latvia’s investment grade rating.

Fifth, Latvia’s current account has adjusted rapidly, moving from a deficit of ~20% of GDP in 2007, to a small surplus likely in 2009. Turkey has also though benefitted from a massive cut in its CAD, from 5-6% in 2008 to ~ 1-2% of GDP expected in 2009.

Sixth, Latvia is sitting on a huge stock of external debt, equivalent to around ~ 130% of GDP, compared to around 40% of GDP for Turkey. Servicing this debt obviously imposes a huge burden in terms of external financing reserves (see below).

Seventh, Latvia’s short term debt/FX reserve ratio stands at a hugely worrying 555%, versus only around 60% for Turkey.

Eighth, Latvia’s external financing needs/reserve ratio also stands at something over 600%, versus only around 160% for Turkey.

Ninth, Latvia is dependent on official financing to avoid a devaluation/default, while Turkey is still able to fund itself from the market. The IMF has though made it plain that it would lend to Turkey in time of need; lending that has been proven in the past.

Tenth, Turkey’s banking sector, while only 40% foreign owned (versus ~ 65% in Latvia), appears in much better shape than its Latvian counterpart. It is much better capitalised and profitable at present. It has not thrown credit down consumers throats at the pace which has occurred in Latvia, and given the more sedate pace of economic downturn in Turkey, NPLs are likely to be contained (probably to sub-10% through the current crisis, versus likely 20%+ in Latvia even without a devaluation). Turkish banks have, meanwhile, proven able to roll external liabilities relatively successfully through the current crisis.

Eleventh, EU support. Evidently the above ten risk factors clearly show Turkey’s credit fundamentals are light years away from those of Latvia, but evidently Moody’s must attach a very big subjective element into its rating in terms of likely EC/EU support, relative to Turkey, given Latvia’s EU membership versus Turkey’s candidate member status. This is the only way we can explain the 3 notch rating differential between the two credits. However, if this support manifests itself in providing a drip feed of official financing, to retain a fixed exchange rate regime, at the complete expense of the real economy in Latvia, its value has to be seriously questioned. The exchange rate peg in Latvia has been described as “key to Latvia’s economic stability” by various official creditors. How these officials can square “economic stability” with a likely 15-20% real GDP contraction this year, and possibly a peak to trough economic contraction of up to 30% is somewhat beyond us.

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