Decline in Western European credit quality eases in 2007; weak outlook for 2008

The decline in the credit quality of Western European issuers of debt eased in 2007 compared to 2006 despite rising borrowing costs, due largely to an unexpected rebound in the second quarter, mainly in the non-financial, speculative-grade sector, Moody’s Investors Service said in a new report.

Overall credit quality did, however, remain in negative territory — the result of turmoil in credit markets by the third quarter and expectations for slower economic growth in the fourth quarter — whilst rating outlook statistics suggest that the credit outlook at the start of 2008 is weaker than a year ago.

“Although the eurozone’s economic performance was strong in 2007, with investment and exports the leading growth drivers, the economy ended the year in a weaker position than a year previously, as domestic firms struggled against rising import volumes and the appreciated euro, whilst private consumption was constrained by higher food and energy price inflation and still high interest rates. The current correction in the US sub-prime sector continues to pose a threat to economic developments in the euro zone, suggesting that credit market fundamentals are likely to deteriorate,” noted Dr Matthew Cairns, Senior European Economist and report co-author.

In the UK, economic growth decelerated by the end of 2007, as higher interest rates finally ate into the housing market and the credit crunch eased output in the financial and business services sectors. Moody’s anticipates that UK household lending and business investment will grow at slow rates in 2008, held back by a high real rate of interest. The slowdown in housing markets and modest job creation will hold back consumer confidence and limit spending, with heavily indebted households already wary of high lending rates.

Rating downgrades among Western European issuers once again outnumbered upgrades in 2007, by 107 to 84, giving a negative ratings balance of -23. However, this was a marked improvement from -46 in 2006, indicating an easing in the decline in credit quality. “This improvement was all the more impressive given that borrowing costs rose throughout 2007 on the back of European Central Bank rate hikes and higher credit premiums,” said Christine Li, co-author of the report.

“Nonetheless,” Li added, “going forward, the softening in the decline in Western European credit quality may not last, as the ongoing credit market malaise has continued to raise borrowing costs, despite ECB rates, being on hold due to the continued widening of corporate spreads. This comes at a time when the euro-zone economy is slowing, whilst raw material and energy prices have been accelerating, putting increasing strain on corporate profit margins.”

“Almost all downgrades were due to further impairments and write-downs on sub-prime-related losses and on- and off-balance sheet structured products.”