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May 6 (The following statement was released by the rating agency)
Fitch Ratings says some recovery in eurozone periphery sovereign ratings is possible in a benign scenario of economic recovery and declining debt ratios. Nevertheless, the agency is generally cautious about the medium-term outlook for the eurozone as many countries face a long period of convalescence and the risk of relapse.
Fitch has taken several positive rating actions on sovereigns in the eurozone periphery as the intensity of the crisis has eased and countries have started to repair damage to their creditworthiness. These include upgrades for Greece (May 2013) and Spain (April 2014); and positive changes in Outlooks (including Negative to Stable) for Ireland (November 2012), Cyprus, Italy and Portugal (all April 2014) and Slovenia (May 2014), as well as Belgium (January 2013).
Positive rating actions reflect an end to recessions, a move into current account surpluses, a narrowing in budget deficits, enhanced financing flexibility and market access, reduced tail risk of eurozone exits, structural reforms and gains in competitiveness, an easing in banking sector risks and reforms at the eurozone level.
Spreads on eurozone periphery government bonds have narrowed sharply since summer 2012. However, market spreads have been more volatile than our ratings through the crisis and, having 'overshot', had more ground to make up. For example, spreads on ten-year sovereign bonds peaked at over 1100bp for Ireland (the lowest Fitch rating was 'BBB+') and over 550bp for Spain (lowest 'BBB'), Italy ('BBB+') and Slovenia ('BBB+').
To the extent that Fitch has a different view on credit fundamentals from the market, as it has done at various stages of the eurozone crisis, it remains to be seen whether ratings are 'too low' or investors are not being adequately compensated for credit risk. Fitch's ratings are purely a measure of the relative rank ordering of credit risk, while current low bond yields may also reflect weak growth prospects, low inflation, anticipated monetary policy easing, strong market liquidity and a search for yield in a low interest rate environment.
Cutting budget deficits and stabilising then reducing public debt ratios would be a key driver of rating upgrades. Our new report today highlights that even with favourable economic conditions and strong fiscal policy discipline this will be challenging. It explains other potential triggers including: sustained and balance economic recovery, structural reforms, a track record of secure market access, reducing net external and private debt ratios, lowering unemployment, strengthening banking systems, continuing eurozone level institutional reforms and avoiding political shocks.
Further upgrades of eurozone periphery sovereigns are possible in a scenario in which these triggers are met. However, ratings could stagnate or even decline if growth is weak and debt ratios flat-line or keep rising.
Fitch believes that Ireland, Portugal and Spain have the greatest medium-term potential, in a favourable scenario, for multi-notch rating recoveries as their ratings fell further in the crisis (7-8 notches) than Italy and Slovenia (4-5 notches) and they have suffered less severe damage and are less exposed to downside risks than Cyprus and Greece (which defaulted and are still in EU/IMF programmes). We do not envisage any sovereigns in the eurozone periphery recapturing pre-crisis rating levels in the foreseeable future. This reflects not only the long and difficult adjustment path ahead, but also the legacy of the crisis.
Some lessons can be drawn from the eurozone crisis. Pre-crisis credit fundamentals were not as robust as they originally appeared. Rates of GDP growth were unsustainably fuelled by credit growth and high capital inflows, budget balances were flattered by cyclical upswings, banking sectors were more risky than they appeared, access to market financing was more fragile, and there were design flaws in European Economic and Monetary Union. Moreover, Greece misreported its public finance figures.
Finally, our report also looks at historical precedents of how quickly countries recovered rating notches lost in crises. We looked at 10 Fitch-rated sovereigns countries ranging from Korea (1997) to Iceland (2007) that experienced downgrades of three or more notches within two years, followed by a recovery in ratings above the 'B' range. These countries saw an average downgrade of 5.9 notches, and recovered an average of 4.1 of those lost notches within five years of the start of the crisis (as measured by the year of the first downgrade) and 5.3 of them within ten years.
However, we also looked at how challenging it is for developed countries to achieve large sustained reductions in government debt ratios. Since 1970, there were only nine episodes of reductions in government debt/GDP ratios of at least 20pp over an eight year period. And these were in environments of stronger GDP growth than is likely in the eurozone today.
The report entitled 'Eurozone Periphery: Rating Recovery Potential' is available on www.fitchratings.com.
Link to Fitch Ratings' Report: Eurozone Periphery: Rating Recovery Potential