Moody's Credit Outlook - November 1

1 NOVEMBER 2012
NEWS & ANALYSIS

Hurricane Sandy Hurricane Sandy Will Likely Spur a Small Pick-Up in ConsumerProducts Sales Hurricane Sandy Will Boost Home-Improvement Retailers, Hurt Halloween Vendors Hurricane Sandy Dashes P&C Insurers Hopes for a Quiet End to Year Hurricane Sandy Will Test Municipalities and Not-for-Profit Enterprises Liquidity Corporates Hong Kongs Curbs on Property Investments Are Credit Negative for Developers Infrastructure E.ON and RWE Sell UK Nuclear Joint Venture and Reduce Debt, a Credit Positive Banks Danske Banks Capital Raise Is Credit Positive for Creditors Tax on Term Deposit Interest Will Be Credit Negative for Bulgarian Banks Bank of Israels Loan-to-Value Limit Is Credit Positive for Israeli Banks New Hong Kong Property Stamp Duty Is Credit Positive for Banks Insurers Increase in Capital Rules Is Credit Positive for US Life Insurers Mexican Government Proposes New Credit Positive Insurance Framework Sovereigns Japans Impasse Over Deficit-Financing Bill Is Credit Negative Sub-sovereigns Tepics Inability to Pay Year-End Bonuses Is Credit Negative 2
CREDIT IN DEPTH
IMF Loan Repayments Strain Pakistans Finances The government of Pakistans fifth loan repayment occurs against the backdrop of a sluggish economy and looming external and fiscal risks. Although the countrys official international reserves will cover debt payments that are due in 2013, Pakistans buffer to external financial shocks or a loss of domestic confidence is thin, thus highlighting its reliance on multilateral or bilateral funding. 23
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MOODYS.COM
NEWS & ANALYSIS

Credit implications of current events
Hurricane Sandy
Kevin Cassidy Vice President - Senior Credit Officer +1.212.553.1676 kevin.cassidy@moodys.com Janice Hofferber, CFA Senior Vice President +1.212.553.4493 janice.hofferber@moodys.com Linda Montag Senior Vice President +1.212.553.1336 linda.montag@moodys.com
Hurricane Sandy Will Likely Spur a Small Pick-Up in Consumer-Products Sales

Consumer-products companies will likely see a pick-up in sales from Hurricane Sandy. However, for makers of batteries, appliances, mattresses and beverages, the bump will be small and temporary and will not lead to a material improvement in the companies financials or credit metrics. The biggest winners will be battery companies Spectrum Brands, Inc. and Energizer Holdings Inc. because batteries are a meaningful part of their business. Below, we outline the likely effects of the storm on several consumer-products subsectors. Batteries: Energizer Holdings Inc. (Baa3 negative), The Procter & Gamble Companys (P&G, Aa3 stable) Duracell brand and Spectrum Brands Inc. (B1 stable) likely saw sales increase in advance of the storm as consumers, preparing for power outages, stocked up on batteries and lighting sources. Increased battery sales will have little effect on the companies overall financial performance, given the companies size and diversity. However, any increase does help offset the companies weak US battery sales. Cleaning and durable products: The Clorox Company (Baa1 stable), Whirlpool Corporation (Baa3 stable), Mohawk Industries Inc. (Ba1 positive), Sealy Mattress Company (B2 review for upgrade) and Serta/Simmons Holdings (B2 stable) will likely see a sales increase in the days and weeks after the storm as consumers clean up and replace water-damaged appliances, carpets and mattresses. The lift for consumer-durables companies, though brief, will more than offset the sales lost from consumers inability to shop during the storm. However, the financial effect of the increased sales on each company is not likely to be significant, because the affected consumers are a relatively small percentage of each companys overall operations. Beverages: Soft-beverage companies, particularly The Coca-Cola Company (Aa3 stable), PepsiCo, Inc. (Aa3 negative) and Dr Pepper Snapple Group, Inc. (Baa1 stable) and to a lesser degree beer companies such as Anheuser Busch InBev SA/NV (A3 positive), Molson Coors Brewing Company (Baa2 stable) and Constellation Brands, Inc. (Ba1 stable), will also experience a sales boost in the affected regions as consumers on the East Coast filled their pantries before the storm. Extended residential power outages could also spur a slight and temporary increase in the sale of shelfstable beverages including juices, waters, teas and carbonated soft drinks produced by many beverage and some food companies. Sales of powdered milk and ultra-heat treatment (UHT) milk (the latter is a small part of Dean Foods Companys [Ba3 review for downgrade] portfolio) likely also increased as fresh milk cannot be kept without refrigeration. However, closures of retail stores owing to storm conditions or power outages could put a temporary hold on post-storm sales, which could offset the pre-storm sales boost. And if flooding disrupts product deliveries and retailers ability to restock, beverage sales would also be hurt.
MOODYS CREDIT OUTLOOK
1 NOVEMBER 2012
NEWS & ANALYSIS

Margaret Taylor Vice President - Senior Credit Officer +1.212.553.0424 margaret.taylor@moodys.com John Paul McMullen Associate Analyst +1.212.553.7295 john.mcmullen@moodys.com
Hurricane Sandy Will Boost Home-Improvement Retailers, Hurt Halloween Vendors

Hurricane Sandy will be credit positive on retailers that sell equipment and provisions that consumers use to weather the storm and its aftermath, while it will be credit negative for those that sell Halloween goods and other discretionary items. However, we do not expect it to have a material effect on retail sales. For home-improvement retailers such as The Home Depot Inc. (A3 stable) and Lowes Companies Inc. (A3 stable), Hurricane Sandy will drive a significant increase in sales. Consumers rushed to these stores to stock up on essentials and buy equipment for storm preparations. The stores will benefit further in the aftermath as consumers seek supplies for home and building repairs. These companies will benefit from heavy sales of generators, flash lights, batteries and plywood. Beyond home-improvement stores, other retail categories stand to benefit from heavy sales of flash lights, batteries, food, water and other essentials, including drug stores such as Walgreen Co. (Baa1 negative) and Rite Aid Corporation (Caa1 stable). Supermarkets such as The Great Atlantic & Pacific Tea Co. Inc. (A&P, Caa1 stable), Koninklijke Ahold N.V. (Baa3 stable), which operates the Stop & Shop and Giant chains, and Tops Holding Corporation (B3 stable) will also benefit, although stores that have power outages may experience product spoilage that could partially offset the benefits of stockpiling by shoppers. Warehouse clubs such as Costco Wholesale Corporation (A1 stable), WalMart Stores Inc.s (Aa2 stable) Sams Club and BJs Wholesale Club Inc., and discounters such as WalMart and Target Corporation (A2 stable) will gain as consumers stockpile critical goods. Most of BJs Wholesale stores are in areas affected by the storm. For retailers with a heavy concentration of Halloween sales, such as Spencer Spirit Holdings Inc. (B2 stable) and Party City Holdings, Inc. (B2 stable), the disruption in store traffic just before the dampened Halloween festivities will hurt revenue and earnings. Many consumers will choose to stay indoors rather than make last-minute Halloween purchases. This is particularly disappointing for these retailers because this is the second consecutive year that the eastern US has had major storm interruptions before Halloween. For many retailers, the aftermath of the storm will reduce store traffic as consumers focus on tending to their homes and communities. Many people who were in the storms path remain without electrical power and flooding is widespread. Some stores have been closed. In coming days, inventory restocking and supply chain operations will be affected in some locations because flooding will limit access to roads and freight rail traffic could see some disruption. As shoppers in the affected region focus on the storm, other discretionary spending will fall and not be recouped. The additional purchases for storm preparation and repairs will strain some consumers discretionary spending budgets. Department stores, apparel, and specialty retailers will see slower store traffic on the East Coast, although consumers who are not affected by power outages may shop online instead. The timing of the storm, at a slower seasonal time between the peak back-to-school and holiday seasons, may limit a more severe effect on apparel sales in the fourth quarter. We continue to expect to a low-single-digit percentage increase in apparel sales, consistent with overall economic growth, in the fourth quarter.
1 NOVEMBER 2012
NEWS & ANALYSIS

Paul Bauer, CFA Vice President - Senior Credit Officer +1.212.553.1334 paul.bauer@moodys.com
Hurricane Sandy Dashes P&C Insurers Hopes for a Quiet End to Year
Insured loss estimates from Hurricane Sandy are still in the early stages, although catastrophe modeling firms have released preliminary estimates. EQECAT published an estimate of $5-$10 billion on 29 October, while on 30 October AIR Worldwide published an estimate of $7-$15 billion. Assuming that ultimate losses are not dramatically beyond these ranges, the event will not jeopardize capital for major property and casualty (P&C) insurers, although it will negatively affect fourth-quarter earnings, and may cause capital volatility for smaller regional insurers (which we generally do not rate). We expect the companies in Exhibits 1-3 to bear the brunt of the losses based on their market shares for particular lines in heavily exposed states on or near the coast and in the center of the storms path. State Farm (unrated), The Allstate Corporation (senior debt A3 negative), The Travelers Companies Inc. (senior debt A2 stable), and Liberty Mutual Insurance Company (surplus notes Baa2 stable) all have high market shares in the affected areas. However, as large national writers, these companies have diversified exposures and strong capital bases to withstand weather-related volatility. Top 10 Homeowners Insurers in States Heavily Exposed to Hurricane Sandy
Insurance Financial Strength Rating Market Share (2011) Direct Premium Written 2011 ($000s)
EXHIBIT 1
State Farm Allstate Travelers Liberty Mutual Chubb Nationwide Mutual Erie Insurance Group USAA Tower Group MetLife
Unrated Aa3 negative Aa2 stable A2 stable Aa2 stable A1 stable Unrated Aaa stable Unrated Unrated
17.2% 13.9% 9.6% 7.6% 6.2% 5.6% 4.6% 3.4% 2.1% 1.6%
$1,863,939 1,497,084 1,026,658 792,385 666,111 618,760 478,689 354,617 230,998 178,212
Note: Reflects premiums for Delaware, Maryland, New Jersey, New York, Pennsylvania and Washington, DC. Sources: SNL Financial LC, Moodys
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NEWS & ANALYSIS

Top 10 Commercial Property Insurers in States Heavily Exposed to Hurricane Sandy (Fire, Allied, Non-Liability Commercial Multi-Peril, Inland Marine)
EXHIBIT 2
Liberty Mutual Travelers Chubb AIG FM Global Assurant CNA Hartford Financial Nationwide Mutual Farmers (Zurich)
A2 stable Aa2 stable Aa2 stable A1 stable unrated A2 stable A3 positive A2 stable A1 stable A2 stable
8.4% 8.1% 6.0% 5.3% 3.9% 3.6% 3.5% 3.3% 3.2% 3.1%
$761,631 733,095 540,137 479,747 348,482 325,392 314,716 301,188 291,593 279,815
Note: Reflects premiums for Delaware, Maryland, New Jersey, New York, Pennsylvania and Washington, DC. Sources: SNL Financial LC, Moodys
Top 10 Automobile Insurers in States Heavily Exposed to Hurricane Sandy (Personal and Commercial Auto Physical Damage)
EXHIBIT 3
GEICO (Berkshire Hathaway) Allstate State Farm Liberty Mutual Nationwide Mutual Progressive Erie Insurance Group Travelers USAA NJ Manufacturers
Aa1 stable Aa3 negative unrated A2 stable A1 stable Aa2 stable unrated Aa2 stable Aaa stable unrated
15.9% 14.9% 13.3% 6.2% 5.9% 5.8% 5.5% 4.4% 4.1% 2.8%
$1,705,420 1,596,006 1,426,026 658,783 626,713 615,846 590,752 471,031 434,537 300,016
Note: Reflects premiums for Delaware, Maryland, New Jersey, New York, Pennsylvania and Washington DC. Sources: SNL Financial LC, Moodys
The P&C industry as a whole is currently at a level of relative capital strength, with good risk-adjusted capitalization, moderate financial leverage, and earnings that have benefited from price increases and relatively low weather-related losses through the first three quarters of the year. So, despite the negative earnings effect of Hurricane Sandy, we expect that major insurers can absorb such losses without harming capital strength. In addition, the event will likely help support price increases going into 2013. We expect the majority of insurance losses to stem from homeowners policies, commercial property coverages and business interruption (e.g., commercial multi-peril, allied, fire, inland marine), and to
1 NOVEMBER 2012
NEWS & ANALYSIS

some degree automobile policies. Storm surges cause significant economic losses, but flood damage is typically not covered by homeowners policies, although this often becomes an area of dispute when the immediate cause of loss (wind versus flood) is unclear. Generally, homeowners losses make up a large portion of hurricane/storm losses. However, in this case, the relatively moderate wind speeds involved should limit structural damage to houses. Instead, damage to homes will likely be primarily from falling trees or minor damage to roofing and siding, rather than the destruction of complete buildings. Power outages will lead to secondary claims such as sump pump failure (an optional coverage in most homeowners policies) causing water damage. In addition, the need to evacuate multiple coastal areas will lead to insurance payments to cover additional living expenses. Water damage to automobiles could be higher than normal owing to flooding. Commercial lines insurance will face losses from flooding, which is typically an optional commercial coverage. In addition, business interruption and direct damage to property from wind will be sources of loss. For Hurricane Irene in 2011, which also caused extensive flooding on the East Coast, commercial losses accounted for roughly one third of total insured losses, which tallied to $5.3 billion, according to Swiss Re Sigma. Commercial losses could make up a larger portion of total losses from Hurricane Sandy, given the widespread storm surge, extended period of rain, and concentration of damage in New York City and other urban areas. For large national insurers, we expect that losses from Hurricane Sandy for the most part will remain within primary layers, so that little earnings or capital relief will be gained through reinsurance covers.
1 NOVEMBER 2012
NEWS & ANALYSIS

Dan Seymour, CFA Associate Analyst +1.212.553.4871 dan.seymour@moodys.com Bill Fitzpatrick Vice President - Senior Credit Officer +1.212.553.4104 bill.fitzpatrick@moodys.com
Hurricane Sandy Will Test Municipalities and Not-for-Profit Enterprises Liquidity

Hurricane Sandy made landfall on the East Coast on Monday, leaving in its wake storm-related damages that some municipal leaders have described as the most severe they have ever experienced in their region. Local governments face the credit negative risk of unbudgeted costs for flood control, cleanup, sheltering evacuees, emergency services and rebuilding damaged infrastructure. In extreme cases, strains on liquidity could occur if recovery costs exceed budget and federal reimbursements are delayed. Public transit systems may be particularly challenged, because they face large cleanup costs in addition to lost revenue during the period in which they are inoperable. Some enterprise credits such as hospitals, higher education institutions and housing projects are also affected. As with hurricanes Isaac and Irene, US municipal issuers have an extremely strong track record of recovering from natural disasters without impairments to bondholders. The immediate disruptions of these disasters tend to cause short-term liquidity problems but subsequent spending from insurance, federal aid, state support and private charitable donations is very simulative for local and regional economies. Automated payment systems, when set up and working properly, ensure timely debt service payments. Most affected local governments have contingency reserves for weather events, and will also be eligible for aid from Federal Emergency Management Agency (FEMA). For disaster areas, the federal government pays 75% or more of various emergency costs and up to 75% for hazard mitigation projects. States decide how to allocate the non-federal share of cleanup costs. President Barack Obama has already authorized emergency funding for Massachusetts, Rhode Island, Connecticut, New York, Pennsylvania, New Jersey, Maryland, Delaware, Maryland, West Virginia, Virginia, and Washington, DC. Private non-profit organizations such as higher education institutions and healthcare facilities that provide services to the general public are also eligible for FEMA assistance. States sometimes assist with delays in federal reimbursement. After Hurricane Isaac, the state of Louisiana (Aa2 stable) signaled a willingness to help issuers bridge gaps in cash flows with revenue anticipation notes. In the aftermath of Hurricane Irene, the state of Vermont (Aaa stable) accelerated local aid and allowed local banks to borrow from the state Municipal Bond Bank to fund short-term loans to municipalities for cleanup efforts. Storm related credit risks include the following:
Upfront cleanup costs exceed budgeted contingencies. Excess costs not offset by immediate revenues will force issuers to use reserves or cut other expenditures. These excess costs will reduce fund balances. A lag in aid from higher levels of government. Even for eligible issuers whose costs are mostly reimbursed, the aid often comes months and sometimes more than a year after the costs are incurred. For issuers with sufficient liquidity, we do not expect such instances to significantly affect long-term ratings. Delays in insurance reimbursements. Elevated risk of mortgage delinquencies or foreclosures as homeowners seek to finance repairs while awaiting insurance funds for damaged properties securing state housing finance agency programs.
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NEWS & ANALYSIS

Hospitals in affected areas are likely to report negative effects from the hurricane. Those negative effects include a significant decline in patient volume this week, the closures of outpatient clinics and physicians offices, and inpatient admissions only handling emergency cases. In addition, there will be expenses for overtime staffing of emergency workers and the immediate costs of cleanup. Insurance may cover a lot of the costs associated with storm-related damage, but is unlikely to cover all of what will likely be higher expenses for the period. Vulnerability of several classes of debt. Classes of debt, including sales and special tax revenue bonds, and revenue bonds supported by the operations of healthcare, educational, housing and other enterprise entities may be more vulnerable owing to factors such as appropriation risk and the cyclical nature of revenue streams. Issuers of revenue bonds will be most immediately affected by increased expenditures.
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NEWS & ANALYSIS

Corporates
Kelvin Tsui Associate Analyst +852.3758.1532 kelvin.tsui@moodys.com Kaven Tsang Vice President - Senior Analyst +852.3758.1304 kaiyin.tsang@moodys.com
Hong Kongs Curbs on Property Investments Are Credit Negative for Developers
Last Friday, the Hong Kong government announced that it would introduce a new buyers stamp duty (BSD) and amend current special stamp duties (SSD) that it first imposed in November 2010. These measures are credit negative for Hong Kong property developers because the new SSD will slow down property sales, which in turn will weaken developers cash flow. Affected developers include Sun Hung Kai Properties (Capital Market) Limited (A1 negative), Nan Fung International Holdings Limited (Baa3 stable), Henderson Land Development Co. Ltd. (unrated) and Cheung Kong (Holdings) Limited (unrated). Under the new scheme, the government will introduce an additional 15% BSD for foreign and corporate homebuyers on top of the SSD. The holding period for property projects that are subject to SSD will extend to three years from two years. In addition, the government will raise the existing SSD for residential properties by five percentage points across all three holding periods (see exhibit). Changes to Hong Kongs Special Stamp Duties
Holding period Less than 6 months 6-12 months 12-24 months 12-36 months
EXHIBIT 1
Old SSD New SSD

Source: Hong Kong Inland Revenue Department
15% 20%
10% 15%
5% 10%
Nil
The new BSD, which targets non-local and corporate buyers, aims to curb investment demand from mainland China investors, who have been one of the major driving forces behind the rise in property prices in the past few years. Under the new scheme, these buyers would have to take a more cautious approach because the changes would require them to speculate on market trends for a longer period and at higher transaction costs, thereby discouraging purchases. In addition, many homebuyers for whom these properties are their main residences will likely stay on the sidelines given the uncertainties about how the amendments would affect property prices, and the possibility the government will take further measures to cool the property market. Preliminary data from property agents indicate that property sales dropped or slowed down over the weekend following last Fridays announcement. According to Midland Realty, the number of transactions recorded from the top 15 housing estates decreased by 52% to 13 on 27-28 October versus the previous weekend. When the Hong Kong government first introduced the SSD, transaction volume within a month (including first and secondary transactions) decreased 26%, while the consideration paid for properties declined 28%, according to the statistics of Land Registry (Exhibit 2).
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NEWS & ANALYSIS

The Effect of the Special Stamp Duties on Transaction Volume and Prices
Agreements for Sale and Purchase of Building Units December 2010 November 2010 Month-over-Month Change
EXHIBIT 2
Number of transaction Consideration (HKD million)

Source: Land Registry of Hong Kong
11,790 53,412
15,967 74,026
-26% -28%
The higher stamp duties will likely affect developers performance if they have recently launched new projects or do so in the near future. Sun Hung Kai Properties, which has several projects planned for sale in the near term, is among those that would be affected. Nevertheless, we do not expect a substantial drop in property prices immediately for two reasons. First, home demand in Hong Kong remains strong amid a low supply of new flats during the past few years, and the SSD could increase investors holding period, which in turn would lower supply in the secondary market. Second, interest rates will remain low in light of the ample market liquidity after the US Federal Reserves recent round of quantitative easing, which encourages investment in fixed assets.
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Infrastructure
Niel Bisset Senior Vice President +44.20.7772.5344 niel.bisset@moodys.com
E.ON and RWE Sell UK Nuclear Joint Venture and Reduce Debt, a Credit Positive
Last Tuesday, E.ON AG (A3 stable) and RWE AG (A3 negative), the giant European power groups, agreed to sell their 50/50 UK nuclear power joint venture, Horizon Nuclear Power (unrated), to Hitachi, Ltd. (A3 stable) of Japan for 696 million (roughly 866 million). The deal, which will net each partner 433 million, is credit positive for both companies because it will reduce debt and is a further step towards completion of their asset disposal programmes. The transaction follows RWEs sale two weeks ago of its 20% licence interest in the Edvard Grieg oil and gas development in Norway for up to 283 million, including a contingent payment of up to 35 million based on achievement of certain operational milestones. On Tuesday, RWE also completed a 658 million sale of its indirect 24.95% stake in water utility Berliner Wasserbetriebe (unrated). RWEs aggregate proceeds of 1.374 billion from the three deals is just under 20% of its 7 billion disposal target, and will reduce the companys approximately 14 billion net debt (as of the end of June) by roughly 10%, a credit positive for RWE. The deal is also credit positive for E.ON because its 433 million share of the proceeds from the sale of Horizon will reduce its approximately 21 billion net debt (as of the end of June) by roughly 2%, and will bring it closer to completing its target of 15 billion of disposals by the end of 2013. Combined with other asset sales, including this years sale of OGE, its gas transmission network,1 proceeds from the programme will have reached almost 13 billion upon completion of the deal, which the companies expect will occur in the fourth quarter. RWEs and E.ONs progress on their asset disposal programmes is credit positive because it reduces their leverage in response to the negative earnings pressure both companies are facing. As with other European utilities, lower electricity prices and narrower margins on gas-fired generation will likely reduce E.ONs and RWEs cash flows from power generation over 2012 and 2013 versus 2011. In addition, like other nuclear power producers in Germany, E.ON and RWE will be required to pay the nuclear fuel rod tax that we estimate will be in the range 700-800 million a year for E.ON and 400 million a year for RWE in 2012-13. The sale also benefits the UK government because it restores momentum to plans to attract investment in new nuclear power plants to replace the UKs ageing nuclear fleet. Hitachi will continue to pursue plans to build new nuclear power stations at Wylfa in Wales and Oldbury-on-Severn in Southwestern UK.
See E.ON Sells Its Gas Transmission Network, Reducing Debt, Weekly Credit Outlook, 21 May 2012.
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NEWS & ANALYSIS

Banks
Oscar Heemskerk Vice President - Senior Credit Officer +44.20.7772.5532 oscar.heemskerk@moodys.com
Danske Banks Capital Raise Is Credit Positive for Creditors

On Tuesday, Danske Bank A/S (Baa1 stable; C-/baa2 stable)2 announced it was raising approximately DKK7 billion of equity. The execution of the issue, which was completed by Wednesday, increased the banks core Tier 1 capital ratio by approximately 0.8 percentage points ahead of the upcoming stricter Basel III capital requirements, a credit positive. We expect that improving the banks capital cushion will further improve Danske Banks access to senior unsecured creditors following intermittently poor access to such funding by Danish banks during the financial crisis. At the end of September, Danske Banks core Tier 1 capital ratio was 12.7% of risk weighted assets, as calculated using the Basel II internal rating based approach, excluding transition floors. The capital raise contributes to the bank reaching its newly stated core Tier 1 capital ratio target of 13%. The bank has not paid dividends since 2008, and does not intend to pay dividends in 2012. The capital increase is particularly relevant given the following challenges that the bank faces: Increasing the buffer against asset quality deterioration. In recent years, Danske Bank has booked elevated impairments on loans, particularly to Danish small and medium-size enterprises, commercial real estate, and agriculture. In addition, Danske Banks operations in Ireland and Northern Ireland have been loss-making since 2008. Funding additional collateral for covered bonds. Danish law requires banks to increase the collateral pool of covered bonds, which can be funded through capital, when house prices decline. The requirement for supplementary capital in Danske Banks mortgage subsidiary, Realkredit Danmark, increased to DKK40.8 billion at the end of September, from DKK34.5 billion at the end of 2011. The average Danish house price has fallen 19% over the five years since housing prices peaked at the end of June 2007, and further price declines could lead to further increases in collateral requirements. Alternatively, Danske Bank could fund such over-collateralisations through junior covered bonds and bank guarantees, as it has done in the past. Meeting increased regulatory requirements. The European Union Capital Requirements Directive IV, which implements Basel III guidance,3 generally increases the level and quality requirements of bank capital. These increased requirements will gradually go into effect starting in 2013. Conditions for unsecured funding should improve. At the end of September, 7% of the banks total funding consisted of senior unsecured funding, and because increased capital improves conditions for unsecured senior creditors, we expect the availability and pricing of unsecured funding to improve for Danske Bank with the capital raising. Year to date, the bank successfully issued DKK30 billion in the senior unsecured market. In addition, the bank has used central bank long-term liquidity; at the end of September it had drawn about DKK35 billion on the three-year Danish central bank liquidity facility and about DKK40 billion on the European Central Bank facility.
2 3
The bank ratings shown in this report are the banks deposit rating, its standalone bank financial strength rating/baseline credit assessment and the corresponding rating outlooks. See Banks Will Need Significant Capital To Meet New Basel III Requirements; A Credit Positive, Weekly Credit Outlook, 20 September 2010.
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Elena Panayiotou Analyst +357.25.693.010 elena.panayiotou@moodys.com
Tax on Term Deposit Interest Will Be Credit Negative for Bulgarian Banks
On 25 October, the Bulgarian Parliament approved at first reading4 the introduction of a 10% tax on interest earned on term deposits, effective in January. This tax is credit negative for Bulgarian banks because it will reduce households incentives to save at banks, thereby increasing banks funding costs. The tax would be imposed on interest earned on term deposits, with depositors paying at the end of the month following the quarter for which interest was due. The banks would be responsible for withholding the tax and paying it to the government. The government estimates that the tax will generate around BGN120 million (61 million), or approximately 0.4% of term deposits in the system. As term deposits are predominantly sourced from the household sector, which composed 79% of the systems term deposits as of June 2012 versus 21% for the corporate sector, household depositors would be most affected by the new law. DSK Bank PLC (Baa3 negative; D/ba2 negative)5 and Raiffeisenbank (Bulgaria) EAD (Ba1 stable; D-/ba3 stable) are equally vulnerable given the predominance of term deposits in their deposit base at around 56% and 59%, respectively. By comparison, Corporate Commercial Bank ADs (Ba3 stable; D-/ba3, stable) term deposits are 38% of its deposit base. Banking system deposits grew by 34% between the end of 2008 and August 2012, supporting the systems liquidity, reducing banks reliance on wholesale funds, and improving the ratio of gross loans to deposits to 100% from 120% during the period (see exhibit below). In an attempt to maintain these deposits against the backdrop of the new tax, banks may raise interest rates, although such a move would hurt interest rate margins and profitability. Shorter term deposit inflows could also increase maturity mismatches between assets and liabilities, while lower deposit growth would increase banks reliance on more volatile interbank funding. Year-over-Year Changes of Bulgarian Banks Deposit Balances and Loan-to-Deposit Ratios
Deposit Growth Year-over-Year - left axis 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% 2008 2009 2010 2011 Aug-2012 Loans/Deposits - right axis 125% 120% 115% 110% 105% 100% 95% 90% 85% 80%
Source: Bulgarian National Bank
4 5
Approval at first reading means that Parliament approved the measure at the first hearing. Before year-end, Parliament will hold a second hearing to approve the 2013 state budget and revote on the adoption of the taxation on deposits. The ratings shown are the banks deposit rating, its standalone bank financial strength rating/baseline credit assessment and the corresponding rating outlooks.
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Constantinos Kypreos Vice President - Senior Credit Officer +357.25.693.009 constantinos.kypreos@moodys.com
Bank of Israels Loan-to-Value Limit Is Credit Positive for Israeli Banks

Last Monday, the Bank of Israel issued a draft directive setting maximum limits on loan-to-value ratios (LTV) of housing loans made by local banks. The new directive is credit positive for Israeli banks because it, along with previous Bank of Israel measures, will help contain the risk inherent in the banks housing loan portfolios by ensuring higher collateral coverage for banks. Moreover, we expect any loss of business or fee income resulting from the new measures to be moderate and of secondary importance from a credit perspective. The directive calls for housing loans to have LTVs of no more than 70%, or 75% for first-time homebuyers. The maximum for loans on investment properties is 50%. The new directive builds upon previous measures that the Bank of Israels Banking Supervision Department has taken, including limiting the floating interest rate component of a housing loan to one-third of the total loan, requiring a 0.75% loan-loss provision for new loans with LTVs of more than 60%, and requiring a 100% risk weighting (for the calculation of the banks capital adequacy ratio) for loans of more than NIS800,000 and LTVs of more than 60%. The new directive comes on the same day that the Bank of Israel cut its interest rates by 25 basis points to 2.0% and as both the number of property transactions and the size of mortgages have grown. These factors are fueling the risk that house price inflation could develop into a crisis. The Israeli Housing Price Index has already appreciated by some 62% in nominal terms between the end of 2007 and June 2012, while housing loans outstanding increased by 71% over the same period and accounted for 29% of all credit as of June 2012, according to the Bank of Israel. However, mitigating the risks associated with those trends is a full-recourse legal structure in Israel, conservative underwriting standards, the Bank of Israels hands-on approach and the macro-prudential measures discussed above. Mizrahi Tefahot Bank (A2 negative; C-/baa2 negative)6 has the highest exposure to mortgage loans, accounting for 60% of its total on-balance sheet credit exposures as of June, followed by Bank Leumi (A2 stable; C-/baa2 stable), whose mortgage book accounted for 23% its total on-balance sheet credit exposures, and Bank Hapoalim (A2 stable; C-/baa2 stable) at 18%. However, Leumi and Hapoalim also have significant exposures to the construction and real estate sector, which displays a high correlation with the housing credit portfolio. These portfolios account for an additional 16% of both banks total credit exposure. Israel Discount Banks (A3 negative; D+/baa3 stable) and First International Bank of Israels (A3 stable; D+/baa3 stable) combined exposure to housing loans and the construction and real estate sector is 28% and 34% of their total credit exposures, respectively.
The bank ratings shown in this report are the banks deposit rating, its standalone bank financial strength rating/baseline credit assessment and the corresponding rating outlooks.
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Sherry Zhang Associate Analyst +852.3758.1392 sherry.zhang@moodys.com Sonny Hsu Vice President - Senior Analyst +852.3758.1363 sonny.hsu@moodys.com
New Hong Kong Property Stamp Duty Is Credit Positive for Banks
On 26 October, the Hong Kong government announced new measures aimed at curbing speculative demand for residential properties and stabilizing prices. The new measures, effective 27 October, introduced for the first time a 15% buyers stamp duty (BSD) on residential property purchases by non-local persons and local and overseas corporations. In addition, the government also raised the rates of a special stamp duty (SSD) already in place, and extended its coverage period (see Exhibit 1). New or Adjusted Property Taxes in Hong Kong
Buyers Stamp Duty New Old
EXHIBIT 1
Buyers Stamp Duty on residential properties acquired by non-Hong Kong permanent residents and local and overseas corporate entities Special Stamp Duty Properties purchased and resold within six months Properties purchased and resold between seven and 12 months Properties purchased and resold between 13 and 24 months Properties purchased and resold between 25 and 36 months
Source: Hong Kong Inland Revenue Department
15%
N/A
20% 15% 10% 10%
15% 10% 5% N/A
These latest measures are credit positive for banks because they reduce the risk of further fund inflows into an already overheated residential property market that could set the stage for a subsequent crash. The government last month tightened its property lending rules7 immediately after the latest monetary easing by the US Federal Reserve. These latest measures are a meaningful follow-up. The BSD directly targets non-local buyers, who have absorbed a significant portion of Hong Kongs new home supply. According to Centaline Property Agency, one of the largest property agencies in Hong Kong, non-resident buyers from mainland China between January and September accounted for 23.1% of primary home transactions, and 8.6% of secondary home transactions. Meanwhile, nonresident buyers from mainland China accounted for 28.3% of all transactions in the luxury sector, compared with 10.4% in the mass market sector. We expect the new BSD to reduce the participation from foreign buyers, thereby moderating overall demand. The increase and extended coverage of the existing SSD will add to the transaction costs of buyers making speculative bets. We also note that the BSD applies to corporate purchases of residential properties regardless of nationality, an attempt to close a potential loophole in which speculators set up companies to trade properties to bypass the SSD levies. Residential property values in Hong Kong have appreciated 17% in the first eight months of 2012, according to governments statistics (see Exhibit 2). Property values have risen further since early September. These follow-up measures are a response to the renewed risks of further property price appreciation.
See New Prudential Measures in Hong Kong Are Credit Positive for Banks, Credit Outlook, 20 September 2012.
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NEWS & ANALYSIS

EXHIBIT 2
220
Hong Kong Private Property Price Index (1990 = 100)

Special Stamp Duty introduced in Nov 2010 200 180 160 140 120 100 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12
Source: Rating and Valuation Department, Hong Kong Government
During 19-24 October, the Hong Kong Monetary Authority, the territorys de facto central bank, sold a combined HKD14 billion in exchange for US dollars in four intervals as the local currency hit its upper bound under the currency board arrangement. The strength of the Hong Kong dollar is a manifestation of the inflow of funds into the territory following the latest round of the US Federal Reserves monetary easing. Monetary conditions in Hong Kong remain very accommodating, and quantitative easing measures in the US will likely further contribute to excessive liquidity conditions in the Hong Kong banking system. The latest government measures to dampen demand for residential properties will make banks less vulnerable in the event of a severe property market downturn in the future.8
According to the Hong Kong Monetary Authority statistics, residential and commercial property related loans accounted for 51.5% of domestic bank loan exposure as of June 2012.
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1 NOVEMBER 2012
NEWS & ANALYSIS

Insurers
Shachar Gonen Assistant Vice President - Analyst +1.212.553.3711 shachar.gonen@moodys.com
Increase in Capital Rules Is Credit Positive for US Life Insurers

Last Friday, the National Association of Insurance Commissioners (NAIC) adopted more conservative assumptions and scenarios for year-end 2012 modeling of non-agency residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBS). The new assumptions are credit positive because they will increase the regulatory capital that US life insurers will be required to hold. However, that benefit is partially offset by the disincentive for insurers to invest in two of the better yielding asset classes in a low-yield environment. The NAICs Valuation of Securities (VOS) task force, which provides regulatory leadership and expertise on investment risk, approved a change to the parameters of the baseline economic scenario and adjusted the weightings of the alternative scenarios that were more aggressive and conservative relative to the baseline. Projections under multiple scenarios are weighted and used to determine the amount of required capital for certain structured securities held by insurance companies. The adjustments capture the potential for worse scenarios than last years downside scenarios. The NAICs preliminary estimate of the industry-wide effect for life insurers of the new scenario weightings is for NAIC risk-based capital (RBC) to increase to 3.2% from 2.7% for RMBS and to 1.0% from 0.9% for CMBS. The higher capital requirements, which will affect insurers in their preparation of year-end 2012 statutory financial statements, are credit positive for the capital adequacy of the insurance industry. However, the additional capital requirements will increase the amount of capital for insurers to hold RMBS and CMBS relative to other investments. That increase may discourage insurers from maintaining existing holdings in these asset classes and from making future purchases. In response to the persistently low interest rate environment, life insurers are constantly searching for investments that provide sufficient yields to meet their long-term liabilities. US life insurers holdings of RMBS and CMBS equaled approximately 10% of their investment portfolios as of year-end 2011. Some recent purchases at deep discounts to par have provided relatively attractive yields and carry significant cushion to absorb potential credit losses. The exhibit below presents the 10 insurers with the largest combined holdings of non-agency RMBS and CMBS as a percentage of regulatory capital as of year-end 2011. The new RMBS and CMBS requirements will have the greatest effect on these insurers capital adequacy.
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1 NOVEMBER 2012
NEWS & ANALYSIS

Insurers Year-End 2011 Holdings of Non-Agency RMBS and CMBS as a Percentage of Regulatory Capital
Insurance Group Insurance Financial Strength Rating [1] Carrying Value $ millions Carrying Value as Percent of Year-End 2011 Statutory Capital
American Financial Group Inc. Goldman Sachs Group Inc. Phoenix Companies Inc. CNO Financial Group Inc. Allianz SE Great-West Insurance Group Jackson National Life Group Ameriprise Financial Inc. Delphi Financial Group Inc. Americo Life
A3 positive A3 negative Ba2 positive Baa3 stable A2 stable Aa3 stable A1 stable Aa3 stable A2 stable A3 stable
$5,230 1,504 1,842 3,319 9,412 2,850 4,861 5,071 899 544
417% 332% 191% 190% 178% 173% 166% 166% 134% 133%
[1] Insurance financial strength (IFS) ratings and outlooks are for the lead US life insurance subsidiary as of 30 October 2012. Source: Moodys and SNL Financial LC. Contains copyrighted and trade secret materials distributed under license from SNL, for recipients internal use only.
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NEWS & ANALYSIS

Jos Montao Assistant Vice President - Analyst +52.55.1253.5722 joseangel.montano@moodys.com
Mexican Government Proposes New Credit Positive Insurance Framework

On 25 October, Mexican President Felipe Caldern submitted to the Mexican Senate a new legal and regulatory framework for insurers and surety companies. The new framework will strengthen the insurance industrys legal, regulatory and capital rules, a credit positive for policyholders and creditors. However, small and midsize insurers, such as Seguros Latinoamericana, S.A. (unrated), Seguros Centauro, S.A. de C.V. (unrated), Sericios Integrales de Salud Nova, S.A. de C.V. (unrated), will find it challenging to meet the new laws requirements. In process for several years, the new set of rules will replace the current law dating from 1935. The new law establishes the adoption of Solvency II, which entails new capital requirements for companies in line with the intrinsic risk associated with their specific lines of business. That would be an improvement over current regulatory-based, risk-adjusted capital guidelines. The new law also would reinforce insurers and surety companies solvency positions, although small and midsize insurers will find it challenging to meet the requirements and will require additional capital injections to meet the new standards. The Mexican governments aim is for the law to take effect in January 2014. The new law includes mandatory adoption of more stringent corporate governance standards, such as the incorporation of independent board members and more professional management practices, that also would be challenging for small and midsize insurers to meet. Some insurers will have to undertake substantial investments and significant organizational changes to meet the new requirements, which could jeopardize their business continuity. Thus, we expect the new law to initiate a consolidations in the industry. In the case of surety (fianza) companies, this new regulation will combine existing lines of business with lines that are new to the Mexican marketplace. Under this proposal, fianza companies would be regulated jointly with credit insurance and will create a new business line called seguro de caucin (surety insurance).To operate this new type of product, fianza companies may require the creation of a new company (with a specific license to operate it). This new product will increase fianza companies penetration because it does not stipulate or require guarantees or other forms of collateral, as is necessary in the traditional fianza product. Moreover, the potential new product lines would complement the current portfolios of insurers currently engaged in the surety and credit insurance sectors improving their scale and product breadth. Exhibits 1 and 2 list the top 10 insurance and surety companies in Mexico.
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1 NOVEMBER 2012
NEWS & ANALYSIS

Top 10 Insurance Companies in Mexico (MXN millions)

Company Gross Premium Written 2011 Net Income 2011 Total Assets 2011 Shareholders' Equity 2011 Market Share 2011
EXHIBIT 1
1) 2) 3) 4) 5) 6) 7) 8) 9) 10)
Metlife Mxico Grupo Nacional Provincial AXA Seguros Seguros Inbursa Seguros BBVA Bancomer Seguros Monterrey New York Life Seguros Banamex Qulitas, Ca. de Seguros Seguros Banorte Generali Mapfre Tepeyac
36,365 31,488 28,055 19,342 15,922 13,569 12,388 11,236 10,176 9,440
4,253 701 413 843 3,096 709 1,279 835 665 177
103,609 65,694 55,808 55,866 46,082 49,549 41,317 14,925 15,919 15,595
23,016 6,177 7,928 7,601 7,064 4,715 5,587 2,564 2,701 1,899
12.6% 10.9% 9.7% 6.7% 5.5% 4.7% 4.3% 3.9% 3.5% 3.3%
Source: Comisin Nacional de Seguros y Fianzas (CNSF).
Top 10 Surety Companies in Mexico (MXN millions)

Company Gross Premium Written 2011 Net Income 2011 Total Assets 2011 Shareholders' Equity 2011 Market Share 2011
EXHIBIT 2
1) 2) 3) 4) 5) 6) 7) 8) 9) 10)
Fianzas Monterrey Fianzas Guardiana Inbursa Afianzadora Aserta Afianzadora Sofimex Afianzadora Insurgentes Primero Fianzas Chubb de Mxico, Ca. Afianzadora Fianzas Dorama Fianzas Atlas Mapfre Fianzas
1,526 1,346 1,123 1,026 670 436 353 270 267 82
399 119 157 262 57 89 13 90 72 4
3,175 4,025 1,681 2,043 2,319 1,014 776 842 1,473 158
1,228 2,430 619 1,049 699 247 222 450 861 60
21.0% 18.6% 15.5% 14.1% 9.2% 6.0% 4.9% 3.7% 3.7% 1.1%
Source: Comisin Nacional de Seguros y Fianzas (CNSF).
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NEWS & ANALYSIS

Sovereigns
Tom Byrne Senior Vice President - Regional Credit Officer +65.6398.8310 thomas.byrne@moodys.com
Japans Impasse Over Deficit-Financing Bill Is Credit Negative

Last Friday, Japans Ministry of Finance (MOF) and Japanese government bond (JGB) primary dealers met to discuss how failure to pass the deficit financing bill would disrupt the JGB market. Passage of the bill has been stymied by a political fight between Prime Minister Yoshihiko Noda and the opposition Liberal Democratic Party (LDP) over the timing of a general election, highlighting risks to Japans (Aa3 stable) stable government bond market. The threat that the political impasse will force the MOF to cancel a bond auction is credit negative. LDP members in the lower house of the Diet have delayed passage of the deficit-financing bill, holding it hostage to their demand that Mr. Noda dissolve the Diets lower house and hold a general election much sooner than the constitutionally required date at the end of August 2013. Without the deficitfinancing bill, a 2.3 trillion auction of 10-year JGBs scheduled for 4 December is in jeopardy. A cancellation of that auction would be the first cancelled 10-year JGB auction in 25 years. Smooth operation of the JGB bond market is crucial to maintaining confidence in the Japanese governments capacity to manage stable JGB issuance and service its outstanding debt. Not only is Japans gross general government debt the highest of any advanced country, but its gross financing needs are also the most burdensome of any advanced country. The International Monetary Fund (IMF) estimates that Japans total debt refinancing plus new budget deficit financing in 2012 was 59.4% of GDP.9 That compares with other highly indebted governments such as Spain, which has gross refinancing requirements of 30.1%, and the US, which requires 26.3%. The paradox of the JGB market is that the most heavily indebted government can issue debt at the lowest cost of any government, including that of the US, which benefits from having the pre-eminent global reserve currency. This reflects the strong home bias and large stock of financial savings in Japan. An outright JGB default is not on the horizon.10 In September, Jun Azumi, Japans then-finance minister, said that if the Diet does not pass the bond issuance bill, the government would begin deferring non-vital spending to maintain flexibility. The government has made assurances that the political impasse would not affect debt service because it has adequate funds in a special account. However, subsidies and tax transfers to local governments are being affected.11
9 10 11
IMF Fiscal Monitor October 2012. See Censure and Political Stalemate in Japan Are Credit Negative, Credit Outlook, 3 September 2012. See Japans Support for Regional and Local Governments Is Credit Positive, Credit Outlook, 10 September 2012.
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NEWS & ANALYSIS

Sub-sovereigns
Adrian Javier Garza Assistant Vice President - Analyst +52.55.1253.5709 adrianjavier.garza@moodys.com Ximena Rubio Associate Analyst +52.55.1253.5743 lauraximena.rubio@moodys.com Alejandro Olivo Vice President - Senior Credit Officer +52.55.1253.5742 alejandro.olivo@moodys.com
Tepics Inability to Pay Year-End Bonuses Is Credit Negative

On Tuesday, Hctor Gonzlez Curiel, the mayor of the municipality of Tepic (B3/B3.mx negative) declared that his administration would not be able to pay the year-end bonus to its workers. This is credit negative because it shows that severe liquidity pressures in the municipality persist roughly one year after the municipality missed payments on its debt. The year-end bonus payment to the municipalitys 4,000 workers is mandated by law. Tepic, the capital city of the state of Nayarit (Ba3/A3.mx negative), requested the state act as a joint-obligor in order to contract new debt to meet these payments. The municipality estimated the required amount at MXN92 million, or roughly 9% of the municipalitys 2012 budget. Significant fiscal imbalances leading to a structural reliance on short-term financing have become a characteristic trait of Tepic. A year ago, when Mr. Gonzlez Curiels administration took office, the municipality missed some interest and principal payments on its long-term bank loans owing to a severe liquidity shortage. Although Tepic recently refinanced a large portion of its short- and long-term debt to ease some of the pressure, the mayors announcement shows that the refinancing solution was short-lived and that the municipality continues to struggle to return to fiscal balance. Tepics credit quality is poor and its debt levels remain high. With the new funding, Tepics debt outstanding will rise to MXN560 million from MXN470 million, or a relatively high 50% of 2012 total budgeted revenues. The municipality services its debt using federal transfers that flow from Nayarit to the creditors without reaching the municipalitys coffers, thereby limiting creditors exposure to municipal credit risk. As a result, debt service payments are senior to operating expenditures. This event supports our view that Tepics inability to rein in expenditures leaves the municipality, like others in Mexico, structurally reliant on short-term financing. It also shows the speculative profile of most of municipalities in Mexico and their relatively poor governance and management practices.
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CREDIT IN DEPTH
Detailed analysis of an important topic
Tom Byrne Senior Vice President - Regional Credit Officer +65.6398.8310 thomas.byrne@moodys.com
IMF Loan Repayments Strain Pakistan as Pressure on Government Finances Rises

The government of Pakistans fifth loan repayment takes place against a backdrop of sluggish economic growth and looming external and fiscal risks. Prominently included in such risks is $7.5 billion in repayments to the International Monetary Fund (IMF) between October 2012 and November 2015, most of which falls due in 2013. The government of Pakistan could in effect refinance such obligations if it were to seek a new program with the IMF, but current indications are that this will not happen. Pakistans most recent program with the IMF, a stand-by loan arrangement struck in November 2008, went off track before it was fully disbursed and expired in September 2011. Although official international reserves have fallen in the past year, at $9.8 billion they are currently adequate to cover debt payments falling due in 2013, but will continue to come under pressure from continued loan repayments. Pakistans buffer to external financial shocks or to a loss of domestic confidence in the rupee would be thin. This fragility in the external payments position highlights Pakistans high reliance on multilateral or bilateral financing, that has proven to be unstable over recent years. The fiscal picture looks equally bleak. After missing the fiscal 2012 original deficit target of 4% by a large margin ( the deficit finally came in at 6.6% ), the budgeted deficit of 4.7% for fiscal 2013 is likely to see slippage as well, due to optimistic revenue assumptions and an expenditure overshoot. Given the paucity in external financing, higher deficits are increasingly being financed through monetization, fuelling inflationary risks and crowding out private sector credit. Price pressures have been muted for now, allowing the central bank to loosen monetary policy and prop growth, but the scope for further easing appears limited. Pakistans deteriorating balance of payments position was a key driver behind Moodys one-notch downgrade of the countrys foreign and local currency bond ratings Caa1 from B3 in July 2012.12 The rating recognizes a weakened credit profile, which correlates to a 35.2% likelihood of default over the upcoming two years, rising to 40.9% over the next five years.13 A Weak Macro Backdrop The macro-environment remains lackluster and characterized by stagflation. Although growth in fiscal 2012 edged higher to 3.7% from 3.0% in fiscal 2011, trends were fuelled largely by consumption, owing to a higher incomes from a bumper agricultural crop and a stable uptick in remittances from workers overseas. Investment growth, however, fell deeper 8.6% year over year, posting a contraction for the fourth consecutive year. The main constraints to growth remain a protracted energy crisis that has deterred investment; high government borrowing and high inflation both of which undermine private-sector investment, and policy uncertainty from contentious politics. Given that these hurdles are unlikely to be resolved anytime soon, we expect growth to remain much weaker than what Pakistan achieved in the years immediately before the global financial crisis and in the 3%-4% range in fiscal 2013.
12 13
See Moody's Downgrades Pakistan's Government Bond Ratings to Caa1, Outlook Negative, 13 July 2012. See default tables in Sovereign Default and Recovery Rates, 1983-2012H1, 30 July 2012.
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CREDIT IN DEPTH
EXHIBIT 1
Trends in Real GDP Growth and the CPI (% Year over Year)
GDP (%YoY) 20 15 10 5 0 CPI (%YoY, Avg)
Source: Federal Bureau of Statistics, IMF, Moodys Investors Service
Balance of Payments Is Becoming Precarious Pakistans current account has historically been in deficit for over a decade, barring a few years. However, averaging 1.4% of GDP during fiscal 2000-10, deficits are limited in comparison with the B-median average of 4.7% (Exhibit 2). Following a small surplus in fiscal 2011 ( 0.1% of GDP), the current account slipped back into deficit in fiscal 2012 (2%). This was on the back of a contraction in export growth owing to lower cotton prices (Pakistan is a net exporter of cotton and textiles), coupled with a continued rise in oil-related import growth. Remittances, which were up 17.7% in fiscal 2012, offset to some extent the widening trade deficit, thereby limiting the deterioration in the current account balance. Trends on the capital account also weakened, with foreign direct investment (FDI) flows slowing to less than $1 billion, and portfolio outflows (both debt + equity). This resulted in a reserve drawdown of $3.3 billion. We think that prospects for fiscal 2013 are unlikely to show an improvement. Latest trends on the current account point to a surplus during July-September period of fiscal 2013. But with export growth in low single-digits and a contraction in import growth, it is too soon to call this a trend exports dipping back into the red, or oil prices edging higher could result in the current account posting a deficit yet again. Moreover, trends in remittances need to be closely tracked, with growth moderating to 9.2% during July-September period of fiscal 2013 from 24.6% during the same period in fiscal 2012. On the capital account, a thawing of relations with the US resulted in a disbursement of long-delayed coalition support funds (CSF)14 in August 2012 totaling $1.1 billion. These, coupled with auction proceeds from 3G licenses worth $850 million, will provide some buffer. However, much of this is likely to be offset by loan repayments to the IMF, which total $2.8 billion in fiscal 2013. Even assuming some recovery in FDI and portfolio flows, the BoP is likely to stay under pressure: we expect to see a further drawdown to reserves to the tune of $3.4 billion during the financial year.
14
The CSF was established in 2001 to support US allies for costs incurred in the fight against extremist violence. In 2011, the US froze $800 million of funding to Pakistan, or 40% of its military support, owing to policy disagreements
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1 NOVEMBER 2012
FY13F
FY07
FY10
FY01
FY00
FY08
FY04
FY06
FY09
FY03
FY05
FY02
FY12
FY11
CREDIT IN DEPTH
EXHIBIT 2
Current Account Balances (% of GDP)

Pakistan 6 4 2 0 -2 -4 -6 -8 -10 -12 B Median
EXHIBIT 3
Capital Account Composition ($ millions)

Other 10 8 6 4 2 0
FY13F
FDI
Capital A/c
Equity Flows
Debt Flows
FY07
FY10
FY01
FY00
FY08
FY04
FY06
FY09
FY03
FY05
FY02
FY12
-2
FY13F
Oct-12
FY11
FY07
FY10
FY08
FY04
FY06
Source: SBP and Moodys Investors Service
Source: SBP and Moodys Investors Service
Although reserves remain more than adequate to fulfill external debt payments coming due over the next year, a continued deterioration in the current account coupled with weak capital flows would ultimately weigh on reserve adequacy. While the External Vulnerability Indicator (EVI) was at a prudent of 32.3% in fiscal 2012, it could climb rapidly if reserve hemorrhaging continues. IMF Repayment Schedule (SDR millions, $ millions)
Principal Interest Total Total in USD millions
EXHIBIT 4 EXHIBIT 5
20 19 18 17 16 15 14 13
Trends in FX Reserves ($ billions)
Fiscal 012 Fiscal 2013 Fiscal 2014 Fiscal 2015 Fiscal 2016
588 1,726 2,063 819 37
104 67 24 7 0
692 1,793 2,087 826 38
1,068 2,767 3,220 1275 58
Assuming US$1=0.65 SDR (Rate as on Oct 22, 2012) Source: IMF
FY09
FY03
FY05
Oct-11
Dec-11
Oct-10
Dec-10
Aug-11
Feb-12
Apr-12
Feb-11
Apr-11
Jun-12
Jun-11
Source: SBP
Fiscal Slippage Is Likely to Continue in Fiscal 2013 Fiscal deficits have been high and persistent over the last decade (averaging close to 5% of GDP between fiscal 2000 and fiscal 2010 versus the B median average of 2.8%). This is because of structurally weak revenue collections the revenue to GDP ratio is at a very low 12.4%, the lowest in our rating universe after Guatemala (Ba1 stable) and Bangladesh (Ba3 stable); and sticky expenditure on subsidies, defense and interest payments. Circular debt of the energy sector has further strained public finances. These arise as lower tariffs and delayed payments from consumers prevent power generation/distribution companies from paying suppliers, and are estimated at about 3% of GDP.
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1 NOVEMBER 2012
Aug-12
FY12
FY11
CREDIT IN DEPTH
For fiscal 2012, provisional numbers peg the deficit at 6.6% (excluding debt consolidation of 1.9% of GDP), unchanged from fiscal 2011, but a large slippage from the governments original budgeted target of 4% (which was revised twice during the course of the year, to 4.7% and then 5.5%).
EXHIBIT 6
Trends in the Fiscal Deficit (% of GDP)

Pakistan -8 -7 -6 -5 -4 -3 -2 -1 0 B Median
Source: Ministry of Finance, Moodys Investors Service
The budgeted deficit for fiscal 2013 appears equally ambitious. Targeted at 4.7% of GDP, assumptions factor in revenues rising to 13.7% of GDP due to higher non-tax revenues ( from 3G license auctions15). We expect expenditures, which were up 14.2% in fiscal 2012, to rise only 3%, based on an optimistic decline in subsidies and a contraction in pensions, even when government pensions have been raised. We expect the deficit to come in at 6.4%, owing to lower revenues and an expenditure overshoot. Adding to the Debt Burden High deficits in recent years have stopped the past reduction in the debt burden. As a percent of GDP, total government debt had moderated to less than 60% in fiscal 2007 from 78.9% in fiscal 2000, but since then the debt burden has crept above 60%. However, the general moderation in debt/GDP has largely been a result of higher nominal GDP stemming from rising inflation rather than a moderation in absolute debt levels, which have nearly quadrupled during the same period. Local-currency denominated debt as a share of total debt has been steadily rising over the years, from 52% in fiscal 2000 to 60% currently. This largely represents a rise in floating debt, which comprises short-term issuances of T-bills. Coupled with high gross financing requirements (estimated at 30% of GDP in fiscal 2012), this results in high rollover risks and has added to the interest rate burden. Foreign-currency denominated government debt, which has moderated from 48% of total debt to less than 40% currently, is predominantly long-term.
15
The Ministry of Finance classifies proceeds from license auctions as revenue, while IMF guidelines call for its classification as financing.
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1 NOVEMBER 2012
FY13F
FY07
FY10
FY01
FY00
FY08
FY04
FY06
FY09
FY03
FY05
FY02
FY12
FY11
CREDIT IN DEPTH
EXHIBIT 7
Trends in Government Debt (PKR trillions, %GDP)

Domestic Debt(LHS) 14 12 10 8 6 4 2 0 External Debt (LHS) Govt Debt/GDP(RHS) B Median Debt/GDP(LHS) 100 90 80 70 60 50 40 30 20
FY00
FY08
FY04
FY06
FY09
FY03
FY05
FY02
FY07
FY10
FY11
Source: Ministry of Finance, Moodys Investors Service
Although external debt has nearly doubled over the last decade to $65.5 billion in fiscal 2012, trends in percent terms have moderated significantly to 28.5% in fiscal 2012 from 43.5% of GDP in fiscal 2000. A substantial portion is long-tenor debt provided by official multilateral and bilateral creditors. However, continued currency depreciation, the termination of the IMFs stand-by arrangement and unstable relations with other bilateral and multilateral lenders have resulted in financing pressures. Higher Government Borrowing, Deficit Monetization Is Adding to Inflation Pressures Given lower development assistance from the US and other multilateral lenders, deficit financing has shifted away from external sources towards domestic bank financing. The share of the latter has increased to 3.4% of GDP in fiscal 2012 from less than 1% of GDP in fiscal 2005. In fiscal 2012, the government borrowed PKR700 billion from the banking system (versus the budgeted PKR300 billion and PKR600 billion in fiscal 2011) and the State Bank of Pakistan (SBP). Higher borrowing is in fact a breach of the SBP Act, which stipulates zero-quarterly government borrowing from the SBP and also entails the government to retire its borrowings over the next seven years. It has also adds to inflationary pressures, through a sharp rise in both reserve money and broad money growth . Although inflation, as measured by the CPI, has moderated from 13.7% in fiscal 2011 to 11% in fiscal 2012 and further to 8.8% as per the latest print (September 2012) this is largely because of lower food and oil prices. Core inflation remains high at 10.5% year over year. In a bid to revive growth and supported by the deceleration in inflation, the SBP recently reduced the key policy rate by 50bps to 10% in October (this is the second rate cut this fiscal year after a rate reduction of 150bps in August); but this could likely act to unhinge inflation expectations. If commodity prices remain benign, the SBP could meet its inflation target of 10%-11% for fiscal 2013. However, shifting to a sustainably lower inflation path would entail resolving energy sector problems and adhering to the SBP Act, by reducing government borrowing from the banking sector. We think inflation will average 10.7% in fiscal 2013.
27
FY01
1 NOVEMBER 2012
FY12
CREDIT IN DEPTH
EXHIBIT 8
Trends in Government Borrowing, Inflation and Interest Rates (%)

Headline CPI (LHS) 16 14 12 10 8 6 Repo Rate(LHS) Govt Borrowing from SBP (RHS) 50 40 30 20 10 0 -10 -20 -30
Feb-10
Nov-10
May-10
Aug-09
Aug-11
Feb-12
Feb-11
May-12
Aug-10
Nov-11
Nov-09
Source: SBP
Annual Statistics Pakistan

2006 2007 2008 2009 2010 2011 2012F 2013F
Economic Structure and Performance Nominal GDP (US$ Bil.) Population (Mil.) GDP per capita (US$) GDP per capita (PPP basis, US$) Nominal GDP (% change, local currency) Real GDP (% change) Inflation Rate (CPI, % change eop) Unemployment Rate (%) Gross Investment/GDP (%) Gross Domestic Saving/GDP (%) Nominal Exports of G & S (% change, US$ basis) Nominal Imports of G & S (% change, US$ basis) Openness of the Economy (%) [1] Government Effectiveness Indicator Government Finance Gen. Gov. Revenue/GDP (%) Gen. Gov. Expenditures/GDP (%) Gen. Gov. Financial Balance/GDP (%) Gen. Gov. Primary Balance/GDP (%) Gen. Gov. Direct Debt (US$ Bil.) Gen. Gov. Direct Debt/GDP (%) Gen. Gov. Direct Debt/Gen. Gov. Revenue (%) Gen. Gov. Int. Pymt/Gen. Gov. Revenue (%) Gen. Gov. FC & FC-indexed Debt/Gen. Gov. Debt (%) Gen. Gov. Guaranteed Debt (US$ Bil) 14.7 18.4 -3.7 -0.3 74.1 58.6 398.7 23.2 46.8 15.4 19.3 -3.9 0.3 81.0 56.5 367.6 27.7 46.0 14.9 22.2 -7.3 -2.5 91.0 60.7 406.2 32.0 45.9 14.7 19.9 -5.2 -0.2 96.3 61.6 418.4 34.1 49.2 14.4 20.3 -5.9 -1.6 108.0 62.4 433.6 30.2 47.9 12.7 19.1 -6.4 -2.5 127.9 61.0 478.3 30.4 43.8 12.6 19.1 -6.5 -2.2 136.6 62.6 496.6 34.2 40.1 13.0 19.3 -6.3 -2.1 146.8 60.5 463.5 31.9 38.0 127.5 161.5 838.0 2,309.6 17.3 5.8 7.1 6.2 22.1 14.2 12.9 38.1 38.5 -0.40 143.2 164.4 933.7 2,467.9 13.8 6.8 7.4 5.5 22.5 15.4 4.6 3.2 35.5 -0.45 163.9 167.4 972.6 2,516.0 18.1 3.7 19.3 5.4 22.1 11.0 3.7 28.1 36.7 -0.68 161.8 170.5 992.1 2,606.5 24.2 1.7 9.6 5.5 18.2 10.7 -1.2 -15.6 33.3 -0.8 176.5 174.0 1,110.9 2,687.6 16.3 3.1 11.8 5.6 15.6 9.7 15.1 3.8 33.0 -0.8 210.2 177.6 1,238.9 21.8 3.0 13.3 13.1 8.0 24.2 17.9 33.4 229.9 181.2 1,312.3 14.5 3.7 11.3 12.5 4.4 -3.7 17.3 33.1 245.7 184.8 1,404.4 14.0 3.3 10.0 11.2 3.5 5.4 3.6 32.3 -
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1 NOVEMBER 2012
Aug-12
CREDIT IN DEPTH
Pakistan
2006 2007 2008 2009 2010 2011 2012F 2013F
GG Direct Debt Owed to Private Creditors/GG Direct Debt (%) GG Direct Debt Owed to Non-residents/GG Direct Debt (%) Short-term GG Direct Debt/Total GG Direct Debt (%) Total GG Direct & Guaranteed Debt (US$ Bil.) Total GG Direct & Guaranteed Debt/GDP (%) Total GG Direct & Guaranteed Debt/GG Revenue (%) External Payments and Debt Nominal Exchange Rate (local currency/US$) Real Eff. Exchange Rate (% change) Current Account Balance (US$ Bil.) Current Account Balance/GDP (%) External Debt (US$ Bil.) Public Sector External Debt/Total External Debt Short-term External Debt/Total External Debt (%) External Debt/GDP (%) External Debt/CA Receipts (%) [2] Interest Paid on External Debt (US$ Bil) Amortization Paid on External Debt (US$ Bil.) Net Foreign Direct Investment/GDP (%) Net Int'l Investment Position/GDP (%) Official Forex Reserves (US$ Bil.) Net Foreign Assets of Domestic Banks (US$ Bil.) Monetary, Vulnerability and Liquidity Indicators M2 (% change, Dec/Dec) [8] Monetary Policy Rate (%, Dec 31) [8] Domestic Credit (% change, Dec/Dec) [8] Domestic Credit/GDP (%)[8] M2/Official Forex Reserves (X) Total External Debt/Forex Reserves (%) Debt Service Ratio (%) [3] External Vulnerability Indicator (%) [4] Liquidity Ratio (%) [5] Total Liabilities due BIS Banks/Total Assets Held in BIS Banks (%) [8] "Dollarization" Ratio (%) [6] "Dollarization" Vulnerability Indicator (%) [7]
Notes: [1] Sum of Exports and Imports of Goods and Services/GDP (%) [2] Current Account Receipts [3] (Interest + Current-Year Repayment of Principal)/Current Account Receipts (%)
47.7 21.3 60.3 5.0 -5.0 -3.9 37.2 95.0 0.5 29.2 117.6 0.9 2.0 2.7 -26.1 10.8 2.1 14.9 9.0 19.6 39.5 5.3 345.8 9.1 23.1 36.4 314.3 7.3 24.4
46.7 22.6 60.5 0.1 -6.9 -4.8 40.3 93.8 0.2 28.2 122.4 1.1 1.8 3.5 -33.1 13.3 3.2 19.0 9.5 16.8 40.6 5.0 302.3 8.7 18.2 38.4 347.2 6.4 20.0
47.3 27.1 68.3 -2.0 -13.9 -8.5 46.2 93.3 1.6 28.2 124.4 1.2 1.9 3.3 -32.1 8.6 2.7 11.9 12.0 32.9 45.6 7.7 538.2 8.6 15.0 30.7 199.7 6.6 32.7
50.7 25.0 81.4 -2.1 -9.3 -5.7 52.3 93.3 1.2 32.3 148.4 1.2 3.6 2.3 -32.4 9.1 3.3 9.5 14.0 15.9 42.6 6.7 574.0 13.5 50.3 39.5 240.7 6.6 26.0
49.6 26.7 85.5 1.0 -3.9 -2.2 61.6 87.0 2.2 34.9 161.9 1.0 3.6 1.2 -30.6 13.0 3.0 13.0 12.5 11.1 40.6 5.1 475.1 12.1 46.6 43.9 274.5 7.2 24.0
45.3 29.9 86.0 5.9 0.2 0.1 66.4 87.2 1.9 31.6 139.6 1.1 2.9 0.8 -27.9 14.8 2.9 16.7 14.0 13.2 37.8 5.2 448.9 8.3 32.6 57.3 278.6 6.7 23.2
40.9 32.3 94.6 -4.6 -2.0 65.6 85.2 2.5 28.5 137.4 1.0 3.5 0.3 10.8 13.4 12.0 19.9 39.5 7.3 607.1 9.4 32.3 51.1 204.8 6.9 31.6
38.9 32.7 97.0 -5.3 -2.2 66.5 85.8 2.6 27.1 135.6 1.2 4.0 0.3 9.5 665.0 10.6 52.0 -
[4] (Short-Term External Debt + Currently Maturing Long-Term External Debt)/Official Foreign Exchange Reserves (%) [5] Liabilities to BIS Banks Falling Due Within One Year/Total Assets Held in BIS Banks (%) [6] Total Foreign Currency Deposits in the Domestic Banking System/Total Deposits in the Domestic Banking System (%) [7] Total Foreign Currency Deposits in the Domestic Banking System/(Official Foreign Exchanges Reserves + Foreign Assets of Domestic Banks) (%) [8] Fiscal years beginning July 1
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1 NOVEMBER 2012
RECENTLY IN CREDIT OUTLOOK

Select any article below to go to last Mondays Credit Outlook on moodys.com
NEWS & ANALYSIS

Corporates Colgates and Kimberly-Clarks Restructurings Show Strains In Mature Markets Targets Sale of Credit Card Business Is Credit Positive ADT Activist Shareholders Proposed Capital Structure Is Credit Negative Removal of Preferred Stock in ARCAS' Funding Structure Is Credit Positive Rosnefts Acquisition of TNK-BP Is Credit Negative for Both Fosun Pharmas Hong Kong Listing Is Credit Positive for Parent Fosun International Indias Approval of Oil and Gas Development Is Credit Positive for Reliance Industries Sumitomos Deal to Combine Cable Operations with KDDI Would Be Credit Positive Infrastructure More International Passengers Are Credit Positive for Sydney Airport Banks Consumer Financial Protection Bureaus Purview Is Credit Negative for US Debt Collectors Russian Banks Reliance on Tier 2 Capital Is Credit Negative Increased Capital Requirements Would Be Credit Positive for Danish Bank Creditors Ally Financial Asset Sales and ResCap Auction Ally Financials Asset Sales Are Credit Positive Ocwens and Walters Purchases of ResCaps Servicing and Origination Platforms Are Credit Negative Ocwens Acquisition of ResCap Is Credit Negative for ResCaps GMAC-Serviced Transactions South Korean Covered Bonds Draft Legislation on Covered Bonds Is Credit Positive for Korean Banks Strong Legal Protection in Proposed Korean Covered Bond Act Is Credit Positive 15 2
Insurers Argentina's Workers' Compensation Insurers Get New Credit Positive Law Sovereigns Laos-China Rail Link Will Be Credit Positive for Laos Sub-sovereigns Montrals Labour Contract Addresses Pension Contributions, a Credit Positive Reform to Mexicos General Accounting Law Is Credit Positive for States and Municipalities Securitization Australian Regulators' Proposals on Securitisation Are Credit Positive for RMBS
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RATINGS & RESEARCH

Rating Changes Last week we downgraded Federal-Mogul; Finmeccanica; Nucor; POSCO; Liberbank; MAPFRE Argentina ART; the Spanish regions of Andalucia, Castilla-La Mancha, Catalunya and Murcia; Pennsylvania State University; the Pennsylvania State System of Higher Education; one Spanish covered bond; and nine Spanish multi-issuer covered bonds, and upgraded Reynolds American, Union Pacific, DTE Energy Center, and two Spanish covered bonds, among other rating actions. Research Highlights 21 Last week we published on tire manufacturers, US healthcare, oil refineries, Mexican homebuilders, US midstream oil and gas partnerships, US homebuilders, aluminium, Chinese real estate, US infrastructure, US municipal and public power utilities, US life insurers, California school districts, US public finance ratings, US notfor-profit healthcare, US CMBS, and Australian covered bonds, among other reports. 42 36
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1 NOVEMBER 2012
EDITORS
News & Analysis: Jay Sherman and Elisa Herr
PRODUCTION ASSOCIATE
David Dombrovskis
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1 NOVEMBER 2012

NEWS & ANALYSIS

RECENTLY IN CREDIT OUTLOOK

NEWS & ANALYSIS

Hurricane Sandy Will Likely Spur a Small Pick-Up in Consumer-Products Sales