November 11 (SeeNews) - Standard & Poor's affirmed on Friday its B+ long-term credit ratings on Montenegro, with a negative outlook, saying that lower fiscal deficit in 2016 appears to be driven by lower-than-budgeted highway-related spending, which has offset increases in current expenditures.
"Montenegro's government debt burden will continue to rise steadily over the forecast horizon to over 80% of GDP in 2019 from 67% in 2015, while interest costs will rise to 9% of general government revenues by 2019 from 6% in 2015," S&P said in a statement.
"The negative outlook reflects our view of the risk of a further deterioration in Montenegro's fiscal and debt metrics in the absence of concrete measures to curtail current expenditures," the rating agency added.
Standard & Poor's also said in the statement:
"RATING ACTION
On Nov. 11, 2016, S&P Global Ratings affirmed its 'B+/B' long- and short-term foreign and local currency sovereign credit ratings on the Republic of Montenegro. The outlook is negative.
RATIONALE
We project that Montenegro's government debt burden will continue to rise steadily over the forecast horizon to over 80% of GDP in 2019 from 67% in 2015, while interest costs will rise to 9% of general government revenues by 2019 from 6% in 2015. In the context of already limited monetary flexibility given the country's unilateral adoption of the euro, the increased leverage of the public balance sheet will further restrict authorities' capacity to respond to domestic and external shocks.
Data available on Montenegro's budgetary performance to date indicates that the fiscal deficit in 2016 has narrowed and is likely to turn out lower than our initial expectation. While we note some revenue growth, much of the deficit reduction appears to be driven by lower-than-budgeted spending on the Bar-Boljare highway. This appears to have offset increases in public wages by 16% and higher social outlays ahead of the October parliamentary elections. However, we believe that this postponed construction expenditure is likely to catch up over 2017-2019.
The construction of the first phase of the Bar-Boljare highway, currently in progress, commenced in 2015. Eighty-five percent of the financing for this phase will be met through a $1.1 billion (25% of GDP) loan from the Export-Import Bank of China (Chinese Eximbank) and the remainder via market issuance. We believe that highway-related spending will keep the general government deficit above 7% on average over 2017-2019. Even after the first phase of the highway, which is 44 kilometers long, is completed, it is unlikely that general government deficits will narrow quickly because:
The other phases of the highway will need to be constructed, and we expect related costs will again flow through the government's budget.
Potential cost overruns related to the highway's construction, if they have to be borne by the state, could increase the government's financing needs. Although the contract with China Road and Bridge Corporation stipulates a maximum cost overrun of 10% of the project's value (which works out to about 2% of 2016 GDP), it remains unclear who would bear such unexpected costs.
Interest expenses are also likely to be higher, increasing to 9% of general government revenues in 2019 from 6% in 2015, reflecting both Montenegro's rising debt and a higher effective interest rate. A sharp depreciation of the euro against the dollar, the currency in which Montenegro must service its loan from the Chinese Eximbank and on which interest payments started in July 2015, could raise interest costs further. We understand that the government is currently contemplating ways to hedge its exchange rate risk.
Poor oversight over the finances of lower tiers of governments, which led to the build-up of arrears in the past, could complicate efforts to consolidate public finances.
We do not consider the bilateral loan from the Chinese Eximbank to be commercial debt. However, by potentially receiving preferential treatment, the liability could, in our opinion, weaken Montenegro's capacity to pay its stock of commercial debt, which we estimate at just over 50% of total government debt.
In addition to the aforementioned risks, we view Montenegro's external finances as an important credit weakness, with narrow net external debt estimated at 195% of current account receipts (CARs) in 2016, while liquidity, as measured by gross external financing needs, is estimated at about 135% of CARs and usable reserves. Montenegro's use of the euro prevents the Central Bank of Montenegro from setting interest rates and controlling the money supply, and restricts its ability to act as a lender of last resort. It also makes the country's income highly sensitive to cross-border capital movements.
Montenegro runs large, persistent, and positive errors and omissions (about 8% of GDP on average between 2011 and 2015), which may reflect unrecorded tourism export revenues and the underestimation of remittances, among other factors. This could mean that the current account deficit may be lower than the reported data indicate. Also, we have very limited information on Montenegro's external assets; therefore external ratios are likely to indicate higher net leverage than is actually the case. What's more, we note that the large current account deficit is probably tied closely to foreign direct investment (FDI)-related projects. If such inflows, particularly in the real estate and construction sectors, were to fall, imports linked to these projects would also likely decrease and the current account deficit would narrow.
Partly mitigating all these risks are policymakers' ongoing efforts to improve tax compliance and formalise the grey economy--an approach that could boost revenue intake. We note a significant reduction in contingent liabilities arising from litigation cases filed against the government after a court recently ruled in Montenegro's favor in a case filed by the Central European Aluminum Corp (CEAC) for €600 million (16% of 2016 GDP). CEAC is the former owner of Montenegrin aluminum producer KAP. Although the outstanding litigation amount now stands at a much lower €220 million (about 6% of 2016 GDP), an adverse ruling could weigh further on already-weak fiscal and debt metrics.
Ongoing projects in the tourism, infrastructure, and energy sectors will aid real GDP growth of 3.4% per year on average over 2016-2019. The high import content of many of these projects is likely to push the current account deficit back over 17% of GDP over 2017-2019 as activity gains momentum. Risks to our growth forecast could materialize if large investment projects were to stall or if the tourism sector were hit by disruption in key markets such as Russia.
For the time being, however, we note that the geopolitical concerns afflicting tourist destinations such as Turkey, Egypt, and Tunisia, among others, are favoring tourism in Montenegro. Furthermore, a long period of low oil prices might translate into lower FDI inflows, since substantial inflows come from oil-exporting countries such as Russia and the United Arab Emirates. We also expect that the pace of credit growth, particularly related to smaller corporate entities, is likely to remain slow. Despite efforts to reduce the level of nonperforming loans (NPLs) on banks' books, the NPL ratio remains high, at 10.2% in September 2016.
We believe the implementation of structural reforms, necessary for Montenegro to achieve its objective of integration with the EU and NATO (North Atlantic Treaty Organization), could have a positive impact on the country's longer-term growth prospects, particularly if integration is managed without pronounced repercussions from major trading and investment partners, notably Russia. In December 2015, NATO invited Montenegro to join the alliance, and accession talks commenced in February this year.
The October parliamentary elections handed a victory to the ruling Democratic Party of Socialists. An attempted coup on election day--viewed by some as an attempt to prevent a pro-Western cabinet from taking office--was purportedly averted. Talks related to the formation of a coalition government are ongoing and our projections do not take into account any major shifts in economic or foreign policies.
OUTLOOK
The negative outlook reflects our view of the risk of a further deterioration in Montenegro's fiscal and debt metrics in the absence of concrete measures to curtail current expenditures.
We could lower the ratings over the next six months if we see a further erosion of Montenegro's policy flexibility, most likely through widening fiscal deficits and rising general government debt; if we view pressures building up on the balance of payments that translate into weaker growth and higher interest rates; or if any tensions in the run-up to the country's NATO accession detract policy focus away from stabilizing public finances.
We could revise the outlook to stable if economic growth in Montenegro picks up faster than we anticipate and if we see an implementation of measures to achieve a material consolidation of public finances and a reduction in government and external debt."