Q&A: What Are The Risks Ahead For European Sovereign Ratings In 2014?

Primary Credit Analyst: Moritz Kraemer, Frankfurt (49) 69-33-999-249; moritz.kraemer@standardandpoors.com Secondary Credit Analysts: Frank Gill, London (44) 20-7176-7129; frank.gill@standardandpoors.com Marko Mrsnik, Madrid (34) 91-389-6953; marko.mrsnik@standardandpoors.com Kyran A Curry, London (44) 020-7176-7845; kyran.curry@standardandpoors.com Elliot Hentov, PhD, London (44) 207-176-7071; elliot.hentov@standardandpoors.com

Table Of Contents
Questions And Answers Appendix Related Research

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Q&A: What Are The Risks Ahead For European Sovereign Ratings In 2014?
Some signs are emerging that the eurozone (European Economic and Monetary Union or EMU) is starting to overcome the economic, financial, and budgetary stress that it has endured in recent years. Rising exports are leading to a rebalancing of debtor economies in the eurozone. Standard & Poor's Ratings Services thinks this year could also see the return of some so-called "program countries" (EMU member states that have benefited from official financial support), such as Ireland and Portugal, to more substantial primary issuance in the capital markets. However, with the improvement in capital market conditions, the risks of complacency could be on the rise. While most of the outlooks on the sovereign ratings in the eurozone are stable, three are negative (see table 1 at the end of this article). Here, Standard & Poor's responds to questions that we've received from investors regarding sovereign creditworthiness in Western Europe's advanced economies.

Questions And Answers

Will 2014 see more upgrades than downgrades since the crisis began?
In the light of our current rating outlooks, upgrades are unlikely to outnumber downgrades. While the rating outlook for European sovereigns has generally improved over the past year and gained more ground than any other region, it is, overall, still negative: Positive minus negative rating outlooks (and CreditWatch placements) as a share of rated sovereigns improved to -20% on Dec. 31, 2013, from -39% a year earlier. Globally, the outlook balance stood at -18% on Dec. 31, 2013, versus -25% a year earlier. Therefore, the trend for European sovereign rating actions is likely to be similar to the global trend in 2014, in contrast to the more negative trend for the region in preceding years (see "Global Sovereign Credit Trends: Downgrades Are Likely To Outnumber Upgrades Again In 2014," published on Dec. 17, 2013, on RatingsDirect). Standard & Poor's rating outlooks indicate our view of the potential direction of a long-term credit rating, typically over six months to two years for "investment-grade" ratings ('BBB-' and higher) and six months to one year for "speculative-grade" ratings ('BB+' and lower). A positive or negative outlook indicates our view of at least a one-in-three likelihood of a rating change in the indicated direction. For a list of our sovereign ratings and outlooks, see "Sovereign Ratings And Country T&C Assessments," last published on Jan. 17, 2014. Based on the data and on overall trends, therefore, we expect the number of sovereign downgrades to exceed upgrades.

Is the eurozone crisis coming to an end?

We believe the eurozone will continue with its slow recovery in 2014, which high-frequency indicators appear to confirm. In a sign of increasing stability, government bond yields have declined to where they were before the financial crisis struck in 2009. Economic activity in the eurozone has stopped shrinking, but is still 2% below precrisis levels, on average, and about 8% below for most countries on the eurozone's so-called periphery (see "The Eurozone Crisis Isn't Over Yet," published Oct. 1, 2013). While most of our sovereign rating outlooks in the eurozone are stable (negative outlooks remain only on the ratings of

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Belgium, Italy, and Portugal), we nevertheless believe it is premature to declare that the eurozone's troubles are over. Unemployment is averaging 12%, (double that in some countries and double again for youths), which in our view is stretching the social fabric. There is a risk of adjustment fatigue: With more favorable conditions in the capital markets in recent months and the increasing impatience of voters, governments could become complacent, and may be tempted to retreat from structural reforms conducive to the eurozone's growth potential, which is currently low. At the same time, we see increased signs of disinflation--and in some cases deflation--across the eurozone. While they are partly evidence of improving competitiveness, these disinflationary trends could threaten private and public sector debt-servicing capacity, if left unchecked. What's more, leverage in the eurozone hasn't yet declined meaningfully, in our view, and the combined share of private and public debt to GDP remains near or above precrisis levels, partly because economies shrank during that time. That said, sovereign creditworthiness hasn't dropped dramatically over the period. A decade ago, when Standard & Poor's began lowering the ratings of some members of the eurozone, the average GDP-weighted rating was 'AA+', compared with the current 'A+', a decline of three notches (on a scale of more than 20). In assessing sovereign creditworthiness during 2014, we will watch progress in economic rebalancing and deleveraging, as well as in overcoming financial fragmentation of the eurozone between core and periphery. We believe that, so far, the region has made little progress in weakening the links between sovereigns and vulnerable banks in their jurisdictions. Over the longer term, we believe that cuts in spending on productivity-enhancing public infrastructure in recent years may further exacerbate what we consider to be a subdued outlook for economic growth (see "Cracks Appear In Advanced Economies' Government Infrastructure Spending As Public Finances Weaken," Jan. 14, 2014).

How is economic rebalancing in the eurozone progressing?

All economies on the eurozone's periphery have, to various degrees, improved their competitiveness and export performance. And most of them are now displaying current account surpluses. But if pent-up import demand is released and if the euro appreciates further in line with the eurozone's overall swelling external surplus, the periphery economies may not be able to sustain the surpluses long enough to bring down their still-large external debt burdens. We think that economic rebalancing across the eurozone, including more robust demand from the monetary union's surplus countries, especially Germany, would go a long way toward resolving the debt crisis for good. Successful rebalancing of the eurozone is, we believe, in the joint interest of both debtor and creditor countries. Indications that wage increases in Germany (and the U.K.) are picking up suggest that these nations will export some modest additional demand to the periphery over the next several years. Creditor countries are also vulnerable, in our view, to the cross-border imbalances that led to the eurozone crisis. Their accumulation of external assets presents financial risks as well. Germany, for example, painfully experienced how this works when in 2010 the sovereign had to bail out domestic financial institutions after they took significant losses on foreign investments. The winding-up institutions ("bad banks") had initially raised Germany's officially recorded public debt by 9% of GDP at the time. But adding in other support for ailing financial institutions, the full debt impact was almost 13% of GDP, according to International Monetary Fund (IMF) estimates. That was surpassed only by The Netherlands (14%, another persistent surplus country), Greece (19%), and, of course, Ireland (40%) (according to the IMF Fiscal Monitor October 2013). Financial-sector contingent liabilities that have crystalized on the government's

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balance sheet in Germany and The Netherlands have topped the cost (relative to national GDP) that Spain has so far incurred in support of its own banks. Bank bailout costs for creditor countries rose despite mechanisms that delivered substantial sums of financial support benefitting creditor banks--ranging from the European Financial Stability Facility (EFSF) and European Stability Mechanism (ESM) to the Eurosystem's Target 2 payment system--which have arguably reduced losses for European financial institutions in the eurozone core (see "The Eurozone's Long, Unwinding Road," published Dec. 3, 2013).

Will the economic recovery in the U.K. last?

For now, we expect U.K. public finances to benefit from improving economic prospects. We project that GDP will accelerate toward 2.6% on average over 2014-2016. Combined with further expenditure-led fiscal consolidation, a multiyear recovery ought to benefit the U.K. government's cyclical budgetary position, enabling the Treasury to put public debt on a downward path starting in 2016. In our opinion, several other factors support the U.K.'s creditworthiness, including the pound's global reserve currency status and the substantial monetary flexibility this provides, as well as the economy's resilience, reflecting liberalized labor and product markets. In the longer term, however, we are less sanguine about the sustainability of the U.K.'s recent economic dynamism. Our negative outlook on the U.K.'s 'AAA' rating speaks to the risks we see to the sustainability of this economic expansion. The largest contributor to the U.K.'s recovery has come from private consumption, fueled by declining household savings rather than rising real wages or productivity. Missing from the recovery to date has been a broader pickup in fixed nonresidential investment, particularly in the tradables sector. Meanwhile, subdued net exports are a continued drag on output, not least because of weak external demand in key European trading partners. As a consequence, the U.K.'s current account deficit widened to nearly 4% of GDP on average during 2012 and 2013. These net external deficits have, however, increasingly been funded by high net inflows of foreign direct investment, rather than by debt. But questions remain about the longer-term sustainability of an economic recovery predicated on further declines in already low savings rates. To be sure, these are early days in the U.K.'s recovery. Credit growth remains weak as banks aim to strengthen capitalization. Annual household credit growth remained below 1% throughout 2013, while lending to private nonfinancial corporations has continued to contract. Therefore, a normalization of credit conditions, particularly for the corporate sector, could make an important contribution to a broader improvement in the U.K.'s economic growth prospects.

Why is Italy's rating outlook still negative?

The negative outlook on Italy's 'BBB' rating indicates that we are still uncertain whether the economic and policy trends we are seeing will hold. Despite some evidence of an incipient economic recovery and easing fiscal headwinds, we expect that weak demand for labor, combined with tight credit conditions, will limit average Italy's GDP growth to 0.5% per year between 2014 and 2016. That would imply that even by 2016, Italian economic output would remain nearly 7% below 2007 levels. Against a backdrop of disinflationary conditions--reflecting limited monetary flexibility--we also see constrained growth in nominal GDP. Such uncertain real and nominal economic prospects continue to raise questions about Italy's public debt trajectory.

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Q&A: What Are The Risks Ahead For European Sovereign Ratings In 2014?

We expect gross general government debt to rise to 134% of GDP by the end of 2014. Our view is that key policy decisions this year may have an important bearing on economic performance, and therefore public finances. Should the current governing coalition implement growth-enhancing structural reforms, especially labor reforms, Italy's potential growth rate could improve. This might reduce the fragmentation of Italy's labor market and decentralize wage setting, promoting flexibility and employment. Improved governance could also go a long way toward reducing debt. We believe that decades-long governance issues have contributed to Italy's very high net general government debt ratio, which in 2013 was the fourth-highest among the 128 sovereigns that Standard & Poor's rates, surpassed only by Japan, Jamaica, and Greece. The governing coalition is aiming to build a cross-party consensus backing a new electoral law (as well as the adoption of a more unicameral parliamentary system), after the Italian Constitutional Court declared the 2005 electoral system to be unconstitutional. Without a new electoral regime, the next round of elections would be held under a highly proportional system, which could imply more fragmented coalitions and potentially weak policy delivery. Our last release on Italy stated that we could lower the rating if, in particular, we conclude that the government cannot implement policies that would help to restore growth and keep public debt indicators from deteriorating beyond our current expectations. We also stated that sustained delays in effectively addressing some of the rigidities in Italy's labor, services, and product markets--which we believe have been holding back growth--could contribute to a downgrade. On the other hand, we could revise the outlook to stable if the government implements structural reforms to the labor, product, and service markets that shift the Italian economy to a higher level of growth (for details see "Ratings On Italy Affirmed At 'BBB/A-2'; Outlook Remains Negative," published on Dec. 13, 2013).

What effect will Slovenia's plan to recapitalize its banks have on the ratings?
The fiscal impact of the Slovenian government's decision to provide up to 4.8 billion to recapitalize its banking system has no immediate effect on the 'A-' long-term ratings and stable outlook. The recapitalization costs are broadly consistent with the estimates in our base-case scenario of the provisioning the banking system will need to maintain an adequate level of capital at the end of 2015. We expect that Slovenia's net general government debt will stabilize at about 71% of GDP during 2014-2016, excluding the guarantees related to the EFSF. The borrowings to fund the recapitalizations will crystallize some contingent liabilities on Slovenia's balance sheet into government debt, thereby reducing the sovereign's total contingent liabilities. Although Slovenian private companies borrow from domestic banks at higher rates than in core eurozone states, the banks have access to the European Central Bank (ECB) as an important liquidity support. It is our understanding that Slovenian banks have ample unencumbered collateral (including from government injections of recapitalization bonds) to access ECB facilities if needed. The stable outlook balances our expectations that fiscal consolidation and restructuring of the banking system will move forward, against the risks associated with the government's rising debt burden and the country's weak growth prospects.

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Q&A: What Are The Risks Ahead For European Sovereign Ratings In 2014?

What is the ratings impact arising from Germany's grand coalition?

We do not expect any major credit impact, as our stable outlook on Germany's 'AAA' rating reflects. On the whole, we believe that Germany is likely to maintain its current policies on all major issues, for example, in its approach to the eurozone crisis or fiscal policy. A grand coalition could provide Germany more political cover to extend support to other eurozone states, but we nevertheless expect measures to be more superficial than substantive. We believe it remains highly unlikely that Germany would change its skeptical view toward Eurobonds or other types of mutualization (or sharing the risk) of financial obligations. We believe that the recent rally in periphery government bonds has further reduced the perceived urgency of that issue for Berlin. Also unchanged is Germany's fiscal goal of structurally balanced budgets. We expect that general government budgets on average should be close to balance in 2014-2016, with support from steady, if unspectacular, economic growth. However, the continued absence of any major investment initiatives in education, research, infrastructure, or energy might constrain long-term growth potential, in our view. Germany's public gross fixed capital formation ratio remains among the lowest in the EU. Labor market policy is perhaps the area of most significant change, with the introduction of an 8.50 minimum wage starting in January 2015 for workers not covered by collective agreements. We see a muted macroeconomic impact because we understand that the new level is not far above current wages for lower-skilled workers in most regions. But the increase might have repercussions in the next round of industrial wage negotiations. Together with the agreed upward adjustments of some pensions, domestic demand should increase modestly and help lower current account surpluses to 4.4% by 2016, down from 7% in 2012.

What is the likely impact of France's fiscal reform efforts?

The government of France (AA/Stable/A-1+) has in our view displayed its commitment to keeping budgetary consolidation on track despite scaling back its deficit reduction strategy. It has also been intent on improving the economic competitiveness of French companies. In this vein, the government is reducing the relatively high corporate tax burden--via tax credits in 2013 to be financed by higher intake of a restructured value-added tax and suspension of the environmental tax for 2014--and has introduced measures as a part of the national pact for growth, competitiveness, and employment. In January 2014, President Hollande announced further payroll tax relief for corporations amounting to an additional 30 billion. The 2013 agreement on labor market reform introduces some flexibility regarding potential adjustments in wages or working hours during a downturn, easier dismissal procedures, and faster administrative processes. While implementation risks remain, we see these efforts as a good starting point for further reducing labor market rigidities. On the other hand, the government has made little progress in reforming the product and services markets, which could help restore competitiveness broadly across several sectors of the economy. The government is taking a gradual approach to reform, in our view, partly because the economy is weak and unemployment is relatively high--by France's own historical standards. In our opinion, the economic policies the government has legislated have not significantly reduced the chances that unemployment will remain above 10% until 2016, compared with an average of 8%-9% prior to 2012. And stubbornly high unemployment is weakening support for further fiscal and market reforms, and is depressing longer-term growth prospects. This year's local and European

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elections will test the policy-making capacity of the government to pursue its reform agenda. The commitment to budgetary consolidation by various governments over the years has relied on increasing an already-high tax burden. We estimate that France's general government revenue will remain at more than 53% of GDP through to 2015, the highest ratio of any OECD member outside of some in the Nordic region. We project that general government spending by France will stay above 56% of GDP over the same period, surpassing only Denmark in the OECD. We understand that the government aims to reduce government spending, but we believe that the effect of the government's measures to this end will be relatively modest.

Has Spain's sovereign creditworthiness stabilized?

We believe that the risks to Spain's economy have indeed become more balanced, which is why in November 2013 we revised the outlook on the sovereign rating to stable. Spain has been undergoing a significant structural adjustment, with the government implementing a series of fiscal, banking, and structural reforms, contributing to an exit in January 2014 from an ESM program in support of the national banking system. We forecast real GDP growth of about 1% in 2014 and 2015, chiefly on the back of robust exports, resulting from the reorientation of the Spanish economy toward external demand and improving price competitiveness. We expect the current account surplus of about 1.4% of GDP in 2013 to rise to an estimated 3% of GDP in 2015-2016, after a deficit of almost 10% of GDP as recently as 2008. Sustained improvement in the external balance is a positive development, because it should lead to a reduction of Spain's still high external debt. On the other hand, domestic demand is weak and constrained by further declines in disposable income arising from very high unemployment, lower wages, higher energy prices, and strong fiscal headwinds. In addition, investment activity remains subdued because the private sector is deleveraging and credit conditions remain very tight. As a result, ahead of the 2015 regional and general elections, reform fatigue may be on the rise. This is of particular importance for the government's budget position, which still shows high deficits of about 7% of GDP in 2013 that we believe should decline to 5.8% this year. The government aims to underpin its ambitious budget deficit targets in 2015 and 2016 of 4.2% and 3% of GDP with the planned reform of public administration and the tax system, especially because the tax-rich components of economic growth will unlikely be enough to meet this aim. We also believe that tensions between the central and regional government of Catalonia will persist, which could make policy choices less predictable. Moreover, we will observe whether the government makes progress on addressing the still highly segmented labor market.

Why is the outlook on Portugal's rating still negative?

We see ongoing social and political risks associated with deleveraging efforts by Portugal's highly indebted private and public sectors, as well as financing uncertainties related to the country's exit from the EU/IMF program in May 2014. We could lower the ratings if factors affecting Portugal's government debt sustainability markedly worsen due to growth that is lower than we expect, slippage in the primary fiscal balance, or the materialization of contingent liabilities. Despite potential constitutional and political impediments, Portugal should achieve its fiscal targets of 5.5% of GDP in 2013 and approach its 4.0% target in 2014. We base this expectation partly on indications that the economy has been showing signs of stabilization since mid-2013, after 10 consecutive quarters of contraction. Export performance that is

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stronger than we expect, and an expected bottoming-out of private consumption, amid a modest decline in unemployment, should support Portugal's fiscal performance in 2014. Portugal's economic outlook continues to depend on competitiveness and external demand for Portuguese goods and services, in our opinion. Domestic demand components are likely to remain subdued as both the private and public sectors continue efforts to reduce high debt burdens. The Portuguese central bank estimates nonfinancial private sector debt at 284% of GDP in September 2013, marginally down from the peak in December 2012 (287%). Under our current growth and deficit assumptions, we expect Portugal's net general government debt to peak in 2014 at about 122% of GDP, and to decline only gradually to below 120% by 2016. We expect the government's gross financing requirement (including short-term debt) for 2014 to be 45.5 billion (28% of GDP), of which 7.9 billion will likely be provided by the EFSF, ESM, and IMF. Constitutional Court rulings have added further uncertainty by forcing the government to adjust elements of its fiscal consolidation plan for both 2013 and 2014. We believe external financing risks remain a key ratings constraint for Portugal, despite a turnaround in its current account that was faster than we expected. We estimate external debt, net of liquid assets, at about 300% of current account receipts (CARs) at the end of 2013. Public sector external financing has been almost entirely met by official lending over the past few years, but is likely to move toward market funding during 2014 as Portugal exits its EU/IMF program. Portugal's large banks will also likely try to increase their borrowing in the international capital markets. Banco de Portugal's Target 2 balances with the Eurosystem have remained almost unchanged (about 40% of GDP) since the ECB's announcement of Outright Monetary Transactions, while other central banks on the periphery of the eurozone have been able to markedly reduce their balances. However, we view both public and private sector access to the markets as vulnerable to domestic shocks and to an external downturn. Portugal's creditworthiness appears to us, therefore, to continue to depend on the support and flexibility of its official creditors. Under our current baseline assumptions, we forecast that the government will exit its EU/IMF program in mid-2014, perhaps with a contingent line of credit provided by the ESM.

Appendix
Table 1

Selected European Sovereign Ratings As Of Jan. 17, 2014

Country Austria Belgium Cyprus Estonia Finland France Germany Greece Ireland Italy Long-term foreign currency rating Outlook AA+/Stable/A-1+ AA/Negative/A-1+ B-/Stable/B AA-/Stable/A-1+ AAA/Stable/A-1+ AA/Stable/A-1+ AAA/Stable/A-1+ B-/Stable/B BBB+/Positive/A-2 BBB/Negative/A-2 Stable Negative Stable Stable Stable Stable Stable Stable Positive Negative

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Table 1

Selected European Sovereign Ratings As Of Jan. 17, 2014 (cont.)

Latvia Luxembourg Malta Netherlands Portugal Slovak Republic Slovenia Spain BBB+/Positive/A-2 AAA/Stable/A-1+ BBB+/Stable/A-2 AA+/Stable/A-1+ BB/Negative/B A/Stable/A-1 A-/Stable/A-2 BBB-/Stable/A-3 Positive Stable Stable Stable Negative Stable Stable Stable

Standard & Poor's Ratings Services Rating Actions are determined by Ratings Committee. This commentary has not been determined by Rating Committee. The opinions expressed in this article do not represent a change to or affirmation of Standard & Poor's ratings Services' opinion of the creditworthiness of any entity or the likely direction of ratings.

Related Research
Commentaries
Sovereign Ratings And Country T&C Assessments, last published on Jan. 17, 2014 Cracks Appear In Advanced Economies' Government Infrastructure Spending As Public Finances Weaken, Jan. 14, 2014 Global Sovereign Credit Trends: Downgrades Are Likely To Outnumber Upgrades Again In 2014, Dec. 17, 2013 Ratings On Italy Affirmed At 'BBB/A-2'; Outlook Remains Negative, Dec. 13, 2013 Sovereign Risk Indicators, Dec. 13, 2013 These Green Shoots Will Need A Lot Of Watering, Dec. 12, 2013 Credit Conditions: Europe Sees A Slight Improvement, But Structural Weaknesses Persist, Dec. 9, 2013 The Eurozone's Long, Unwinding Road, Dec. 3, 2013 The Eurozone Crisis Isn't Over Yet, Oct. 1, 2013 An Expected Grand Coalition For Germany Has No Direct Impact On Sovereign Ratings In The Eurozone, Sept. 23, 2013 Is Austerity Being Relaxed In The Eurozone And Does It Matter For Ratings? June 4, 2013 Default Study: Sovereign Defaults And Rating Transition Data, 2012 Update, March 29, 2013 Outlooks: The Sovereign Credit Weathervane, Year-End 2012 Update, Jan. 18, 2013

Rating actions
Portugal 'BB/B' Ratings Affirmed; Outlook Negative On Policy Uncertainty, Jan. 17, 2014 Slovenia Ratings Affirmed At 'A-/A-2'; Outlook Stable, Jan. 17, 2014 Germany 'AAA/A-1+' Ratings Affirmed On Steady Growth Prospects; Outlook Stable, Jan. 10, 2014 United Kingdom 'AAA/A-1+' Ratings Affirmed; Outlook Remains Negative, Dec. 20, 2013 Outlook On Spain Revised To Stable From Negative On Economic Rebalancing; 'BBB-/A-3' Ratings Affirmed, Nov. 29, 2013 France Long-Term Ratings Lowered To 'AA' On Weak Economic Growth Prospects And Fiscal Policy Constraints; Outlook Stable, Nov. 8, 2013

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Additional Contact: SovereignEurope; SovereignEurope@standardandpoors.com

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