Subject: Global Insight Upgrades East Timor's Sovereign Risk Rating on Improved Solvency

Global Insight Daily Analysis

June 16, 2008

Global Insight Upgrades East Timor's Sovereign Risk Rating on Improved Solvency

By Simona Mocuta

Global Insight Perspective

Significance

The upgrade brings East Timor's sovereign risk rating to 50 points—likely to fulfil obligations (equivalent to "BB-" on the generic ratings scale)—from 55. The new rating is assigned a "stable" outlook.

Implications

Today's rating action was anticipated given steady improvements in East Timor's balance-of-payments position in recent years. Global Insight had indeed placed the country's prior rating on a "positive" outlook several months ago, in expectation of today's upgrade.

Outlook

Although the next rating action is likely to be another upgrade, we do not anticipate such a move in the next 12 months. In addition, we expect East Timor's sovereign rating to remain in speculative territory over the medium term due to fundamental constrains to the development of a diversified, non-oil, domestic economy.

Risk Ratings

Currently, none of the other three major ratings agencies rate East Timor's sovereign creditworthiness.

From Debtor to Creditor Status

With hydrocarbon revenues starting to come in since 2004, East Timor's external liquidity position has changed dramatically. After recording huge liquidity gaps (equivalent to nearly 90% of adjusted foreign-exchange earnings) in previous years, the country has now completely closed its liquidity gap. In fact, East Timor is now in a sufficiently strong position to set aside a significant share of its oil and gas revenues as investment for future generations.

Less Onerous Debt Service

East Timor's debt service costs were extremely high in the early part of this decade, mostly because hydrocarbon earnings were non-existent at the time. The situation has greatly improved over the last couple of years, however, and this solvency ratio has now moved into non-scoring territory, triggering the current sovereign rating upgrade. Debt servicing as a share of adjusted foreign-exchange earnings (which exclude volatile income and official transfer inflows) still reached 20% in 2005, but declined to an estimated 13% in 2007 and is expected to move lower still over the next couple of years.

Methodological Peculiarities

Due to the peculiarities of East Timor's oil royalty earnings, there is a big difference in solvency ratios derived using the two methodologies for calculating solvency ratios (total versus adjusted forex earnings). For instance, relative to all export earnings, the country's debt burden is moderate, at about 70% of earnings. However, when income credits (which include large royalty payments) are excluded, the ratio climbs to over 150% of adjusted foreign-exchange earnings. We generally use adjusted forex earnings as a preferred method because they tend to include the more stable, less volatile sources of foreign exchange, such as exports and remittances. In the case of East Timor, however, income earnings (almost exclusively hydrocarbon royalties) are just as stable as the typical export earnings. Therefore, the country's fundamental creditworthiness can be said to be even more favourable than what the solvency ratios calculated using adjusted forex earnings indicate. That said, even these ratios have plummeted from much higher levels over the past couple of years, and are expected to improve further by 2012.

Outlook and Implications

Severe limitations to the development of a diversified non-oil economy, and a history of political unrest and violence are the main risks to East Timor's sovereign creditworthiness. One of the main obstacles to be overcome in East Timor's drive for economic progress and modernisation is the appalling state of the country's infrastructure. Most buildings were destroyed in 1999, when the Indonesian army retreated, resulting in accommodation costs that are currently among the highest in the region. The transportation and telecommunications networks have expanded in recent years, but much remains to be done to bring them to international standards; electricity supply is patchy. East Timor's infrastructural development costs will place a substantial burden on the country's financial resources in the coming years. The task is extremely urgent, since it is a prerequisite for developing a modern economic base and expanding the tourism and manufacturing industries. Finally, given East Timor's recent political instability and the potential risk of a violent government overthrow in the future, any sovereign risk rating for the country must take into account the possibility that it might refuse or be unable to service some or all of its debts under a new regime.


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