Today, Moody’s warned that Iceland, Latvia and Hungary were stabilizing but that their economies remained fragile. The problem is high debt levels, which is restraining consumer spending. Recovery in the Eurozone has been the main aid to stabilization, the report said. Absent this support, the outlook is considerably worse.

Moody’s re-affirmed Iceland and Hungary’s ratings of Baa1 and Latvia’s of Baa3, one notch above junk. But, Moody’s refused to remove its negative outlook to the countries’ credit ratings.

The Wall Street Journal reported:

“These three countries are the only ones whose government ratings have experienced multiple downgrades over the past two years,” says Kenneth Orchard, vice president in Moody’s sovereign-risk group. The ratings of these countries still carry negative outlooks, signaling the possibility of further downgrades in the next 12 to 18 months.

As I mentioned in my last post, it is the debt that is holding these countries back. The report states:

The domestic sides of the economies remain weak as households and corporates struggle with elevated debt levels, the aftermath of housing bubbles in the cases of Latvia and Iceland, and weak banking sectors that are unable or unwilling to extend credit.

As a result, the FX Team at brown Brothers Harriman think these countries are over-rated. In a note released today Win Thin said:

All three of these countries saw improvements in their sovereign risk profiles this past quarter, but all three still remain overrated.  Our model puts Iceland at B, Hungary at BB, and Latvia at B.  Moody’s has always been too generous with its Eastern European ratings, and we have to question why all three remain investment grade still…

All three are also likely to contract in 2010, so the stresses on their economies and their social fabric won’t be going away anytime soon.  Downgrade risks are likely to persist for these three well into next year, as well as for Estonia and Lithuania.

I can’t help but see this as yet another data point demonstrating that this whole house of cards is being stitched together via fiscal and monetary stimulus. Absent this stimulus, the U.S., the U.K., the Eurozone, Japan, and China would all relapse into recession, dragging weaker economies like Latvia or Spain deeper into Depression.

Watch for any signs of premature policy normalization in the the Eurozone or the U.S. as a prelude to a double-dip. The silver lining here is that Moody’s also upgraded Brazil to investment grade today, showing that the emerging markets outside of eastern Europe are doing quite well (story here).