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MOODYS.COM
11 SEPTEMBER 2017
NEWS & ANALYSIS Hurricane Irma Credit Effects 2 » Primary Insurers Will Experience Significant Losses » Traditional Reinsurers Face Heavy Losses, Mitigated by
Increased Retrocessions » Florida Hurricane Catastrophe Fund's Reimbursement Cap
Insulates It from Severe Damage » Citizens Is Well Prepared and Assessment Revenue Provides
Additional Credit Protection » Southeast US Municipal Electric Utilities Are Financially and
Operationally Resilient
Corporates 13 » United Technologies’ Planned Acquisition of Rockwell Collins Is
Credit Negative » Breach of Equifax’s Cybersecurity Is Credit Negative » H.B. Fuller’s Planned Acquisition of Royal Adhesives & Sealants
Is Credit Negative » Nomad Foods’ Share Buyback Is Credit Negative » European Food Retailers Report Mixed Results Despite
Improving Economy » Schneider Merges Its Industrial Software Business with AVEVA,
a Credit Positive » China SCE’s Proposed Share Issuance Is Credit Positive » Korean Court’s Ruling on Kia Motors’ Wage Lawsuit Is
Credit Negative
Infrastructure 22 » China Cuts Natural Gas Prices; Negative for Pipeline Operators,
Positive for Gas Distributors » Australian Utilities Agree to Promote Electricity Price
Discounts, a Credit Negative
Banks 26 » Rate Changes Are Credit Negative for BNDES, but Positive for
Private Banks » German Retail Banks Face Challenges from Low Interest Rates,
a Credit Negative » Nordea’s Headquarters Relocation to Finland from Sweden Is
Credit Negative » Belfius Bank Issues Belgium’s First Senior Non-Preferred Bond,
a Credit Positive » Russia Central Bank’s Emergency Liquidity Facility Is Credit
Positive for Banks
» Uzbekistan’s Currency Devaluation Is Credit Negative for Banks with Foreign-Currency Exposures
Insurers 38 » Proposed Discount Rate Reforms Are Credit Positive for UK
Motor Insurers and Reinsurers
Exchanges 40 » Nasdaq’s Acquisition of eVestment Is Credit Negative
Sovereigns 42 » US Debt Ceiling Risks Linger Despite Prospect of a
Brief Suspension » Peru’s Planned Boost in Public Investment in 2018 Is
Credit Positive » Planned Catalan Independence Referendum Raises Tensions
with Spain’s Central Government, a Credit Negative » Uzbekistan’s Currency Depreciates 50% after Move to Floating
Rate, a Credit Negative for the Sovereign » Repeat of Kenyan Presidential Election Is Credit Negative » Extent of Credit-Negative Effect of War on South Korea Would
Depend on Magnitude
Sub-sovereigns 52 » Nordrhein-Westfalen’s Unexpected Deficit Will Delay Fiscal
Consolidation, a Credit Negative » Russian Regions’ Revenue Growth Helps Contain Debt Burdens,
a Credit Positive
RECENTLY IN CREDIT OUTLOOK
» Articles in the 4 September issue of Credit Outlook 55 » Go to the 4 September issue of Credit Outlook
Click here for Weekly Market Outlook, our sister publication containing Moody’s Analytics’ review of market activity, financial predictions, and the dates of upcoming economic releases.
NEWS & ANALYSIS Credit implications of current events
2 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017 8
Hurricane Irma Credit Effects Hurricane Irma made landfall in Florida Sunday morning after wreaking havoc in the Caribbean. The storm will continue to affect the Southeastern US through Wednesday, and although a complete accounting of the damage will take weeks, the loss of life and property and displacement of tens of thousands people has already been tragic.
We cover the credit effects of Irma on the following sectors and names:
» Homeowner, commercial and auto insurers, including Florida-only homeowner insurers and their reinsurers
» Traditional reinsurers
» Florida Hurricane Catastrophe Fund
» Citizens Property Insurance Corporation
» Municipal Electric Utilities
NEWS & ANALYSIS Credit implications of current events
3 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
Primary Insurers Will Experience Significant Losses Primary property and casualty insurers will incur significant losses as a result of Hurricane Irma, particularly from the homeowners, commercial property and auto physical damage lines of business. In particular, Florida-only insurers and their reinsurers will bear outsize losses, while large national primary insurers have considerable resources to withstand a significant event.
It will take weeks for insurers to have a reliable estimate of losses. Extensive flood damage in Texas from Hurricane Harvey could hamper the availability of claims-adjusting resources and further slow the claims process. Given the disasters, a sudden spike in demand for materials and labor (known as “demand surge”) will almost certainly increase losses from Harvey and Irma, and could push up rebuilding costs nationwide.
FLORIDA-ONLY INSURERS AND THEIR REINSURERS LIKELY WILL HAVE LARGE LOSSES
Florida-only insurers, which we define as insurance companies with at least 75% of their homeowners and commercial property premiums written in Florida, write more than 60% of the Florida homeowners market. These companies manage their significant Florida hurricane exposure through extensive property-catastrophe reinsurance coverage, exposing their claims-paying ability to counterparty credit risk from their reinsurers following a large storm.
Florida-only insurers face the risk of a significant deterioration of capital if Irma or future events significantly exceed their reinsurance limits. Exhibit 1 shows the 10 largest Florida-only insurers by premium for homeowner policies.
EXHIBIT 1
Top 10 Florida-Only Homeowners’ Insurers
Florida Direct Premiums Written
$ Millions
US Direct Premiums Written
$ Millions Premium Concentration
in Florida Surplus
$ Millions
Universal $781 $874 89% $314
Federated National $430 $466 92% $142
Citizens Property $429 $429 100% $7,402
Heritage & Zephyr $398 $466 86% $276
Homeowners Choice $322 $322 100% $183
Security First $294 $294 100% $71
Florida Peninsula $254 $254 100% $131
First Protective $245 $282 87% $62
People's Trust $244 $244 100% $52
St. Johns $227 $242 94% $52
Totals $3,624 $3,873 94% $8,684
Note: Florida-only insurers have at least 75% of their homeowners premiums in Florida. Sources: SNL Financial L.C. (contains copyrighted and trade secret materials distributed under license from SNL, for recipient’s internal use only) and Moody’s Investors Service
The Florida-only homeowners companies have taken advantage of declining reinsurance prices and expanded contract terms to extend their protection in recent years. Exhibit 2 shows the top reinsurers that have assumed premiums from the top 25 Florida-only insurers. We expect Florida-only insurers to cede significant losses to these reinsurers. However, because reinsurers often retrocede business, the amount of retained exposure is not transparent from public disclosures. Although the premiums are relatively small relative to the companies’ overall equity, the gross exposure is substantial.
Jasper Cooper Vice President - Senior Analyst +1.212.553.1366 [email protected]
NEWS & ANALYSIS Credit implications of current events
4 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
EXHIBIT 2
Top 10 Reinsurers of Florida-Only Property Insurers and Estimated Premiums Assumed
Note: The exhibit includes reinsurers with exposure to the top 25 Florida-only homeowners and commercial property insurers. Not all reinsurance is necessarily catastrophe-related coverage. Data exclude affiliated reinsurers. Sources: SNL Financial L.C. (contains copyrighted and trade secret materials distributed under license from SNL, for recipient’s internal use only) and Moody’s Investors Service
LARGE NATIONAL PRIMARY HOMEOWNER INSURERS ARE WELL DIVERSIFIED, WITH MANAGEABLE EXPOSURES IN FLORIDA
Large national primary homeowner insurers have considerable resources to withstand a significant event based on careful monitoring of their coastal exposure, geographic diversification, high-quality reinsurance protection and strong capital bases. Still, an insurer would have negative credit effects if it were to sustain sizable losses from one or more catastrophic events. The top US homeowner insurers have significantly reduced their exposure to Florida over the past decade. Among the top 10 US homeowners insurers, only United Services Automobile Association (Aaa stable) and Chubb INA Holdings, Inc. (A3 stable) have more than 5% of their direct written premiums in Florida (see Exhibit 3).
EXHIBIT 3
Largest US Homeowners Insurers Have Low Florida Exposures
Florida Direct Premiums Written
$ Millions
US Direct Premiums Written
$ Millions
Premium Concentration
in Florida Surplus
$ Millions
State Farm $581 $17,889 3% $87,591
Allstate $169 $7,904 2% $16,490
Liberty Mutual $120 $6,334 2% $20,132
Farmers $65 $5,515 1% $5,677
USAA $382 $5,341 7% $25,343
Nationwide $50 $3,774 1% $15,552
Travelers $25 $3,558 1% $20,249
American Family $6 $2,975 0% $6,867
Chubb $249 $2,747 9% $17,837
Erie $0 $1,538 0% $7,701
Total $1,648 $57,575 3% $223,440
Sources: SNL Financial L.C. (contains copyrighted and trade secret materials distributed under license from SNL, for recipient’s internal use only) and Moody’s Investors Service
$0
$100
$200
$300
$400
$500
$600
$700
$800
$900
FHCF Lloyd's ofLondon
Allianz Tokio Marine Everest Re W.R. Berkley XL Group Ltd Endurance Chubb Partner Re
$ M
illio
ns
NEWS & ANALYSIS Credit implications of current events
5 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
COMMERCIAL PROPERTY INSURERS Commercial property coverage is written by a combination of regional, national and international insurers, which typically insure commercial facilities, as well as by Florida-only companies, which often insure small businesses (see Exhibit 4). Aside from property damage, commercial lines claims will likely include business-interruption losses. However, such losses are difficult to predict because they depend on provisions in individual insurance contracts. Direct business-interruption coverage is triggered only if the loss was caused by damage to business premises from a covered peril.
EXHIBIT 4
Florida’s Top 10 Commercial Property Insurers
Florida Direct Premiums Written
$ Millions
US Direct Premiums Written
$ Millions
Premium Concentration
in Florida Surplus
$ Millions
Citizens Property $545 $545 100% $7,402
Assurant $385 $1,915 20% $1,166
American International Group $377 $3,573 11% $21,762
Zurich American $329 $2,143 15% $7,852
Chubb Limited $297 $3,380 9% $17,837
C N A $273 $4,243 6% $10,748
American Coastal $250 $250 100% $177
Liberty Mutual $242 $5,442 4% $19,582
QBE $172 $916 19% $1,844
Heritage & Zephyr $169 $169 100% $276
Total $3,040 $22,576 13% $88,646
Notes: Data include allied lines, commercial multiple peril – non liability, fire, and inland marine. Sources: SNL Financial L.C. (contains copyrighted and trade secret materials distributed under license from SNL, for recipient’s internal use only) and Moody’s Investors Service
Contingent business-interruption insurance, which is much less common, covers business-interruption losses caused when access to a building is lost, even though the building itself is not damaged. A third type of business-interruption insurance, power outage coverage, is also less common, but could pay significant claims if power outages continue for an extended period. As with homeowners, the Florida-only commercial property writers purchase significant quantities of property-catastrophe reinsurance.
Other than Citizens Property Insurance Corporation (A1 stable), the largest commercial property insurer is Assurant Inc. (Baa2 stable). A significant portion of Assurant’s commercial property exposure stems from its lender-placed homeowners insurance, which is classified as commercial property. In addition to Florida Hurricane Catastrophe Fund coverage, Assurant manages its catastrophe exposure through reinsurance, including about $1.0 billion of coverage in excess of the company’s $125 million retention.
AUTO INSURERS Many personal and commercial autos likely will be damaged by the storm, but they will probably account for a smaller share of insurers’ losses compared with Hurricane Harvey. We expect that most auto claims from Irma will be from repairable wind damage, while auto claims from Harvey were typically flood-damaged total losses. Additional losses are likely to come from personal watercraft. Exhibit 5 lists Florida’s top 10 auto insurers.
NEWS & ANALYSIS Credit implications of current events
6 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
EXHIBIT 5
Florida’s Top 10 Auto Physical-Damage Insurers
Florida Direct Premiums Written
$ Millions
US Direct Premiums Written
$ Millions
Premium Concentration
in Florida Surplus
$ Millions
Geico/Berkshire Hathaway $1,255 $10,166 12.3% $137,194
Progressive $749 $7,630 9.8% $8,580
State Farm $738 $15,809 4.7% $87,591
Allstate $504 $8,691 5.8% $16,490
USAA $353 $5,225 6.8% $25,343
Liberty Mutual $180 $4,913 3.7% $20,132
Travelers $123 $1,964 6.3% $20,249
Infinity $110 $456 24.1% $669
National General $95 $883 10.7% $1,209
Auto-Owners $91 $1,072 8.5% $9,690
Total $4,198 $56,809 7% $327,149
Sources: SNL Financial L.C. (contains copyrighted and trade secret materials distributed under license from SNL, for recipient’s internal use only) and Moody’s Investors Service
NEWS & ANALYSIS Credit implications of current events
7 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
Traditional Reinsurers Face Heavy Losses, Mitigated by Increased Retrocessions Traditional reinsurers and alternative capital providers such as catastrophe bonds, collateralized reinsurance and sidecars likely will bear substantial losses from Hurricane Irma. Reinsurers with an outsize concentration in Florida will be more vulnerable than those with a globally diversified catastrophe portfolios.
The exhibit below shows rated reinsurers’ 1-in-250 year and 1-in-100 net probable maximum loss (PML) for all US wind exposures as a percent of second-quarter shareholders’ equities. With exceptions, Florida is generally reinsurers’ biggest wind exposure. Additionally, RenaissanceRe, a Bermuda reinsurer, is also exposed, but does not disclose its catastrophe PMLs. Reinsurers’ PML disclosures are not directly comparable across companies because they incorporate different models and assumptions. However, they can indicate each firm’s vulnerability. These modeled losses vary dramatically with actual hurricane losses.
US Wind 1-in-250 Year and 1-in-100 Year Event Probable Maximum Loss Relative to Equity at June 2017
Notes: Munich Re is 1-in-200-year annual aggregate PML; Swiss Re is 1-in-200-year occurrence PML; Hannover Re is annual aggregate PML; PartnerRe and XL Group exposure is as of 1 April 2017; Munich Re, Swiss Re, Hannover Re and Alleghany exposures are as of 1 January 2017; Alleghany is Moody’s estimate of pre-tax net losses using 30% effective tax rate. Sources: Company reports and Moody’s Investors Service
Reinsurance losses related to Irma will depend on the underlying exposures of individual cedants as well as the terms and conditions of the underlying primary insurance policies and the reinsurance contracts. The majority of reinsurers also cede significant peak zone catastrophe business to alternative capital providers through collateralized reinsurance and catastrophe bonds. Some reinsurers also have shifted capacity to affiliated sidecar vehicles. Although the portion ceded will vary dramatically, average cessions have increased substantially over the past few years. However, catastrophe bonds and collateralized reinsurance only have one limit, and once exhausted, the risk shifts back to the reinsurer.
After a severe disaster, counterparty credit risk will be a significant factor and the response from the alternative capital providers could either solidify or raise doubts about their reliability. The event will test contract provisions, including collateral release mechanisms.
Two major hurricanes in less than one month will result in higher pricing for US-catastrophe-exposed business. However, price increases are likely to be lower relative to prior severe events given our expectation of continued interest by alternative capital.
0%2%4%6%8%
10%12%14%16%18%20%22%24%
LancashireGroup
Everest Re ValidusHoldings
XL Group Munich Re AspenInsuranceHoldings
Swiss Re HannoverRe
AXISCapital
AlleghanyCorporation
PartnerReLtd.
ArchCapitalGroup
1 in 250 1 in 100
Sid Ghosh Vice President - Senior Analyst +1.212.553.0456 [email protected]
NEWS & ANALYSIS Credit implications of current events
8 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
As a rough benchmark, a 10% decline in shareholders’ equity over a 12-month horizon would likely trigger a negative rating action in the absence of credible plans to rebuild capital. However, some reinsurers are likely to retrench and de-risk after Irma if they are not able or willing to raise additional capital.
NEWS & ANALYSIS Credit implications of current events
9 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
Florida Hurricane Catastrophe Fund’s Reimbursement Cap Insulates It from Severe Damage The Florida State Board of Administration Finance Corporation (Florida Hurricane Catastrophe Fund, FHCF, revenue bonds Aa3 stable) has greater financial resources than its statutory reimbursement cap. However, a large increase in bond issuance stemming from significant reimbursement claims could lead to downward pressure on its bond rating.
FHCF provides $17 billion of reimbursement coverage to 159 insurance companies across the state, including Citizens Property Insurance Corporation (revenue bonds A1 stable). The FHCF, overseen by the State Board of Administration, was established by the Florida legislature in 1993 in response to Hurricane Andrew. It is statutorily authorized to collect annual premiums from residential property insurers, issue debt to fund payments to insurance companies that have incurred losses, and levy emergency assessments on all property and most casualty insurance lines.
Participation in the FHCF is mandatory, with limited exceptions, for insurers writing residential property insurance in Florida, excluding flood coverage. The FHCF relies on liquidity from its accumulated premiums, reinsurance, and proceeds from pre-event bonds to pay claims immediately following a storm, before proceeds from post-event bonds are needed to reimburse insurers for any remaining claims.
After 11 years with limited claims-paying events, the FHCF estimates that it has $17.5 billion of total available resources for the 2016-17 contract year, exceeding the fund’s statutory reimbursement limit. For the 2017-18 contract year, the fund estimates $1.1 billion in premiums, plus $1.0 billion in reinsurance coverage, resulting in total resources of $18.6 billion, which exceeds its statutory liability cap of $17.0 billion (see exhibit).
FHCF’s Estimated Claims-Paying Resources Exceed Statutory Liability Cap
Source: Florida CAT Fund Probable Maximum Losses, Financing Options and Potential Assessments
The limited liability structure of the FHCF absolves it from being liable to participating insurers for their share of the fund’s capacity above the amount of available funds. Since the fund’s resources currently exceed the statutory cap, the fund will not have to issue debt regardless of Irma’s damage. We do not expect the fund to exhaust all claims-paying capacity on one storm and would expect it to preserve liquidity by utilizing alternate sources of revenue. If necessary, it could also issue post-event bonds to cover a portion of liabilities arising from Hurricane Irma to preserve liquidity for another storm.
$0
$2
$4
$6
$8
$10
$12
$14
$16
$18
$20
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
$ Bi
llion
s
Fund Balance Other Liquidity Sources Risk Transfer
Genevieve Nolan Vice President - Senior Analyst +1.212.553.3912 [email protected]
NEWS & ANALYSIS Credit implications of current events
10 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
Citizens Is Well Prepared and Assessment Revenue Provides Additional Credit Protection Citizens Property Insurance Corporation (revenue bonds A1 stable) has substantial resources to withstand damage claims from Hurricane Irma because of the growth in its claims-paying resources and the reduction in its outstanding policies during the past 11 years. Furthermore, Citizens has additional revenue sources that provide significant additional claims-paying ability before resorting to additional bond issuance. Significant growth in damage claims relative to available resources could result in future bond issuance and potential downward rating action.
The Florida legislature created Citizens in 2002. Currently the third-largest property insurer in the state, Citizens provides coverage for coastal properties, as well as non-coastal residential and commercial property, but excludes flood damage. Citizens’ total insured value is $124.1 billion, with 453,339 policies outstanding as of 31 July 2017. Although Florida is the peak hurricane zone in the US, the state has not experienced a major hurricane since 2004-05, when eight storms hit the state. Consequently, Citizens’ has built up significant resources, and projects that its current claims-paying ability exceeds $13.3 billion, including more than $7.4 billion of surplus, $1.3 billion of traditional reinsurance and capital markets risk transfer, approximately $2.3 billion of reimbursement coverage from the Florida Hurricane Catastrophe Fund, and $2.3 billion of proceeds from outstanding pre-event bonds. In 2015, Citizens legally defeased all post-event bonds, which were secured by special assessments on new and renewed policies.
Citizens estimates a probable maximum loss of $10.8 billion in a 1-in-250 year event. Given its current claims-paying resources of $13.3 billion, resources exceed Citizens’ loss estimate by $2.5 billion. In the event that damage from Irma exceeds the 1-in-250-year loss threshold, Citizens has three additional revenue sources that provide significant claims-paying ability:
» A onetime 15% surcharge on its policyholders that would generate $150 million
» A onetime 2% regular assessment on property and casualty insurers that would generate $810 million
» An emergency assessment of up to 10% on aggregate statewide assessable premiums that could be levied over a period of years.
Following the 2004-05 storms, Citizens’ policy count rose to a high of nearly 1.5 million in 2011. Since then, outstanding policies have declined by 65% to just under 500,000 (see exhibit). Should Hurricane Irma result in substantial property damage, we expect that a pullback or loss of other insurers would lead to significant increase in Citizens’ insured policy base.
Number of Citizens’ Policies
Source: Citizens Property Insurance Corporation
0
200,000
400,000
600,000
800,000
1,000,000
1,200,000
1,400,000
1,600,000
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Genevieve Nolan Vice President - Senior Analyst +1.212.553.3912 [email protected]
NEWS & ANALYSIS Credit implications of current events
11 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
Southeast US Municipal Electric Utilities Are Financially and Operationally Resilient Municipal electric utilities in the Southeast US will be able to better withstand the effects of Hurricane Irma because they have sound liquidity and most have debt-service reserves with the capacity to pay debt service for a full year. Moreover, utilities in Florida, Georgia and South Carolina have demonstrated resilience following severe weather events. However, smaller utilities that face concentration risk are vulnerable. Utilities whose assets take a direct hit from Irma risk needing to completely replace distribution and transmission facilities. Indeed, after Hurricane Andrew in 1992, electrical facilities in Homestead, Florida, required more than a year to be fully restored.
We rate 54 municipal electric utilities in the Southeastern US exposed to Irma and many others are participants in joint action agencies such as Municipal Electric Authority of Georgia (MEAG Power, senior lien A1 stable). Total debt outstanding for the largest 15 municipal electric utilities is approximately $21.1 billion, primarily related to generation projects. Most of these utilities (see exhibit) have cash on hand to cover about 200 days or more of operating expenses. The self-regulated rate-setting authority of the local governments for these utilities is a positive should immediate new ratepayer revenue be required.
Southeast US Municipal Utilities in Irma’s Path
Name Senior Lien
Rating
Debt Outstanding
$ Millions Debt Service
Reserve? Debt Ratio
Total Days Cash on
Hand
South Carolina Public Service Authority, SC (Santee Cooper)
A1 negative $8,195 Yes/CIP Reserve
83.9% 278
Municipal Electric Authority of Georgia (MEAG Power)1
A1 stable $2,887 Yes See Note 1 See Note 1
JEA, FL Aa2 stable $2,471 Yes 70.4% 421
City of Gainesville Combined Utility Enterprise, FL
Aa2 stable $1,908 Yes 78.6% 192
Florida Municipal Power Agency2 A1, A2 stable $1,690 Yes See Note 2 See Note 2
Orlando Utilities Commission, FL Aa2 stable $1,498 Yes 50.4% 292
Piedmont Municipal Power Agency, SC
A3 stable $961 Yes 142.3% 264
City of Tallahassee Electric Enterprise, FL
Aa3 stable $539 Partial 53.8% 173
City of Lakeland Electric Enterprise, FL
Aa3 stable $409 Springing 46.5% 244
City of Ocala Combined Utility Enterprise, FL
A1 no outlook $141 Yes 30.8% 300
City of Rock Hill Combined Utility Enterprise, SC
A3 stable $120 Yes 28.4% 33
Kissimmee Utility Authority, FL A1 no outlook $93 Yes 25.2% 325
Greer Commission of Public Works, SC
A1 no outlook $76 Yes 31.6% 170
Key West Utility Board, FL A1 stable $43 Yes 26.0% 169
City of Leesburg Electric Enterprise, FL
A2 no outlook $37 Yes 28.4% 284
Notes: 1 MEGA Power has several financing projects, including Project One, General Resolution Project and Combined Cycle, which have in excess of 200 days of liquidity. 2 Florida Municipal Power Agency has several financing projects, including All-Requirements Project, St. Lucie Project and Stanton Project I & II, which have combined in excess of 200 days of liquidity. Source: Moody’s Investors Service
Dan Aschenbach Senior Vice President +1.212.553.0880 [email protected]
Thomas Brigandi Associate Analyst +1.212.553.2985 [email protected]
NEWS & ANALYSIS Credit implications of current events
12 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
System reliability and emergency responsiveness are municipal electric utilities’ key objectives and involve initiatives that include training for events such as major storms. Many utilities have received designations of proficiency in reliability from the American Public Power Association, which evaluates various factors including system reliability. Also, many utilities are part of joint-action agencies with coordination agreements to assist each other in disasters.
For example, Key West Utility Board (A1 stable), a utility in the path of Irma, can absorb substantial damage-related costs because it has strong cash on hand and a fully funded debt service reserve of $4.1 million that equals the utility’s maximum annual debt service. Importantly, Key West Utility Board completed a significant transmission and distribution reliability improvement project that added a second transmission line to the mainline. Both transmission lines now provide import capability of 329 megawatts. Key West Utility Board now meets a reliability requirement with on-island generation of 111 megawatts which meets at least 60% of peak demand, which is important if the transmission lines to the mainland are adversely affected by the storm. Additionally, the utility is nearly finished with a storm-hardening project that includes spending $4.5 million for pole replacement across its service territory.
Since Hurricane Andrew, Key West and most Florida municipalities have revised their building codes to require higher building elevations and storm hardening of new construction. Irma’s impact will be a first test whether the municipal electric utility sector’s efforts have mitigated the wind and storm surge effects of a major hurricane.
NEWS & ANALYSIS Credit implications of current events
13 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
Corporates
United Technologies’ Planned Acquisition of Rockwell Collins Is Credit Negative Last Monday, United Technologies Corporation (A3 review for downgrade) said that it had agreed to acquire Rockwell Collins, Inc. (Baa2 stable) for about $30 billion. Although strategically sound, the planned transaction is credit negative for United Technologies because it will increase leverage sharply, with the possibility of a protracted deleveraging time frame. Following the deal announcement, we placed United Technologies’ A3 senior unsecured debt rating and Baa1 junior subordinated debt rating on review for downgrade. We affirmed the company’s Prime-2 short-term ratings.
United Technologies expects to close the transaction by the third quarter of 2018, financing the acquisition with one third equity and two thirds cash, including $14 billion in new debt and $1 billion in available cash. Upon closing, we expect pro forma 2018 debt/EBITDA of 4.3x and retained cash flow/net debt of slightly less than 15%, weakening from current levels of around 3.0x debt/EBITDA and 25% retained cash flow/net debt. Our review of United Technologies’ ratings will consider the company’s ability and commitment to restore these metrics to their current levels. As part of the review, we will assess any constraints that United Technologies may have to deploying the cash that it generates outside the US toward debt repayment in the US. Such constraints could extend the deleveraging time frame, and increase reliance on inherently uncertain earnings growth to trim leverage.
The acquisition would create a formidable supplier to the aerospace and defense sectors with a comprehensive product portfolio including aircraft engines, electro-mechanical components, electronics, cabin interiors and aero structures. In addition to being strategically preemptive amid continued industry consolidation, the transaction would also enhance United Technologies’ position relative to aircraft manufacturers Airbus SE (A2 stable) and The Boeing Company (A2 stable), both of which will seek to increase their respective profitability over the next several years. The Rockwell Collins’ acquisition comes at a time of robust deliveries of new commercial aircraft driven by mid-single-digit annual traffic growth and less concern about declines in defense spending.
We estimate that the planned acquisition of Rockwell Collins will improve United Technologies’ consolidated profit margins and cash flow. Rockwell Collins’ EBITA margin of about 21%, which it will likely retain following its recent acquisition of B/E Aerospace, compares favorably with United Technologies’ consolidated EBITA margin of 16%. Rockwell Collins’ strong competitive position in flight deck solutions, flight controls, cabin interiors, communications and connectivity systems is underpinned by high research and development spending and is evidenced by important contract wins that increased the company’s order backlog to about $9 billion.1
1 See Rockwell Collins Inc.: Financial Policy to Prioritize Deleveraging, Pulling Back from Aggressive Capital Allocation, 28 March
2017.
Rene Lipsch Vice President - Senior Credit Officer +1.212.553.1908 [email protected]
NEWS & ANALYSIS Credit implications of current events
14 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
Breach of Equifax’s Cybersecurity Is Credit Negative On Thursday, Equifax Inc. (Baa1 stable) announced an information security breach that potentially affects 143 million US consumers. The breach is credit negative for Equifax because it will impede the company’s solid earnings growth over the next three to four quarters and hurt its reputation as a custodian of consumer credit data for more than 200 million US consumers.
Equifax reported that unauthorized intrusions through its consumer-facing website applications resulted in suspected criminals accessing personally identifiable information such as names, Social Security numbers, birth dates, addresses, and, in some instances, driver’s license numbers, of approximately 143 million US consumers.
The suspected criminals also accessed limited personal information of certain consumers in the UK and Canada. However, the company has found no evidence of unauthorized access to its core consumer or commercial credit reporting databases, which underpin its business-to-business credit reporting and ancillary services in its core US Information Solutions segment (USIS). In addition, Equifax reported no breaches in its Work Number employment and income data repository, which drives its Workforce Solutions segment revenue.
Equifax will incur significant costs to remediate the breach, potential litigation and regulatory actions, and higher cybersecurity insurance premiums. However, we expect that the increased costs will be mitigated by insurance reimbursements, although the reimbursements will lag outlays. Although the costs are difficult to estimate, assuming about $200 million of increased expenses before insurance recoveries, we expect only a modest deterioration in total debt to EBITDA and still-strong free cash flow. We estimate that Equifax’s organic growth will moderate to the mid-single digits over the next 12 months, from about 10% organic growth in the year to date to second-quarter 2017.
In addition to the costs, we estimate that revenue growth will likely be disrupted for the next three to four quarters. However, the main, longer-term risk is that the breach will cause lasting harm to Equifax’s reputation and damage its relationships with customers, which include financial institutions and consumer lending institutions.
Raj Joshi Vice President - Senior Analyst +1.212.553.2883 [email protected]
NEWS & ANALYSIS Credit implications of current events
15 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
H.B. Fuller’s Planned Acquisition of Royal Adhesives & Sealants Is Credit Negative Last Monday, H.B. Fuller Company (Baa3 review for downgrade) said that it had agreed to acquire Royal Adhesives & Sealants, the main operating subsidiary of Royal Holdings, Inc. (B2 stable), for about $1.6 billion from affiliates of American Securities LLC. The debt-funded transaction, which the companies expect to close as soon as next month, is credit negative for Fuller because it will increase leverage sharply and marks a decisive shift away from the company’s historically conservative financial policy. Following the announcement of the deal, we placed Fuller’s ratings on review for downgrade.
Fuller plans to fund the acquisition with new debt, which will triple its total debt load, including our adjustments. Pro forma for the transaction, adjusted debt/EBITDA will increase to 6.3x from about 3.4x for the 12 months that ended 30 June, or to 5.8x including $35 million in cost synergies that Fuller expects to realize.
Fuller’s decision to pursue such a large debt-funded acquisition departs from its publicly stated commitment to maintain an investment-grade leverage target of 2x-3x. Fuller said that it remains committed to maintaining its current dividend and intends to use free cash flow to reduce reported leverage to around 3x by 2020. The company said that it has fully underwritten interim financing in place through Morgan Stanley and intends to renew and extend its $400 million revolver, which will be largely undrawn.
The planned acquisition of Royal will increase Fuller’s annual revenue to $2.9 billion from $2.2 billion, strengthen the company’s presence in higher-margin adhesive applications, such as engineered adhesives for aerospace, and add new adhesive technologies. Given the size of the transaction and two other smaller acquisitions completed this year, Fuller will face heightened integration and execution risk.
Our review of Fuller’s ratings will focus on our expectations for cost synergies, free cash flow generation and the pace of deleveraging, as well as the ultimate capital structure of the new entity. Fuller said its capital structure will include more than $1.275 billion of new covenant lite term loans and new $300 million senior unsecured notes. The company said that it will repay some of its existing debt, but the $300 million notes due in 2027 will remain outstanding. The final rating on the 2027 notes will depend on the security and its place in the capital structure once the new instruments are added.
On 1 September, Royal warned that severe flooding caused by Hurricane Harvey will likely affect the supply of raw materials from the Gulf region for some time. Following the acquisition announcement, Fuller said that it had confirmed that Royal does not expect Harvey to have a significant effect on its operations. If that proves to be the case, we expect our review of Fuller’s ratings to result in a downgrade of no more than three notches from the current rating.
Anastasija Johnson Assistant Vice President - Analyst +1.212.553.1723 [email protected]
NEWS & ANALYSIS Credit implications of current events
16 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
Nomad Foods’ Share Buyback Is Credit Negative Last Thursday, frozen food manufacturer Nomad Foods Limited (B1 stable) announced that it will repurchase approximately 7.1 million ordinary shares from funds advised by investment firm Pershing Square. The transaction is credit negative because Nomad Foods will fund the aggregate purchase price, which we estimate is approximately $100 million (approximately €83.3 million), with available cash, therefore reducing liquidity that could have been used for debt prepayment or for an acquisition.
Pershing Square, Nomad Foods’ largest shareholder, is disposing of its 18.3% stake (approximately 33.3 million ordinary shares) through an underwritten secondary offering at a price to the public of $14.30 per ordinary share. However, Nomad Foods agreed to repurchase approximately 7.1 million shares of the shares being sold at a price per share equivalent to the price at which the underwriting banks agreed to underwrite Pershing Square’s shares. Upon completion of the secondary offering, Pershing Square, which invested in Nomad Foods two years ago, will have fully sold its stake in the company.
This is Nomad Foods’ second share buyback in less than three months, and indicates a more shareholder-friendly financial policy than we had initially anticipated. Last June, Nomad Foods repurchased approximately 9.8 million ordinary shares owned by funds advised by global investment firm Permira. The aggregate purchase price of $105.1 million (approximately €93.7 million) also was funded with available cash.
After completing the transaction, Nomad Foods’ cash will fall to approximately €217 million from €300.5 million as of 30 June 2017. We continue to view the company’s liquidity as good, but the reduced cash will constrain its ability to fund acquisitions with a higher amount of cash in the funding mix, which would have potentially reduced its leverage.
We expect Nomad Foods to make further acquisitions over the next 12 to 18 months given that its integration of Findus Group’s continental European operations is almost complete. The company’s list of potential targets includes European frozen food companies to maximise cost synergies, notably procurement and operational synergies; European non-frozen to expand into new categories with potentially higher growth prospects than the mature Europe frozen food segment; and non-European food companies to improve geographic diversification and potentially expand into new product category.
UK-based Nomad Foods is a leading branded frozen foods producer that supplies much of Western Europe’s retail market. The company was initially set up as special-purpose acquisition company and made its first acquisition with the Iglo transaction. It then acquired the continental European frozen food businesses of Findus Group in October 2015.
Eric Kang, CFA Assistant Vice President - Analyst +44.20.7772.1965 [email protected]
NEWS & ANALYSIS Credit implications of current events
17 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
European Food Retailers Report Mixed Results Despite Improving Economy On 31 August, German food retailer Metro AG (Ba1 stable) released interim results showing mixed domestic performance despite Germany’s improving economic growth. Metro’s results came a day after Carrefour S.A. (Baa1 stable) released results showing a 36.1% year-on-year decline in EBIT in France during the first half of 2017. Despite an uptick in GDP growth in most of Europe, these results show that competition in some markets is constraining the profitability of some continental European food retailers (see exhibit), a credit negative. However, we do not expect that the sector’s credit quality will deteriorate significantly because these companies are well-diversified and have strong credit metrics.
Real GDP Growth and Retailers’ Reported EBIT Margins
Note: Data as of January-June for Carrefour and as of April-June for Metro, DIA, and Ahold Delhaize. DIA’s Iberia division operates in Spain and Portugal. Sources: Company reports and Moody’s Investors Service
In France, Carrefour had to cut prices to preserve its market share because of competition from independent retailers. So far, Carrefour has not benefitted from a moderately improving French economy that prompted us revise upward France’s GDP growth forecasts to 1.6% for both 2017 and 2018, from previous forecasts of 1.3% for 2017 and 1.4% for 2018. However, we still forecast that the company will achieve a debt/EBITDA ratio of nearly 3x and a ratio of retained cash flow/net debt of at least 25%, on a Moody’s-adjusted basis, owing to the proceeds from an initial public offering of Carrefour Brazil.
Germany’s economic growth continues to pick up, but we do not expect competition to ease there. Retailers remain under pressure from hard discounters such as Aldi and Lidl. Metro’s hypermarket subsidiary Real reported negative EBIT of €2 million in the second quarter of 2017, versus positive EBIT of €8 million a year earlier, as a result of price cuts and higher marketing expenses. Still, Metro’s overall EBIT rose by €14 million to €256 million because of the contribution of the more geographically diversified Metro Wholesale segment. We expect Metro’s debt/EBITDA, which was 4.7x for fiscal 2016, to decline over the next 18 months if it reduces its exceptional items and does not make any debt-financed acquisitions.
Southern Europe will remain a bright spot, as reflected by stronger interim results from companies based there or have operations in the region. Stronger economic growth and a store portfolio optimization resulted in a 22-basis-point increase in Spain-based Distribuidora Internacional de Alimentacion’s (DIA, Baa3 stable) EBIT margin to 5.8% in the second quarter of 2017, and we expect DIA’s Moody’s-adjusted debt/EBITDA to fall toward 3x over the next 18 months from 3.4x in 2016. Spain should remain one of the fastest-growing economies in Europe in 2017 and 2018: we forecast GDP growth of 2.6% this year and 2.0% next year.
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France - Carrefour Germany - Metro's Real Belgium - Ahold Delhaize Netherlands - Ahold Delhaize Spain - DIA Iberia
2016 GDP Growth 2017 GDP Growth 2016 EBIT Margin 2017 EBIT Margin
Vincent Gusdorf, CFA Vice President - Senior Analyst +33.1.5330.1056 [email protected]
NEWS & ANALYSIS Credit implications of current events
18 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
We also expect Netherlands-based Koninklijke Ahold Delhaize N.V. (Baa2 positive) to continue performing well in its home market. The company remains a clear leader in a market where it has limited competition and had a robust EBIT margin of 5.1% in the second quarter of 2017. This, combined with €750 million of synergies from its Ahold Delhaize merger will allow the company to achieve a Moody’s-adjusted debt/EBITDA of nearly 3.0x by the end of 2017, compared with 3.3x in 2016.
NEWS & ANALYSIS Credit implications of current events
19 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
Schneider Merges Its Industrial Software Business with AVEVA, a Credit Positive Last Wednesday, France’s Schneider Electric SE (Baa1 stable) announced that it had reached an agreement with AVEVA Group plc (unrated) to merge Schneider’s industrial software business with Aveva. The combination is credit positive because it results in a larger product offering, increases Schneider’s share of recurring revenues and diversifies its end-market exposure.
Schneider will pay £550 million (almost €600 million) to Aveva shareholders and will control 60% of the combined entity. The transaction will increase Schneider’s pro forma 2017 debt/EBITDA to 2.8x from 2.7x, assuming it is funded entirely with debt. This is within our leverage range of 2.50x-3.25x for its rating. Schneider has certain rights to increase its stake to up to 75% after an initial two-year standstill period.
The transaction will combine two largely complementary businesses and create an end-to-end solution in engineering. Schneider’s software portfolio focuses on process design, modelling and simulation, while Aveva’s product suite covers plant design. Schneider expects annual pro forma sales to reach £658 million, nearly 50% larger than Schneider’s standalone industrial software sales. Aveva generates 77% of its revenue on a recurring basis, which adds revenue and cash flow stability.
The geographical revenue mix will become more balanced, as well the-end market exposure as Schneider gains access to Aveva’s presence in the marine, petrochemical and power sectors. Schneider derives around half of its software sales from North America, while Aveva derives half of its software sales from Europe, the Middle East and Africa. Aveva also has a strong foothold in the Asia-Pacific region, which contributes around 35% of sales.
Schneider twice before attempted to combine its industrial software business with Aveva. Aveva will remain listed on the London Stock Exchange and will maintain its headquarters in the UK.
Martin Kohlhase Vice President - Senior Credit Officer +49.69.70730.719 [email protected]
NEWS & ANALYSIS Credit implications of current events
20 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
China SCE’s Proposed Share Issuance Is Credit Positive On 1 September, China SCE Property Holdings Limited (B1 stable) announced that it had proposed issuing shares that will raise net proceeds of around HKD1.44 billion. The proposed issuance, if completed, would be credit positive for China SCE because the company will have additional funding to support its growing property development business and reduce its moderately high debt leverage.
With the proposed issuance, we estimate that China SCE’s pro forma adjusted debt/total capitalization will decrease to 63.5% from 65.4% as of the end of June 2017. In addition, we expect China SCE’s debt leverage, as measured by revenue/adjusted debt, to improve to 60%-70% over the next 12-18 months from 58% for the 12 months that ended June 2017, largely supported by the new equity funding and our expectation of strong revenue growth.
China SCE’s revenue likely will grow 20%-25% over the next 12-18 months, supported by strong property contracted sales. Its contracted sales increased year over year by 31% to RMB17.7 billion in the first seven months of 2017, following 62% year-on-year growth to RMB23.5 billion in 2016. The company’s year-to-date sales performance puts it on track to meet its full-year sales target of RMB28 billion.
The company’s high growth in contracted sales will result in an increase in cash requirements for construction. The company can partially meet those funding requirements with the funds it raises from the proposed share subscription.
China SCE is a property developer focused on first- and second-tier cities in the Yangtze River Delta region, the West Strait Economic Zone, the Bohai Rim Region and the Pearl River Delta region. As of the end of June 2017, the company had a land bank of around 12.1 million square meters in terms of total saleable gross floor area across 21 cities in China.
Chris Wong, CFA Analyst +852.3758.1531 [email protected]
NEWS & ANALYSIS Credit implications of current events
21 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
Korean Court’s Ruling on Kia Motors’ Wage Lawsuit Is Credit Negative On 31 August, Kia Motors Corporation (Baa1 stable) announced that the Seoul Central District Court had ordered the company to pay about KRW422 billion in unpaid wages, mainly related to additional holiday and overtime payments from August 2008 to October 2011. If the court ruling is applied to payments from November 2011 to August 2017, Kia estimates total payments (including the KRW422 billion) will be around KRW1 trillion. The court’s ruling is credit negative for Kia because it will lead to a sizable net loss in third-quarter 2017. Kia said that it will appeal the court’s ruling.
Kia’s total estimated losses of around KRW1 trillion from the lawsuit is larger than its operating income of KRW787 billion for the first six months of 2017. In addition, the court order could lead to a permanent increase in Kia’s domestic labor costs, depending on negotiations with its labor union.
The KRW422 billion payment in unpaid wages is mainly based on a calculation that includes regular bonuses as part of ordinary income. This amount covers a period of about 38 months, retroactively, from August 2008 to October 2011 for 27,424 employees, and equals about 39% claimed by Kia employees. In October 2011, Kia’s labor union filed a lawsuit demanding additional holiday and overtime wages calculated based on adding regular bonuses as part of ordinary income. Ordinary income is used as a basis to decide holiday and overtime wages.
Given the company’s decision to appeal the court’s ruling, there will be no immediate cash outlays from Kia, and the estimated payments will be recorded as provision expenses. If Kia ultimately loses the lawsuit, we believe that the company has sufficient liquidity to withstand the one-off cash outlay, assuming the final amount is broadly similar to that decided in the initial ruling. At the end of June 2017, Kia had a reported net cash position of about KRW1 trillion, which provides a key support to its balance sheet strength (see exhibit).
Kia Motors’ Reported Net Cash
Sources: Moody’s Financial Metrics and Moody’s Investors Service forecasts
Kia’s global auto retail sales declined by 7.6% in first-half 2017, mainly because of weak sales in Korea, the US and China. Kia’s auto sales in China were linked to political tension between Korea and China, which we expect will persist at least over the next one to two quarters.
Despite such challenges, we expect Kia to generate modest free cash flow and its balance sheet strength to remain intact over the next 12-18 months, because its capital spending and dividend payments will remain lower than its cash flow from operations. Kia’s rating also incorporates a one-notch uplift based on the support that parent Hyundai Motor Company (Baa1 stable) is likely to provide Kia in a stress scenario.
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Wan Hee Yoo Vice President - Senior Credit Officer +852.3758.1316 [email protected]
NEWS & ANALYSIS Credit implications of current events
22 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
Infrastructure
China Cuts Natural Gas Prices; Negative for Pipeline Operators, Positive for Gas Distributors On 30 August, China’s National Development and Reform Commission (NDRC) announced that it had reduced the benchmark city-gate prices of natural gas for non-residential users by RMB0.1 per cubic meter, equal to an average cut of 4.6% to 8.7% for different provinces (see exhibit). The latest benchmark city-gate price adjustment followed a lowering of transmission tariffs for midstream inter-provincial pipelines and a 1 July reduction in the value-added tax for natural gas to 11% from 13%. Both benchmark city-gate prices and transmission tariffs cuts took effect on 1 September.
The price reduction is credit negative for midstream pipeline operators because it comes on top of a 15% average reduction in transmission tariffs for inter-provincial pipelines. However, the price reduction is credit positive for downstream gas companies because it will stimulate natural gas consumption and improve these companies’ earnings.
China’s Decline in Benchmark City-Gate Prices for Non-Residential Customers by Province as of 1 September
Source: China’s National Development and Reform Commission and Moody’s Investors Service
Among midstream pipeline operators negatively affected are Kunlun Energy Company Limited (A2 negative) and Beijing Gas Group Company Limited (A3 stable), because their revenue derived from midstream operations will decline immediately, and the effect of higher sales to end-users will take time to materialize.
Among downstream gas companies that we expect will benefit from the lower price are ENN Energy Holdings Limited (Baa2 stable), China Resources Gas Group Limited (Baa1 positive), Towngas China Company Limited (Baa1 stable), China Oil and Gas Group Limited (Ba2 stable) and Binhai Investment Company Limited (Ba1 negative). Most of these companies recorded more than 10% growth in gas sales volumes in the first half of 2017, and we expect them to achieve growth of more than 10% growth for the full year.
Benchmark city-gate prices are effectively the regulated procurement costs for downstream players. We believe that the price cut will make natural gas more competitive against alternative fuel sources such as oil, and thereby increase gas consumption.
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Ralph Ng Analyst +852.3758.1530 [email protected]
Ivy Poon Vice President - Senior Analyst +852.3758.1336 [email protected]
Osbert Tang Vice President - Senior Analyst +86.21.2057.4019 [email protected]
NEWS & ANALYSIS Credit implications of current events
23 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
The government reviewed the audit of regulated asset bases and permitted costs associated with natural gas transmission operations, using a new tariff mechanism introduced in August 2016 and based on a cost plus reasonable return. The permitted return is 8% on effective regulated assets on after-tax basis.
The tariff adjustments demonstrate the Chinese government’s commitment to price reforms for the wholesale, midstream, and retail gas markets and to establishing a direct link between gas prices along the value chain. The announcement also promotes trading platforms for petroleum and natural gas in Shanghai and Chongqing and will facilitate market-oriented pricing. The aim of stimulating gas consumption also is consistent with policy targets. The government expects that natural gas will contribute to 10% of primary energy consumption in China by 2020, and 15% by 2030, up from 5.8% in 2015.
There will be a limited effect on gas distributors’ dollar margins because we do not expect a material delay in passing-through the cost changes to end-users. As a result, gas distributors will transfer most of the cost savings to non-residential end-users, which lowers end-users’ production costs. This is consistent with the Chinese government’s incentive to ease corporates’ financial burden and promote the usage of natural gas as a major energy source.
NEWS & ANALYSIS Credit implications of current events
24 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
Australian Utilities Agree to Promote Electricity Price Discounts, a Credit Negative On 31 August, the Australian government announced that the country’s large energy utility companies, including AGL Energy Ltd. (Baa2 stable) and Origin Energy Limited (Baa3 stable), had agreed to improve and simplify pricing disclosure in their energy contracts and to notify customers who are on standard contracts of cheaper alternatives. The initiatives are credit negative for the utilities because they will result in more retail customers choosing cheaper electricity contracts, thereby lowering utilities’ profit margins.
Around 25% of retail energy consumers (i.e., households) in Australia’s populous east coast markets (see Exhibit 1) purchase their electricity under standard contracts with the utilities. According to the Australian Energy Market Operator, these contracts have tariffs that are generally 11% higher than discounted (or market) contracts. In the Australian state of Victoria, the tariffs are 25% higher. Any shift by customers to discounted contracts from the more expensive standard contracts will erode utility companies’ retail profitability.
EXHIBIT 1
Percent of Retail Customers with Standard Contracts, June 2016
Source: Australian Energy Regulator
We estimate that AGL’s and Origin’s earnings will decline by as much as the mid-single-digit percent range, assuming that all of their consumers currently on standard contracts switch to discounted contracts. Such declines will increase their financial leverage ratio, as measured by funds from operations/debt, by 1.0-1.5 percentage points. A lot will rest on how many retail customers choose the discounted contracts, and whether other retailers will actively compete for these customers by offering their own discounted products.
Even if a large number of retail customers choose the discount, the effect on AGL and Origin will be diluted by earnings from their other business segments. More than half their earnings derive from activities not affected by the discounting, including wholesale power generation, gas retail and liquefied natural gas exporting.
Over time, AGL and Origin may also recover some of the lost revenue by paring back their average discounts, if competition from smaller second-tier retailers declines. Smaller retailers have used discounting as the main tactic to win over customers from larger competitors, the effectiveness of which will likely wane if customers are already paying a discounted price for electricity.
Moreover, AGL and Origin are vertically integrated and have their own power stations that generate power at a fixed cost. Consequently, their retail margins are more stable, even after factoring in the discounts, than small retailers, which source most of their electricity on the volatile wholesale markets.
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South East Queensland New South Wales Victoria South Australia
Spencer Ng Vice President - Senior Analyst +61.2.9270.8191 [email protected]
NEWS & ANALYSIS Credit implications of current events
25 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
The agreement is a further indication of the heightened regulatory scrutiny on retail energy profitability as a result of a material increase in retail energy prices over the past couple of years (see Exhibit 2).
EXHIBIT 2
Retail Electricity Price Index by Australian Capital City, Fiscal Year 1990 = 100
Source: Australian Bureau of Statistics
Although not our expectation, we believe the risk of an introduction of more intrusive regulation to curb retail prices has increased. The Australian Consumer and Competition Commission is carrying out a review of electricity prices that will focus on competition and profitability, the outcome of which could result in further regulatory intervention in the market.
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NEWS & ANALYSIS Credit implications of current events
26 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
Banks
Rate Changes Are Credit Negative for BNDES, but Positive for Private Banks Last Tuesday, Brazil’s senate passed a bill that will change as of January 2018 the basic lending and funding rates for government-owned development bank Banco Nac. Desenv. Economico e Social (BNDES, Ba2/Ba2 negative, ba22). Over the next five years, BNDES will phase in a new long-term rate, Taxa de Longo Prazo (TLP), which will be based on the five-year treasury note yield. The TLP will replace the current long-term lending rate, the Taxa de Juros de Longo Prazo (TLJP), which is determined purely at the discretion of the National Monetary Council. Although the increase in the bank’s base lending rate will drive top-line revenue growth, an increase in the cost of new funding from the government will fully offset it.
The change is credit negative for BNDES because it will decrease the bank’s profitability by raising the cost of its loans to borrowers, which will reduce its competitive advantage and demand for its loans even as the economy rebounds. At the same time, however, the more level playing field that these changes create are credit positive for Brazil’s private banks.
We estimate that if the TLP were in place and fully matched to a market rate today, it would equal 7.6%, compared with the current TJLP of 7%. Brazil’s currently declining interest rates will mitigate the incremental effect of this change. However, if and when interest rates begin to rise, the implications for BNDES will be significantly credit negative. Moreover, if the bank is not able to cut operating expenses as its balance sheet shrinks, its operating efficiency will deteriorate, driving profits down.
Despite greater market competition from private banks for loans with tenors of between two and three years, BNDES will maintain its dominant position for long-term loans and infrastructure financing because of its access to government-provided long-term funding. We expect that private banks’ access to long-term funding will gradually increase, allowing them to compete with BNDES for longer-term loans. However, significant improvement in access will take several years to materialize. Also, it is uncertain to what extent private banks will be willing to incur the high capital charges associated with long-term lending.
The transition to a market-based lending rate also will reduce the spreads the bank can earn on its government securities holdings, which will put downward pressure on profitability. Over the past two years, BNDES’ investment in government securities has risen because the country’s economic recession has diminished borrowers’ demand for long-term financing. As a result, new loan origination has plunged and liquid assets have increased to BRL172 billion ($52 billion) as of June 2017. In the first half of 2017, securities investment income accounted for 26% of the bank’s total interest income, down from 31% a year earlier, before interest rates began to decline.
Under the new rates, BNDES will be required to pay the government a rate equal to Brazil’s short-term policy rate, the SELIC (currently 8.25%) for all public funds, both new and existing, that it does not use for lending but rather invests in government securities. As the exhibit shows, despite falling sharply from 14.25% as recently as September 2016, the SELIC remains higher than the TLJP, which is the rate that BNDES has paid the government until now on all its funding. Because BNDES invests much of its excess liquidity in government securities that currently return as little as 7%, depending on maturity and other terms, this change will sharply reduce BNDES’ ability to earn spreads on its liquid assets. To offset this effect, we expect that BNDES will increase its investments in private assets and hold fewer government securities, which will help it fulfill its mission to foster the development of capital markets, but also will reduce its liquidity and increase its asset risks.
2 The bank ratings shown in this report are the bank’s local deposit rating, senior unsecured debt rating and baseline credit
assessment.
Alexandre Albuquerque Vice President - Senior Analyst +55.11.3043.7356 [email protected]
NEWS & ANALYSIS Credit implications of current events
27 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
Comparison of Brazil’s TJLP and the SELIC Authorities have reduced subsidies embedded in BNDES’ lending rates by leaving the TJLP unchanged as they cut the SELIC.
Source: Central Bank of Brazil
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NEWS & ANALYSIS Credit implications of current events
28 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
German Retail Banks Face Challenges from Low Interest Rates, a Credit Negative On 30 August, German regulator BaFin and Bundesbank, the German central bank, published the results of their third low-interest-rate survey of 1,555 small and midsize German banks,3 which showed that banks’ profitability and capital generation capacity remain challenged and will decline from already-low levels, a credit negative. These challenges are the result of a low-yield environment and banks’ persistently high cost base, but the survey shows that most banks have sufficient capital to cope with these challenges. Amid these pressures, we expect consolidation to continue as weaker banks merge with stronger ones, particularly smaller entities with larger ones.
The low-interest-rate environment continues to put significant pressure on German banks’ profitability. Interest income accounts for most banks’ profits and it is already lower than for other European banking systems. A rate cut of 100 basis points would erode profitability unless banks were to take more pronounced measures to counterbalance this effect. In such a scenario, we would expect the banks to focus on cost-cutting measures to stabilize profitability. However, we expect a more pronounced immediate effect on profitability in the case of a significant interest rate hike: if rates were to rise 200 basis points this year, it would result in a 50% drop in banks’ profitability, but then recover in subsequent years.
As the exhibit below shows, small and midsize German banks expect their return on total capital before taxes to drop to 0.43% in 2021 from 0.51% in 2016 (shown by the bars), despite planned balance-sheet growth of 10% during the period. Banks expect their pre-tax profits to fall by 9% (or €1 billion) over 2018-21, primarily based on higher provisions on loan portfolios, while they expect a forecasted decline in interest income of €3.2 billion to be largely offset by higher fee and commission income of €2.9 billion. The effect is further offset by more limited capital generation via lower contributions to general reserves during 2018-21. Additionally, banks intend to limit the increase of administrative costs to €100 million.
German Banks’ Expected Return on Total Capital Before Taxes Under Various Interest-Rate Scenarios
Sources: Deutsche Bundesbank, BaFin and Moody’s Investors Service
With nearly 1,700 banks, Germany’s banking system is one of Europe’s most fragmented. We expect merger activity to increase to streamline operations and save costs, especially for small and midsize banks.
3 The survey participants comprise 41% of Germany’s total banking assets and largely are composed of savings banks and regional
cooperative banks.
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Plan Assuming Dynamic Balance Sheet -100 bps and Static Balance Sheet +200 bps and Static Balance Sheet
Mathias Kuelpmann, CFA Senior Vice President +49.69.70730.928 [email protected]
Andrea Wehmeier Vice President - Senior Analyst +49.69.70730.782 [email protected]
NEWS & ANALYSIS Credit implications of current events
29 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
For larger banks, we expect the cost of credit to ease both from lower provisions for shipping loans and litigation costs. Small and midsize banks have benefitted from a benign credit environment in Germany in recent years, and adjusting to lower earnings will require them to cut operational costs. Banks’ solid finances, in terms of capital, loan book and deposit funding, will provide a cushion from a creditor's perspective.
The pressure on banks’ cost structure could intensify if the system were to come under stress by further interest rate cuts or abrupt increases in interest rates according to the German central bank. Although most banks are likely to weather the storm of an immediate interest hike of 200 basis points, given their solid capital cushion, the survey expects 68 banks’ capital position to come under pressure.
NEWS & ANALYSIS Credit implications of current events
30 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
Nordea’s Headquarters Relocation to Finland from Sweden Is Credit Negative Last Wednesday, Nordea Bank AB (Aa3/Aa3 stable, a34), the Nordic region’s largest lender, announced that it would move its headquarters to Finland from Sweden so the bank can be in the European banking union and have, as the bank stated, a “level playing field and predictable regulatory environment.” Although such a move will not fundamentally change Nordea’s credit quality or alter its business model, it is credit negative because we expect that the bank will have slightly lower capital requirements in Finland and will issue significantly less subordinated debt for resolution purposes than it would if it had remained in Sweden. Such debt provides a cushion to senior debt. Additionally, there is a risk, albeit limited, for reputational damage in Sweden.
Nordea is a global systemically important pan-Nordic bank with a diversified regional footprint in the Nordic region (see exhibit).
Nordea Bank’s Lending Exposure by Geography as of the End of June 2017
Note: Lending includes reverse repos. Source: The bank
Although there is some risk that Nordea’s headquarters move causes some reputational damage in Sweden, limiting customer growth there and ultimately weighing on profits, we do not expect that this will be a significant factor. Instead, we expect that the key changes for Nordea would be external, including a limited change in the applicable regulations, and a new main financial supervisor, resolution authority, central bank and government.
When Nordea moves to Finland, the European Central Bank will take over supervision. Regulations in Sweden, being a European Union (EU) member, and Finland, a member of the banking union, are broadly similar. Nevertheless, there are differences in supervision, and we expect that capital requirements are likely to be slightly lower in the banking union. Whereas the future requirements will only be known once the ECB has approved Nordea’s capital models, we believe that the ECB will not require the 2% systemic risk requirement in Pillar 2 that the Swedish Financial Services Authority (FSA) does, even though there is some uncertainty about whether the Swedish FSA ultimately will be able to keep that requirement. Nevertheless, there is a high likelihood that future capital requirements will be slightly lower in Finland and that Nordea may release this capital.
4 The bank ratings shown in this report are Nordea Bank’s deposit rating, senior unsecured debt rating and baseline credit
assessment.
Denmark25%
Finland20%
Norway17%
Sweden35%
Russia1%
Outside Nordic2%
Louise Lundberg Vice President - Senior Credit Officer +46.85.0256.568 [email protected]
NEWS & ANALYSIS Credit implications of current events
31 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
Another difference is that the Single Resolution Board (SRB) that is part of the ECB is unlikely to apply the unique requirements that the Swedish resolution authority has included, namely that banks cannot use their excess capital to meet the recapitalisation part of the future Minimum Requirements for Eligible Liabilities and own funds (MREL). This means that Nordea would likely need to issue significantly less subordinated debt over the next few years versus had it remained in Sweden. Hence, Nordea is likely to have lower cushions or loss-absorption for senior unsecured debt.
We expect government support to remain broadly unchanged, even if Nordea after the relocation would be part of the European Single Resolution Fund instead of the Swedish Resolution Fund. Until the European Single Resolution Fund is fully funded (which the EU expects will be around 2024), national governments would still bear the formal responsibility and may, if needed, have access to a bridge financing facility.
Finland is a highly rated sovereign and, in our view, would have the capacity to provide capital support in the remote case that it would be needed (and after a resolution with bail-in has taken place). Nevertheless, we believe that given Nordea’s Nordic-wide presence, the support would likely come from a collaboration between all states where the bank has significant operations.
NEWS & ANALYSIS Credit implications of current events
32 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
Belfius Bank Issues Belgium’s First Senior Non-Preferred Bond, a Credit Positive Last Tuesday, Belfius Bank SA/NV (A2/A2 positive, baa25) became the first Belgian bank to issue senior non-preferred debt securities (or what we call junior senior debt). These new instruments are credit positive for Belfius because they will increase the bank’s bail-in-able buffer, providing greater protection to other senior creditors from losses in a resolution.
The issuance follows Belgium’s enactment on 31 July of a law creating a new category of senior non-preferred notes that rank junior to other senior obligations, including senior unsecured debt, and senior to subordinated debt. According to Article 29 of the law, junior senior notes must have a minimum maturity of one year, and their prospectuses must explicitly refer to their junior senior status. Under Belgian law, there is no restriction on the types of investors to which these instruments can be sold.
Junior senior securities are bail-in-able in a resolution and therefore eligible in Belgian banks’ resolution buffers, that is, the so-called minimum requirement for eligible liabilities and own funds (MREL) defined in Article 45 of the European Union’s (EU) Bank Recovery and Resolution Directive (BRRD). The new instrument will make it easier for Belgian banks to meet MREL requirements, which also will reduce potential losses for senior debtholders.
MREL targets are currently being defined by EU resolution authorities and among Belgian banks only Belfius and KBC Bank N.V. (A1 stable, baa1) have published informative MREL targets (Belfius’ was 27.25% of risk-weighted assets as of the end of 2016, while KBC’s was 26.55% as of the same date). Such targets are not yet requirements given that the EU’s proposed legislation on MREL, published on 23 November 2016, is currently under discussion. In this proposal, the MREL requirement is defined as the sum of the following:
» A loss-absorption amount, composed of a bank’s Pillar 1 capital requirement of 8% of risk-weighted assets, a Pillar 2 requirement and the fully loaded combined buffer (itself composed of the capital conservation buffer, systemic risk buffer and counter-cyclical buffer)
» A recapitalisation amount, composed of a bank’s Pillar 1 and Pillar 2 requirements
» A market confidence charge equal to the combined buffer minus 1.25% of risk-weighted assets
Based on June 2017 risk-weighted asset and capital figures, we expect that Belfius will have to issue €3 billion of junior senior debt by 2019 to meet its indicative MREL target (see exhibit). As these new debt instruments progressively replace maturing plain vanilla senior notes, we do not expect Belfius to increase materially its use of market funding and believe that the bank’s current target should be easily achievable.
5 The bank ratings shown in this report are the bank’s deposit rating, senior unsecured debt rating (where available) and baseline
credit assessment.
Laurent Le Mouël Vice President - Senior Analyst +33.1.5330.3340 [email protected]
NEWS & ANALYSIS Credit implications of current events
33 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
Belfius’ Minimum Requirement for Eligible Liabilities and Eligible Buffer
Source : Moody’s Investors Service
KBC is unlikely to issue debt in this new form because we expect the bank to increase its MREL buffer by issuing senior debt from its holding company, KBC Group NV (Baa1 stable). This senior debt is structurally subordinate to the bank’s own senior debt in a resolution scenario and therefore protects investors in senior bonds issued by the bank. We expect other major Belgian banks ING Belgium SA/NV (A1 stable, baa1) and BNP Paribas Fortis SA/NV (A1/A2 stable, baa1) to meet their future MREL requirements with intercompany transactions with their parents (internal MREL).
MREL Loss Absoprtion Amount
MREL Recapitalisation Amount
MREL Market Confidence Charge
CET 1 Capital (Basel 3 Fully Loaded)
Tier 2 Capital (Basel 3 Fully Loaded)
Eligible Senior Unsecured Debt
MREL Gap
€ 0
€ 1
€ 2
€ 3
€ 4
€ 5
€ 6
€ 7
€ 8
€ 9
€ 10
€ 11
€ 12
€ 13
Requirement as of 1 January 2019 Buffer as of 31 December 2016
€Bi
llion
s
NEWS & ANALYSIS Credit implications of current events
34 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
Russia Central Bank’s Emergency Liquidity Facility Is Credit Positive for Banks Last Monday, the Central Bank of Russia (CBR) announced that it had introduced on 1 September emergency liquidity support to banks in case of stress. The CBR’s introduction of an emergency liquidity facility is credit positive for Russian banks because it will support them in case of market turbulence and deposit outflows. These measures in particular will benefit systemically important banks with a high market share of customers’ deposits (see Exhibit 1).
EXHIBIT 1
Russia’s Systemically Important Banks
Total Assets RUB Billions
Customer Deposits RUB Billions
Customer Deposits Market Share
Sberbank 22,350 17,218 33.1%
Bank VTB, JSC 9,230 5,971 11.5%
Gazprombank 5,225 3,858 7.4%
Russian Agricultural Bank 2,765 2,093 4.0%
Alfa-Bank 2,438 1,862 3.6%
Bank Otkritie Financial Corporation OJSC 2,162 1,210 2.3%
Promsvyazbank 1,212 969 1.9%
UniCreditBank 1,100 724 1.4%
JSB Rosbank 826 519 1.0%
AO Raiffeisenbank 807 593 1.1%
Note: Banks’ data as of 1 August 2017 under unconsolidated local GAAP. Sources: Central Bank of Russia and the banks’ local GAAP financials
This measure follows the recent failure of large private Bank Otkrytie Financial Corporation, PJSC (B2/B2 developing, ca6), which experienced a significant outflow of client funds and was subsequently taken over by the CBR. Banks experiencing temporary liquidity difficulties can apply for emergency liquidity support when they run out of ordinary liquidity sources. The CBR will base its decision on providing additional liquidity on the bank’s systemic importance and financial stability.
The scope of collateral for the new emergency liquidity from the CBR is wider than collateral eligible for standard liquidity facilities and may comprise securities not included in the official Lombard list of securities acceptable for repo with the CBR, credit claims on non-financial institutions and third-party sureties, which widens banks’ ability for CBR refinancing. However, the CBR’s funding costs are rather high, with the interest rate amounting to the key CBR rate plus 1.75 percentage points (10.75% as of now). The emergency liquidity will be provided in rubles for a maximum term of 90 days.
We think that Russian banks have a limited need for this emergency liquidity given the system’s excessive liquidity and the rather high funding cost of the CBR’s emergency liquidity support. As of last Tuesday, the CBR’s funding in the form of securities repo transactions totaled RUB660 billion, compared with RUB1.472 trillion of deposits placed at the CBR (see Exhibit 2), which indicates that Russia’s banks have a liquidity surplus. However, following a recent increase in standard repo transactions with the CBR, several banks may be interested in using the new facility if other liquidity sources already have been used.
6 The bank ratings shown in this report are Bank Otkrytie’s local deposit rating, senior unsecured debt rating and baseline credit
assessment.
Maria Malyukova Assistant Vice President - Analyst +7.495.228.6106 [email protected]
NEWS & ANALYSIS Credit implications of current events
35 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
EXHIBIT 2
Russian Bank Liquidity
Source: Central Bank of Russia
-1,500
-1,250
-1,000
-750
-500
-250
0
250
500
750
1,000
10-J
an
17-J
an
24-J
an
31-J
an
7-Fe
b
14-F
eb
21-F
eb
28-F
eb
7-M
ar
14-M
ar
21-M
ar
28-M
ar
4-A
pr
11-A
pr
18-A
pr
25-A
pr
2-M
ay
9-M
ay
16-M
ay
23-M
ay
30-M
ay
6-Ju
n
13-J
un
20-J
un
27-J
un
4-Ju
l
11-J
ul
18-J
ul
25-J
ul
1-A
ug
8-A
ug
15-A
ug
22-A
ug
29-A
ug
5-S
ep
RU
B Bi
llion
s
Due to CBR Due from CBR Structural Liquidity Deficit/(Surplus)
NEWS & ANALYSIS Credit implications of current events
36 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
Uzbekistan’s Currency Devaluation Is Credit Negative for Banks with Foreign-Currency Exposures Last Tuesday, the Central Bank of Uzbekistan sharply devalued the local currency, the som, by almost 50% against the US dollar, to UZS8,100 per dollar. The devaluation followed a decree by Uzbekistan President Shavkat Mirziyoyev to liberalize the currency’s exchange rate, and is credit negative for Uzbek banks.
The measure will harm the credit quality of foreign-currency denominated loans because the debt-servicing capacity of unhedged borrowers will weaken. It also will harm the credit quality of som-denominated borrowers dependent on imported goods, equipment or consumer spending. All borrowers will likely feel an indirect effect from an increase in inflation. Exhibit 1 shows Uzbek banks’ percent of foreign-currency loans and deposits.
EXHIBIT 1
Uzbek Banks’ Percent of Foreign-Currency Loans and Deposits
Sources: Central Bank of Uzbekistan and Moody’s Investors Service
Since 2014, the som has depreciated against the US dollar less than the regional currencies of Uzbekistan’s key trading partners in the Commonwealth of Independent States. Uzbekistan’s authorities had conducted a managed depreciation of the som through a de facto crawling peg to the US dollar. The annual depreciation rate was below 10% in 2007-14 and 15% in 2015-16. As a result, Uzbek exporters were less competitive versus other countries.
We estimate that Moody’s-rated Uzbek banks’ overall exposure to foreign-currency loans was around 40% at year-end 2016, or around 23% excluding National Bank of Uzbekistan (B2 stable, b27), the country’s largest state-controlled bank and which holds 25% of the banking system’s assets. Among the banks we rate, National Bank of Uzbekistan, Asaka Bank (B2 stable, b2) and Ipoteka Bank (B2 stable, b2) are the most at risk from a weaker som in terms of asset-quality deterioration because they have the highest shares of foreign-currency loans (see Exhibit 2).
7 The bank ratings shown in this report are the bank’s deposit rating and baseline credit assessment.
0% 5% 10% 15% 20% 25% 30% 35% 40% 45%
Net Foreign-Currency Position/Equity
Foreign-Currency Loans/Net Loans
Foreign-Currency Deposits/Deposits
Banking Sector Banking Sector Excluding National Bank of Uzbekistan
Alexandra Yalozina Associate Analyst +7.495.228.61.09 [email protected]
Lev Dorf Assistant Vice President - Analyst +7.495.228.60.56 [email protected]
NEWS & ANALYSIS Credit implications of current events
37 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
EXHIBIT 2
Moody’s-Rated Uzbek Banks’ Ratio of Foreign-Currency Loans to Total Loans
Source: The banks and Moody’s Investors Service
The risk associated with the devaluation will be partially mitigated by the material portion of foreign-currency loans provided to export-oriented companies with foreign-currency revenues. Other mitigants include government guarantees for loans extended to systemically important large corporates, the low level of system-wide problem loans and good loss-absorption capacity from adequate pre-provision profitability and capital buffers (see Exhibit 3). In addition, those banks holding net long positions in foreign currencies would benefit from a som devaluation, although there is a risk that the negative effect from credit risk will overwhelm that benefit.
EXHIBIT 3
Uzbek Banks’ Tangible Common Equity Ratio
Sources: The banks and Moody’s Investors Service
Recently approved capital injections from Uzbekistan’s Ministry of Finance of around UZS500 billion and from the Fund for Reconstruction and Development of Uzbekistan of $500 million will materially bolster banks’ capital adequacy metrics. The capital went to special deposit accounts at state-controlled banks in June 2017 as per the president’s decree, with additional funds channeled into Tier 1 equity at the new exchange rate. This will further improve certain banks’ tangible common equity ratios.
0%
10%
20%
30%
40%
50%
60%
70%
80%
0%5%
10%15%20%25%30%35%40%45%50%
TCE Ratio Year-End 2016 TCE Ratio After Devaluation and Capital Injection
NEWS & ANALYSIS Credit implications of current events
38 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
Insurers
Proposed Discount Rate Reforms Are Credit Positive for UK Motor Insurers and Reinsurers Last Thursday, the UK Ministry of Justice (MoJ) proposed reforms that would change the discount rate (known as the Ogden rate) that UK courts use in significant bodily injury insurance cases to determine lump-sum payments awarded to claimants, such as for serious brain or spinal injuries sustained in motor accidents. The proposed reforms could result in the discount rate rising to between 0% and 1% from the current minus 0.75%, based on current market conditions. Any increase in the Ogden rate would be credit positive for UK motor insurers because it would partially reverse the substantial one-off hit to operating earnings after a 325-basis-point rate cut in March this year. A higher discount rate also would help relieve some of motor insurers’ future claim-cost pressures.
Following a change in the Ogden rate, insurers must revalue all their so-called large bodily claims reserves. After the March rate cut to minus 0.75%, insurers reserves were insufficient, and the subsequent increase in these reserves materially reduced company earnings for the period. Insurance broker Willis Towers Watson estimated that the March rate cut cost the sector approximately £5.8 billion (56% of total UK motor premiums), affecting not only primary UK motor insurers, but also reinsurers that provide material quota share and excess loss protection to the primary market.
Therefore, any rise in the Ogden rate would reverse some of the industry losses following the March rate cut. If the rate rises to 0%-1%, we estimate a one-off industry earnings benefit of £1.5-£3 billion. The two insurers that were most affected by the March Ogden rate cut were Direct Line Insurance Group Plc (Baa1(hybrid) stable) and Admiral Group plc (unrated), and are therefore set to benefit most if the rate increases. Other large UK motor insurers are Aviva Plc (A3 review for upgrade), Ageas SA/NV (Baa3 positive), esure Group plc (unrated) and Hastings Group Holdings plc (unrated). Reinsurers writing material quota share policies, including Munich Reinsurance Company (financial strength Aa3 stable) and SCOR SE (financial strength Aa3 stable), also could benefit from these reforms.
The Ogden rate also affects insurers’ future earnings. A lower Ogden rate increases the present value of estimated future losses that severe bodily injury victims will incur, pushing up the future cost to insurers. Willis estimated that the 325-basis-point cut to minus 0.75% would increase costs for the sector by £868 million a year, which equals around 8% of UK motor claims paid in 2015. Although the future discount rate will likely remain well below the historic 2.5%, any increase from the current minus 0.75% rate would at least relieve some of the burden of rising claims costs that the UK motor insurance industry faces. We estimate that if the discount rate rose back to 0%-1%, future costs increases would be lower than original estimates at £400-£650 million a year.
Following the Ogden cut in March, insurers were able to pass on some of these costs to policyholders by increasing prices. The Automobile Association British Insurance Premium Index reported an 8.3% increase in the motor insurance shop-around rates during the three months to 30 June, with the average comprehensive car insurance policy premium reaching its highest level since the index began in 1994. Although we expect UK motor insurers to remain disciplined in their approach to underwriting, the proposed reforms will likely curb further material upward price momentum.
Helena Kingsley-Tomkins Assistant Vice President - Analyst +44.20.7772.1397 [email protected]
NEWS & ANALYSIS Credit implications of current events
39 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
The draft legislation, which follows more than six months of industry consultations, establishes a new method to determine the Ogden rate. The MoJ said the new framework better reflects claimants’ actual investment habits, and assumes that recipients of personal injury compensation would generate a rate of return on a “low risk” rather than a “very low risk” diversified portfolio. The new proposals also would ensure that the discount rate is reviewed more regularly in future, at least every three years, and would involve an independent expert panel in the process. The Ogden rate had not changed since it was set at 2.5% in 2001, which is why the 325-basis-point rate cut in March was so sharp and materially affected the insurance industry.
NEWS & ANALYSIS Credit implications of current events
40 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
Exchanges
Nasdaq’s Acquisition of eVestment Is Credit Negative Last Tuesday, Nasdaq, Inc. (Baa2 stable) announced that it will pay $705 million to acquire eVestment (unrated), a content and analytics provider for asset managers and investors. The acquisition, which Nasdaq expects to complete by year-end, will be financed with cash on hand and debt, increasing the company’s debt leverage and lengthening the time it will take to reach its targeted debt leverage, both credit negatives.
Nasdaq expects its debt/EBITDA to increase to the low-3x range upon closing the acquisition, from 3.0x for the trailing 12 months through June 2017. Nasdaq’s Moody’s-adjusted debt/EBITDA is more conservative at 3.3x for the trailing 12 months through June 2017. Assuming a 100% debt-funded acquisition, we calculate its pro forma Moody’s-adjusted debt/EBITDA at 3.7x for the trailing 12 months through June 2017.
In its acquisition announcement, Nasdaq also signaled that it will not meet its targeted mid-2x debt leverage ratio until early or mid-2019, rather than the mid-2018 date it had previously expected. This delay increases credit risk in the lengthened intervening period. Although Nasdaq has committed to debt reduction after it acquires eVestment, there is a risk that the company will engage in other M&A transactions, adding more leverage and further delaying its de-leveraging, absent a shift in shareholder distribution policies or significantly better-than-expected earnings.
Despite being credit negative, we affirmed Nasdaq’s Baa2 ratings and stable outlook after the acquisition was announced because the anticipated increase in leverage will not significantly distort Nasdaq’s credit metrics and because of eVestment’s credit-positive attributes. Also, Nasdaq has historically used debt to help fund M&A, but has demonstrated its ability and intent to subsequently de-lever, as shown in the exhibit below.
Nasdaq’s M&A Purchase Consideration Components and Trailing 12-Month Moody’s-Adjusted Debt/EBITDA Nasdaq uses a considerable amount of debt to fund mergers and acquisitions, but also has demonstrated an intent and ability to subsequently de-lever.
Note: NOS =NOS Clearing; TR = Thomson Reuters’ Investor Relations, Public Relations and Multimedia Solutions businesses. Source: Company reports and Moody’s Investors Service estimates
0.0x
0.5x
1.0x
1.5x
2.0x
2.5x
3.0x
3.5x
4.0x
4.5x
$0
$200
$400
$600
$800
$1,000
$1,200
$1,400
$1,600
$1,800
Q1 12 Q2 12 Q3 12 Q4 12 Q1 13 Q2 13 Q3 13 Q4 13 Q1 14 Q2 14 Q3 14 Q3 14 Q1 15 Q2 15 Q3 15 Q4 15 Q1 16 Q2 16 Q3 16 Q4 16 Q1 17 Q2 17
$ M
illio
ns
Cash Cash and/or Debt Debt Stock Other Debt/EBITDA - right axis
Donald Robertson Senior Vice President +1.212.553.4762 [email protected]
Valerie Rojdestvenskaia Associate Analyst +1.212.553.0814 [email protected]
NEWS & ANALYSIS Credit implications of current events
41 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
eVestment has several credit-positive attributes, including profitable and growing subscription-based activities with a large client base and no significant single-name concentrations, mitigating the credit-negative effects on leverage. Also, although the purchase price indicates that this is somewhat larger than a traditional bolt-on acquisition, it is not transformative. eVestment had $81 million in revenue in the trailing 12 months to 30 June 2017, compared with $2.4 billion for Nasdaq, and it aligns well with Nasdaq’s existing business activities and competitive strengths.
NEWS & ANALYSIS Credit implications of current events
42 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
Sovereigns
US Debt Ceiling Risks Linger Despite Prospect of a Brief Suspension Last Friday, the US (Aaa stable) House of Representatives passed a final bill to fund disaster relief, extend federal government funding and suspend the debt ceiling through 8 December 2017. Passage followed an agreement between President Donald Trump and Democratic leadership in Congress reached earlier in the week.
Although demonstrating bipartisanship in a historically controversial policy area, the deal only provides a brief resumption of normal government operations. If the agreement goes through, negotiations on raising the currently binding debt ceiling will start again in only a few months. There has been no apparent progress among lawmakers in achieving consensus about how to resolve the credit-negative political impasse and strains on the government operations that a debt ceiling regularly causes.
If the debt ceiling is suspended in the coming days and reinstated in December, extraordinary measures that the US Treasury has relied on to fund the government since the debt ceiling was reinstated in March will be effectively reset. This will likely allow the Treasury to fund government operations, including debt service, through the end of the year and into early 2018, even if a permanent deal or another extension is not reached in December, and through a possible government shutdown. The timing of the critical deadline for another debt-ceiling deal, when the extraordinary measures are exhausted again, will depend on several highly uncertain variables, including the Treasury’s cash balance from mid-December, revenue performance in early 2018, and the timing of disaster relief and flood insurance outlays.
The agreement has no effect on our assessment of the government’s fiscal dynamics because it does not include any provisions for additional revenue or offsetting expenditure cuts to fund the proposed disaster relief spending or, more generally, affect the budget balance. However, the extension of debt ceiling and government funding debates into fourth-quarter 2017 may limit Congress’ ability to pass tax reform. Our baseline assumes tax cuts that would further exacerbate a projected increase in government debt, a credit negative for the sovereign.
The window for policy action presented by this deal will almost certainly be insufficient to generate policy consensus on a potentially politically unpopular fiscal reform required to stabilize the debt trend. Moreover, the tactical policymaking approach that we are currently observing does not indicate that a long-lasting solution to these structural fiscal challenges is coming in 2018, given the risk aversion that is likely to predominate ahead of midterm elections in November next year.
The short-term extension prevents for now any potential market disruption that would have arisen from a government default under a binding debt ceiling, an event to which we attached a low probability. However, the risk of an economically disruptive stalemate on the debt ceiling will persist. That uncertainty also will extend to the Trump administration’s broader reform agenda, which may weigh on financial and fixed asset investment.
Sarah Carlson Senior Vice President +44.20.7772.5348 [email protected]
Matt Kulakovskyi Associate Analyst +1.212.553.2755 [email protected]
NEWS & ANALYSIS Credit implications of current events
43 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
Peru’s Planned Boost in Public Investment in 2018 Is Credit Positive Last Tuesday, Peru’s (A3 stable) Ministry of Finance submitted a 2018 draft budget to Congress that makes reconstruction and recovery a priority, expanding investment by 19% over 2017 levels. Following an average contraction in public investment of 10% year-on-year during the first two quarters of 2017, the new investment will be credit positive for Peru, supporting economic growth. The package will be financed using Peru’s extensive fiscal reserves to minimize its effect on debt metrics.
The budget attempts to counter the effects of two shocks Peru experienced this year. The first was Brazil’s Lava Jato corruption scandal, involving Brazilian construction company Odebrecht S.A. Odebrecht’s participation in a consortium that managed a large infrastructure project in Peru caused the consortium to be unable to raise financing, slowing work on public projects.
The second shock came in March, when Peru’s economy took a hit following El Niño-related flooding that severely damaged coastal infrastructure and hurt the agriculture, transport, and tourism sectors, among others. The authorities estimate that around 30% of the country’s coastal infrastructure was damaged. Total damage equaled 3.2% of GDP and year-on-year growth fell to 2.2% in first-quarter 2017 from 4.0% in calendar 2016.
The government has budgeted to rebuild damaged areas and support growth while cutting current spending. The continued reduction in current expenditures in 2017-18 provides room for the boost in capital expenditures while also meeting the deficit limits outlined in the government’s announced fiscal trajectory. Government spending on capital investments is associated with positive fiscal multiplier effects, while government consumption has a lower fiscal multiplier, making this shift in expenditure composition positive for growth.
Total budgetary outlays are to increase 10% over 2017 levels and the budget targets a 19% increase in investment spending. The increase in capital spending accounts for 44% of the total increase in 2018 outlays and the majority is concentrated at the central government level, which has improved execution of capital projects recently. Overall, we expect the higher public investment to provide a direct boost to the economy equal to 0.6% of GDP and we expect growth in 2018 to be 3.9%, higher than our previous forecast of 2.6% (see exhibit).
Peru’s Capital Expenditures by Level of Government as a Percent of GDP Public investment in Peru will support growth in 2018.
Source: Peru’s Ministry of Economy and Finance
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
4.5%
5.0%
5.5%
6.0%
6.5%
2017 2018
Central Government Regional Government Local Government
0.6% of GDP Increase
Michael Brown Associate Analyst +1.212.553.4515 [email protected]
Jaime Reusche Vice President - Senior Credit Officer +1.212.553.0358 [email protected]
NEWS & ANALYSIS Credit implications of current events
44 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
Importantly for Peru’s credit quality, the increased investment will be financed with savings, avoiding an incremental addition to the country’s debt. The government will be able to maintain the underlying fiscal trajectory (excluding reconstruction costs) identified last year as part of its macro-fiscal framework for 2018 to 2021. Reconstruction costs of 3.2% of GDP will be spread over four years, and 80% will be funded with savings, with the remainder funded with multi-lateral debt. Debt will stabilize at below 30% of GDP, which is lower than the median for A-rated peers.
NEWS & ANALYSIS Credit implications of current events
45 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
Planned Catalan Independence Referendum Raises Tensions with Spain’s Central Government, a Credit Negative Last Wednesday, the Catalan regional parliament approved a referendum vote for independence from Spain (Baa2 stable) to be held on 1 October. Under the terms of the referendum law, the assembly would declare independence within 48 hours of a “yes” vote, with no minimum turnout requirement to make the result binding. Although the law already has been suspended by Spain’s constitutional court, which is reviewing whether the vote breaches the country’s constitution, the developments mark a further escalation in the long-running tensions between the Catalan regional government and the central government, a credit negative.
As we have previously stated, Catalan independence would have material negative credit implications for Spain because of the size of the region. The region contributes approximately 19% of Spain’s GDP and contains 16% of its population, and has a higher GDP per capita than the national average. Thus, a withdrawal would weaken Spain’s economic strength.
Our expectation is that Catalonia remains part of Spain. There are many hurdles to Catalonia’s independence, including the central government’s firm and sustained opposition, a range of legal and constitutional tools available to the state to address the challenge, and polling showing that popular support within Catalonia for secession from Spain is below a majority. Even if the referendum were to go ahead and result in support for independence, the lack of a legal basis and the absence of a minimum turnout threshold would likely undermine its legitimacy.
Nevertheless, the political relationship between the Spanish central government and the Catalan authorities is set to remain highly strained, potentially complicating efforts to arrive at a compromise that addresses many Catalans’ desire for greater autonomy. An increase in regional devolution remains likely given pro-independence pressures. In our view, a lasting solution would need to satisfy some of Catalonia’s main demands, particularly those related to greater fiscal resources and reform of the regional financing framework, while respecting the Spanish constitution’s legal restrictions.
The credit implications of such greater autonomy would depend on the exact institutional arrangements put in place, particularly with regard to central government control over regions’ finances. As it stands, Spain is already one of the most decentralised countries in the European Union in terms of public-sector spending, although its tax-raising powers are more centralised. Control over regional government finances has been a notable weakness in Spain’s overall deficit-reduction strategy in recent years, despite the central government having greater legal powers since the adoption of Spain’s Budget Stability Law of 2012 to compel fiscal consolidation at the regional level.
The continued tensions also present potential credit implications for the Generalitat de Catalunya (The Government of Catalonia, Ba3 negative). Since 2012, Catalonia has received €68.5 billion of liquidity support from the central government through diverse funding mechanisms, particularly the Fondo de Liquidez Autonomico (FLA), which constitutes around 70% of the region’s total stock of outstanding debt. So far, the political debate on independence has not affected central government liquidity support to the region. However, the region’s credit quality could be negatively affected if political tensions escalate further, triggering doubts about the central government’s willingness to provide support through the FLA.
Sarah Carlson Senior Vice President +44.20.7772.5348 [email protected]
Marisol Blazquez Analyst +34.917.688.213 [email protected]
Mickaël Gondrand Associate Analyst +44.20.7772.1085 [email protected]
NEWS & ANALYSIS Credit implications of current events
46 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
Uzbekistan’s Currency Depreciates 50% after Move to Floating Rate, a Credit Negative for the Sovereign Last Tuesday, Uzbekistan’s (unrated) central bank liberalized its exchange rate regime to allow its currency, the som, to float freely. By Thursday, the som had depreciated 50% against the US dollar. Given the severe economic disruptions that it will cause, the central bank’s lack of experience calibrating monetary policy in a floating exchange-rate regime and responding to abrupt exchange-rate movements, already-elevated inflation and credit growth, the som’s sharp depreciation is credit negative for the sovereign. We expect the som’s sharp depreciation to prompt significant additional inflationary pressures that will lower real wages, profits and reduce domestic demand and growth.
The central bank’s move follows a managed 23% depreciation since the beginning of the year. As the exhibit below shows, based on the experience of other countries in the region whose currencies have sharply depreciated, inflation is likely to rise into the double digits over the next few months from around 8% at the end of 2016. Implementing monetary and fiscal policy effectively in order to restore confidence in the som’s value, contain inflation expectations and shore up the economy will be extremely challenging. Higher interest rates to contain inflationary pressure would further dampen economic growth.
Annual Inflation Trends in Neighboring Countries to Uzbekistan that Underwent Sharp Currency Depreciation
Note: t=0 is the month of each respective country’s currency de-peg or devaluation: June 2014 for Russia, August 2015 for Kazakhstan and December 2015 for Azerbaijan. Sources: Russian Federal State Statistics Service, Agency of the Republic of Kazakhstan on Statistics, State Statistical Committee of Azerbaijan, Haver Analytics and Moody’s Investors Service
The som’s sudden depreciation may produce export gains as competiveness increases and may encourage domestic and foreign investment that was stalled by restrictions in currency convertibility that hampered the repatriation of profits. However, investment will only materialize once growth, the exchange rate and policies stabilize. Over the next couple of years, investment will be slowed by a likely downturn in the domestic economy and tighter financing conditions. Companies have no experience in planning their operations and longer-term investments in a flexible exchange-rate regime. Overall, unless government spending greatly increases, GDP growth is likely to fall to low or possibly negative rates from 8% on average over the past five years.
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%
t-24
t-23
t-22
t-21
t-20
t-19
t-18
t-17
t-16
t-15
t-14
t-13
t-12
t-11
t-10 t-9 t-8 t-7 t-6 t-5 t-4 t-3 t-2 t-1 t=0
t+1
t+2
t+3
t+4
t+5
t+6
t+7
t+8
t+9
t+10
t+11
t+12
t+13
t+14
t+15
t+16
t+17
t+18
t+19
Russia Kazakhstan Azerbaijan
Shirin Mohammadi Associate Analyst +1.212.553.3256 [email protected]
Martin Petch Vice President - Senior Credit Officer +65.6311.2671 [email protected]
NEWS & ANALYSIS Credit implications of current events
47 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
The currency shock also will likely affect the financial sector. Although the government’s own foreign-currency debt was relatively modest at only around 12% of GDP in 2016, corporations, including state-owned enterprises, have substantial foreign-currency loans. Their debt repayment costs will surge because of the som’s depreciation and, combined with a slump in revenue from weaker GDP growth, banks’ asset quality will likely deteriorate. Weaker banks likely will negatively affect growth, particularly if lenders become less willing to lend, including for working-capital needs.
Beyond the next two to three years, the move to a flexible exchange rate, if maintained, has credit-positive implications for Uzbekistan because it will allow the economy to adjust more easily to price changes in energy and commodities, the sovereign’s main sources of revenue. Flexible exchange rates help maintain trade competitiveness because they adjust according to trade and capital account flows. A floating, yet broadly stable exchange rate, would encourage investment and increase foreign direct investment inflows, supporting diversification efforts and growth. Moreover, currency flexibility would help the central bank preserve foreign-exchange reserves.
Until now, most individuals and small companies have not had adequate access to foreign exchange and routine foreign-currency transactions often required government approval. Under the new regulations, all companies will have equal access to foreign currencies. Wire transfers of foreign currencies and the payment of dividends in foreign currency will be permitted, obligations of forced sales of foreign exchange by exporters will be phased out, and foreign entities will be able to open accounts at Uzbek banks.
NEWS & ANALYSIS Credit implications of current events
48 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
Repeat of Kenyan Presidential Election Is Credit Negative On 1 September, Kenya’s (B1 stable) Supreme Court nullified the electoral outcome of the country’s 8 August presidential election and ordered a new vote within 60 days. The court’s unexpected decision is credit negative for Kenya’s creditors because it will further stymie the development of policies to address the country’s main credit challenges, in particular a large fiscal deficit of 10% of GDP. The ruling also prolongs a period of political uncertainty that has damaged business confidence and undermined growth.
The Supreme Court ruled 4-2 in favor of a petition filed by opposition leader Raila Odinga, citing irregularities in the transmission of presidential electoral results. Mr. Odinga received 45% of the popular vote in the recent election, versus 54% for incumbent President Uhuru Kenyatta. Following the Supreme Court’s ruling, the electoral commission decided to organize an election on 17 October and narrow the number of candidates competing for the presidency to Mr. Kenyatta and Mr. Odinga. The Raila Odinga-led National Super Alliance opposes the electoral date and runoff, and put together a list of demands regarding the organization of the election and the composition of the electoral commission.
As Kenya prepares for a new election, policy inertia and uncertainty will continue. Kenya’s constitution allows for a rerun election outcome to be challenged again, but such a scenario would be highly unusual. A clear and uncontested outcome would positively influence the authority of Kenya’s political and policymaking institutions and the credibility of policy, provide a strong mandate for the future president, and reduce the risk of post-election violence. Although the violence following the most recent election did not match the unrest that occurred in 2007, there have been violent protests and several dozen fatalities in the days since the election.
Meanwhile, Kenya’s socioeconomic and fiscal challenges persist. Prices of basic goods such as maize, sugar and milk have increased rapidly, contributing to an annualized consumer price inflation rate of 7.5% in the year to July 2017, following a peak of 11.7% between May 2016 and May 2017.
Year-on-year growth fell to a five-year low of 4.3% in the first quarter of 2017, as business investment stalled ahead of the August elections and agricultural output fell as a result of a severe drought. Room for further public infrastructure spending, which has been the main driver of growth in recent years, is limited. The fiscal deficit hit 10.2% of GDP in the fiscal year that ended June 2017, driven by substantial infrastructure capital expenditures and drought-related costs. Government debt continued increasing, reaching 55% of GDP in June 2017, up from 41% in June 2012.
Lucie Villa Vice President - Senior Analyst +1.212.553.1990 [email protected]
Patrick Cooper Associate Analyst +1.212.553.3811 [email protected]
NEWS & ANALYSIS Credit implications of current events
49 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
Extent of Credit-Negative Effect of War on South Korea Would Depend on Magnitude On Monday, the United Nations security council meets to discuss further sanctions against North Korea (unrated), after the country conducted its sixth nuclear test on 3 September. This is the latest in a series of ever-more-frequent nuclear tests and missile launches that have escalated tensions between North Korean and the US (Aaa stable) to an all-time high. The increased – albeit still low – probability of a military conflict on the peninsula is credit negative for South Korea’s (Aa2 stable) government.
Although our expectation is that the status quo will prevail, with ongoing tensions and periodic shows of force, and further sanctions by the US and other members of the United Nations Security Council, a conflict would inflict tragic loss of life and would damage Korea’s credit profile across all key credit factors (see Exhibit 1). Any military conflict would damage the economy, the functioning of the government and its finances, and potentially the country’s payment system. The severity of the credit effect would depend on the duration and intensity of the conflict.
EXHIBIT 1
Potential Effects of War on Korea’s Credit Quality
Source: Moody’s Investors Service
In the event of a relatively short-lived military confrontation involving North and South Korea and the US, the implications for Korea’s credit profile could be quite limited. A conflict would likely trigger capital outflows that would dent Korea’s reserves, but these buffers are substantial, and a clear resolution would allow them to be replenished. Additionally, Korea’s flexible exchange rate would help mitigate the reserve drawdown.
As of August 2017, Korea’s gross official foreign-exchange reserves were $375 billion. That compares with around $407 billion in total external debt, of which about $117 billion was short term as of the end of June 2017. Moreover, foreign investors have been net buyers of Korean equities and bonds since December 2016 (see Exhibit 2). And, as of July 2017, total foreign holdings of stocks and bonds reached a record KRW712 trillion ($636 billion, or 43% of estimated GDP for 2017), of which 85% are equities.
Destruction of production capacity
Transmission through supply chain, income losses for consumers and lower corporate
profits
Long-term negative effect on economy’s
competitiveness
Economic Strength
Institutional Strength
Fiscal Strength
Susceptibility to Event Risk
Increase in military expenditures
Rise in other government spending
in attempt to offset economic damage
Reduced incomes and profits weigh on
government revenues
Banking sector risk: disabled payment
systems, destruction of physical assets &
collateral, rising nonperforming loans
External vulnerability risk:
capital outflows reduce reserve buffers
Lack of policy tools to prevent economic destruction and
weakening fiscal position
Government operations potentially incapacitated
Steffen Dyck Vice President - Senior Credit Officer +49.69.70730.942 [email protected]
Shirin Mohammadi Associate Analyst +1.212.553.3256 [email protected]
NEWS & ANALYSIS Credit implications of current events
50 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
EXHIBIT 2
Foreign Investors’ Monthly Net Purchases of Korean Stocks and Bonds Foreign investors have been net buyers despite increased tensions.
Sources: Korea’s Financial Supervisory Service, Haver Analytics and Moody’s Investors Service
Korea’s economic infrastructure would be damaged in a short conflict, growth would slow and inflationary pressures would rise, at least temporarily. The Korean government would likely make use of fiscal space (with government debt at less than 40% of GDP in 2016) to support the economy, but the overall financial profile would most likely remain strong.
The longer the military conflict drags on, the higher the human casualties and economic costs. Apart from the direct economic effect of destroyed or disabled production capacity, the disruption of production chain links between suppliers and customers would lead to loss of income for and spending by employees and business owners.
Although reconstruction at the end of the conflict would likely begin relatively rapidly, it would take time and might only be partial. For instance, some affected producers could opt to relocate elsewhere. In such a scenario, it seems highly likely that Korea’s competitiveness would suffer, preventing a rapid economic recovery.
The cost of waging a war, extending welfare spending, and rebuilding the economy in its aftermath would raise government spending significantly. At the same time, lower incomes, profits and consumption would severely cut revenues. The fiscal deficit would widen and government debt would rise.
For the banking sector, a conflict could incapacitate the payment system, impairing bank intermediation. Moreover, asset quality would weaken substantially as borrowers lost some or all of their sources of revenue and collateral was destroyed. Banks’ ability to service the economy would be impaired and the probability that some institutions would need financial support from the government would rise.
In a prolonged conflict, we expect that external vulnerability risks would remain contained, but may no longer be minimal. Capital outflows could dent foreign-exchange reserves. The effect on the current account is difficult to estimate because imports and domestic demand would slump at the same time that exports dropped. Finally, the likely depreciation of the Korean won would raise the value of external liabilities, although external assets also would appreciate.
-8
-6
-4
-2
0
2
4
6
8
10
12
Jan-
2010
Mar
-201
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ay-2
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Jul-2
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2010
Nov
-201
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ar-2
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May
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ov-2
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2012
Mar
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2M
ay-2
012
Jul-2
012
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2012
Nov
-201
2Ja
n-20
13M
ar-2
013
May
-201
3Ju
l-201
3Se
p-20
13N
ov-2
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Mar
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ay-2
014
Jul-2
014
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2014
Nov
-201
4Ja
n-20
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ar-2
015
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-201
5Ju
l-201
5Se
p-20
15N
ov-2
015
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2016
Mar
-201
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ay-2
016
Jul-2
016
Sep-
2016
Nov
-201
6Ja
n-20
17M
ar-2
017
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7Ju
l-201
7
KRW
Tril
lions
Stocks Bonds
NEWS & ANALYSIS Credit implications of current events
51 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
In a conflict, Korea’s governmental and policymaking institutions would be hugely distracted and their effectiveness significantly impaired. In all likelihood, the government’s operations would be at least partially incapacitated. Its ability to deal with the immediate consequences of the conflict, let alone recover lost strength once the conflict was over, would be highly uncertain. Weakened institutions would magnify the more direct economic and fiscal effect of a prolonged conflict. Even a proactive policy response would not offset the credit effect of those shocks.
NEWS & ANALYSIS Credit implications of current events
52 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
Sub-sovereigns
Nordrhein-Westfalen’s Unexpected Deficit Will Delay Fiscal Consolidation, a Credit Negative Last Wednesday, the German land of Nordrhein-Westfalen (NRW, Aa1 stable) presented a supplementary 2017 budget that foresees a financial deficit of around €1.5 billion, or 2.1% of total revenue, a credit negative. Following NRW’s surplus of 0.3% of operating revenue in 2016, the first surplus since 1973, we expected the state to have a surplus again this year.
As a result of NRW’s deficit forecast, we expect a two-year delay in our earlier forecast that NRW’s ratio of net direct debt to operating revenue will fall to less than 250% by 2019 from 283% in 2016. We also expect the state’s direct debt to increase to around €141 billion by 2019, the deadline when the state must reach a structurally balanced budget as required by the debt-brake mechanism, from €138 billion currently. The increase in direct debt over the next three years will likely be offset by a decline in indirect debt, mainly from the wind down of Erste Abwicklungsanstalt (Aa1 stable) (see exhibit). Despite the state’s currently low interest payments (i.e., 4.3% of operating revenues) and declining indirect debt, high direct-debt is likely to put future budgets under pressure once interest rates begin rising.
Nordrhein-Westfalen’s Net Direct and Indirect Debt/Operating Revenue Ratio We expect the ratio to decline, despite NRW’s increased direct debt.
Sources: Nordrhein-Westfalen, DESTATIS and Moody’s Investors Service
The proposed supplementary budget follows the election of NRW’s parliament in May, which led to a change in regional government. The newly elected coalition of the Christian Democratic Union (CDU) and the Free Democrats (FDP) has campaigned strongly for improvements in security, education and infrastructure investments.
Consequently, the new government coalition’s supplementary budget would direct funds that accrued from €1.2 billion of higher-than-expected tax revenue and €400 million of lower labour costs toward security, child care and investment, instead of further consolidating NRW’s finances, as we had previously expected. However, according to public statements, the CDU/FDP coalition remains committed to a balanced budget by 2020 at the latest, when the debt-brake mechanism takes effect.
€ 132 € 136 € 137 € 139 € 137 € 139 € 140 € 141
€ 86 € 63 € 56 € 54€ 50 € 47 € 41 € 36
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2012 2013 2014 2015 2016 2017 Estimate 2018 Estimate 2019 Estimate
€Bi
llion
Direct Debt - left axis Indirect Debt - left axis
Janko Lukac Analyst +49.69.70730.925 [email protected]
NEWS & ANALYSIS Credit implications of current events
53 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
Russian Regions’ Revenue Growth Helps Contain Debt Burdens, a Credit Positive Last Wednesday, the Russian Federal Treasury published data showing that growth of Russian regions’ own-source revenues had accelerated to 11% during January-July 2017, versus 5% in the year-earlier period, and that the regions concomitantly had contained their expense growth to 7% during the period. The results are credit positive for Russian regions because they show that growing tax proceeds and cost controls are offsetting expense pressures from the upcoming presidential election and inflation, and will allow regions to record balanced performance and control their debt growth this year.
As Exhibit 1 shows, we expect Russian regions’ budgetary performance to continue stabilising, resulting in a relatively balanced sector-wide budget and lower debt burden this year. Russian regions will be able to absorb the majority of their expense growth with higher revenues as a result of an improving economy and stronger tax collection procedures. We expect that the regions will contain their expense growth through cost optimization measures that will partially mitigate the upward pressure from Russia’s presidential election in 2018. Additionally, we expect that lower inflation (forecasted to be 3.8% this year versus 5.4% in 2016) also will restrict the growth rate of expenses.
EXHIBIT 1
Russian Regions’ Debt and Deficits
Sources: Russian Federal Treasury, Russian Ministry of Finance and Moody’s Investors Service calculations and forecast
Growth of 11% in corporate income tax revenue and 9% growth in personal income tax revenue were the key contributors to the increase in own-source revenue. Tax proceeds benefited from stronger tax collection procedures. In addition, stronger corporate profits elevated corporate income and higher salaries boosted personal income tax proceeds. We forecast that nominal GDP growth will accelerate to 7.8% this year from 3.4% in 2016, which will further drive up these tax revenues. Property tax proceeds also got a boost from a larger property base because of new facilities, a gradual elimination of property tax benefits and changes to the taxable property value calculation for some property types. Exhibit 2 shows the key contributors to Russian regions’ own-source revenue.
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35%
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2%
3%
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5%
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7%
8%
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017Forecast
Net Direct and Indirect Debt to Total Revenues - right axis Deficit to Total Revenues - left axis
Vladlen Kuznetsov Vice President - Senior Analyst +7.495.228.6060 [email protected]
NEWS & ANALYSIS Credit implications of current events
54 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017
EXHIBIT 2
Key Taxes’ Contribution to Own-Source Revenue Growth
Note: Contribution to own-source revenue growth for each tax is calculated as nominal value growth of this tax relative to total own-source income increase. Sources: Russian Federal Treasury and Moody’s Investors Service calculations
Regions with substantial deficits will continue to face challenges matching revenue with growing expenses. Despite forecasted improvement of their budgetary performance, some regions will continue to report deficits and grow their debt this year. As Exhibit 3 shows, Moody’s-rated regions with persistent financing deficits, such as the Republic of Komi (B1 negative), Oblast of Omsk (Ba3 negative) and Krasnoyarsk Krai (B1 stable), will have difficulty restricting growth of their already-sizable debt burden.
EXHIBIT 3
Moody’s-Rated Russian Regions’ Surplus (Deficit) as a Percent of 2016 Revenues and Debt Burden
Sources: Russian Federal Treasury, Russian Ministry of Finance and the regions
Corporate Income Tax37%
Personal Income Tax27%
Propety Tax19%
Other17%
0%
10%
20%
30%
40%
50%
60%
70%
80%
-10%-8%-6%-4%-2%0%2%4%6%8%
10%
Net Direct and Indirect Debt to Operating Revenues in 2016 - right axis Surplus (Deficit) to Total 2016 Revenues - left axis
RECENTLY IN CREDIT OUTLOOK Select any article below to go to 4 September issue of Credit Outlook
55 MOODY’S CREDIT OUTLOOK 11 SEPTEMBER 2017 8
NEWS & ANALYSIS Hurricane Harvey Credit Effects 2 » Credit Negative for Gulf Coast Refiners » TPC's Two Plants Are Down, Negatively Affecting Third-
Quarter Results » Lake Charles, Louisiana Casinos Are Negatively Affected » Roads’, Ports’ and Airports’ Strong Liquidity and Cost
Recovery Mitigate Credit-Negative Disruptions » Utilities’ Liquidity and Cost-Recovery Provisions Mitigate
Harvey’s Effect » Utility Cost-Recovery Securitizations Exposed to Harvey Will
Likely Draw on Reserves » Auto ABS Cash Flows Will Decline for Next Few Months
Corporates 15 » Freeport-McMoRan's Deal on Indonesia Mine Is
Credit Positive » Evergrande's Deleveraging Plans Are Credit Positive
Banks 17 » Wells Fargo's Reputational Woes Continue with New Finding
of Potentially Unauthorized Accounts » US G-SIBs' First-Time Liquidity Coverage Ratio Disclosure Is
Credit Positive » Bank of Nova Scotia's Acquisition of BBVA Chile Would Be
Credit Negative » Dominican Republic’s Economic Slowdown Is Credit Negative
for Banks » Brazil Approves Covered Bond Regulation, a Credit Positive
for Banks » HSH Nordbank's Improved Solvency Raises Prospects for Its
Privatisation, a Credit Positive » Nigerian Banks Will Benefit from Moderating Foreign-
Currency Lending
Insurers 29 » UnitedHealth’s Acquisition of The Advisory Board Company’s
Health Care Business Is Credit Positive
Sovereigns 30 » Poland's Stronger-than-Expected Growth and Fiscal
Performance Are Credit Positive
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Additional terms for Japan only: Moody's Japan K.K. (“MJKK”) is a wholly-owned credit rating agency subsidiary of Moody's Group Japan G.K., which is wholly-owned by Moody’s Overseas Holdings Inc., a wholly-owned subsidiary of MCO. Moody’s SF Japan K.K. (“MSFJ”) is a wholly-owned credit rating agency subsidiary of MJKK. MSFJ is not a Nationally Recognized Statistical Rating Organization (“NRSRO”). Therefore, credit ratings assigned by MSFJ are Non-NRSRO Credit Ratings. Non-NRSRO Credit Ratings are assigned by an entity that is not a NRSRO and, consequently, the rated obligation will not qualify for certain types of treatment under U.S. laws. MJKK and MSFJ are credit rating agencies registered with the Japan Financial Services Agency and their registration numbers are FSA Commissioner (Ratings) No. 2 and 3 respectively.
MJKK or MSFJ (as applicable) hereby disclose that most issuers of debt securities (including corporate and municipal bonds, debentures, notes and commercial paper) and preferred stock rated by MJKK or MSFJ (as applicable) have, prior to assignment of any rating, agreed to pay to MJKK or MSFJ (as applicable) for appraisal and rating services rendered by it fees ranging from JPY200,000 to approximately JPY350,000,000.
MJKK and MSFJ also maintain policies and procedures to address Japanese regulatory requirements.
EDITORS SENIOR PRODUCTION ASSOCIATE Jay Sherman and Elisa Herr Amanda Kissoon
