"Following an extended period of political paralysis from 2014-2017, the domestic political situation has normalised, and the EU accession process acts as a positive policy anchor," Fitch Ratings said in a statement last week.
Fitch also said in the statement:
North Macedonia's 'BB+ rating is supported by a track record of coherent macroeconomic and financial policy, which underpins the longstanding exchange rate peg to the euro, and by more favourable governance, human development and ease of doing business indicators than the 'BB' medians. These support strong exports and solid FDI inflows, albeit concentrated in Development Zones that are not well integrated with the rest of the economy. Following an extended period of political paralysis from 2014-2017, the domestic political situation has normalised, and the EU accession process acts as a positive policy anchor. Set against these factors are the greater exposure of public debt to exchange rate risk than the peer group median, banking sector euroisation, and still-high structural unemployment, partly reflecting a large informal economy and skills mismatches, together with weak productivity growth.
Parliamentary elections called after the European Council postponed in October its decision on opening EU accession talks give rise to somewhat greater policy uncertainty. Prime Minister Zaev announced he will seek a renewed mandate by bringing forward next year's elections from December to April. The outcome is uncertain: the ruling centre-left SDSM is trailing the more nationalist, centre-right, VMRO-DPMNE in the polls but support is fluid and the result could hinge on coalition agreements struck with pro ethnic-Albanian parties. Regardless, Fitch does not anticipate a marked change in economic or fiscal policy, including on the long-term goal of EU membership. An April election would also mean a caretaker administration in place from January, which together with potentially lengthy negotiations on forming a coalition, may prevent new policy measures for much of 1H20.
In our view, the EU accession process continues to act as an important policy anchor for sustained reform. The European Council will next consider whether to open talks in May, with the potentially pivotal decision of the French government expected to depend on more general reform of the EU accession process, including added flexibility to re-open completed Chapters, as well as on its own domestic political considerations. The European Commission has already made a positive technical recommendation, reflecting North Macedonia's steady reform progress in key areas such as the rule of law, judicial systems, and public administration. While a further postponement could significantly weaken reform momentum and investor confidence, we think there would be continued engagement with the EU process. In addition, NATO accession is likely to be ratified in 1H20.
Fitch expects the fiscal deficit to stabilise following a moderate expansion in 2020. We forecast the 2019 general government deficit at 1.7% of GDP, up from 1.1% last year but well below the government's 2.5% target (primarily due to an estimated 30% capital underspend, as well as a lower local government deficit of 0.2% of GDP, and strong non-tax revenue growth). The 2020 budget includes a number of expansionary measures, including increases to pensions, public sector wages, and employment and investment subsidies, as well as reversing last year's higher income tax for the top 1% of earners. We forecast the general government deficit widens to 2.2% of GDP next year, followed by 2.1% in 2021, broadly in line with the government targets (but with continued capital under-execution offsetting spending overshoots elsewhere), and still below the projected 'BB' median of 2.5%.
General government debt is projected to gradually rise from 40.7% of GDP at end-2019 to 41.2% at end-2021, close to the projected peer group median of 43.4%. In addition, government guarantees of public entities, mainly related to roads projects, are set to increase, from 8.1% of GDP in 3Q19 to around 10% in 2020. Under our longer-term debt projections, which assume an average primary fiscal deficit of 0.9% of GDP from 2019-2028 and average GDP growth of 3.3%, general government debt rises slightly to 42.6% of GDP in 2028. North Macedonia's debt structure is more exposed to currency risk than peers, despite some improvement. 76.7% of government debt is FX-denominated - albeit predominately in euros and down 2.0pp over the last six months - compared with the 'BB' median of 55.6%. However, this exposure is mitigated somewhat by the longevity and credibility of the exchange rate peg.
Fitch forecasts GDP growth of 3.4% in 2019, up from 2.7% last year, driven by domestic demand. Investment has recovered from last year's 7.2% decline, helped by strengthening confidence and supportive credit conditions. Labour market dynamics are positive, with employment rising 5.2% yoy and unemployment falling 2.3pp to 17.1% in the year to September. We expect similar GDP growth in 2020 of 3.5%, on the back of further, albeit reducing investment and employment growth, and a boost to disposable income from increases to the minimum wage, pensions and public sector pay. Growth in 2021 is forecast to edge down to 3.3%, partly due to a somewhat larger drag from net exports as productive capacity in the Development Zones levels off, which is in line with our assessment of North Macedonia's trend rate of growth (and close to the 'BB' median rate of 3.4%).
Exports have continued to grow strongly, up 11.2% in the year to September, despite eurozone weakness particularly in the key German auto sector. Imports are similarly rising quickly, at 11.4%, but driven by intermediate goods and supported by capital imports, and we forecast some widening in the 2019 current account deficit to 1.0% of GDP from 0.2% last year. This month's 16% minimum wage hike has taken the cumulative increase since the beginning of 2017 to 44%, contributing to a pick-up in overall unit labour costs since then of more than 10%. Real wages are rising faster than productivity this year, at 3.7%, although are still below those of most regional competitors, partly mitigating the impact on competitiveness. Fitch forecasts a moderation in export growth, driven mainly by the earlier wave of investments in the Development Zones reaching capacity, with the current account deficit widening to 1.9% of GDP in 2021, but still below the forecast 'BB' median of 3.0%.
Net FDI has fallen sharply from last year's 10-year high of 5.6% of GDP, to a forecast 1.6% this year, but driven by outflows including of inter-company debt. We forecast a normalisation of net FDI, to an average 3.5% of GDP in 2020-2021 (comfortably covering the current account deficit), and for net external debt to edge up from 21.2% of GDP in 2018 to 22.9% in 2021, above the 'BB' median of 18.8%. FX reserves are expected to continue the stable trend, at near 4.2 months of current external payments (which compares with the peer group median of 4.5). Alongside muted headline and core inflation, of 0.9% and 0.7%, respectively, in the year to October, and a more accommodative ECB monetary policy outlook, we now expect a further 25bp interest rate cut to a new all-time low of 2.0% in 1H20 then remaining flat through 2021, and with inflation gradually picking up to close to 2% by end-2021.
North Macedonia's banking sector fundamentals remain sound. The sector is relatively well capitalised, with a Tier 1 capital ratio of 15.8% at end-2Q19, and profitable, with a return on equity of 13%. The gross non-performing loan ratio is moderate, at 5.4% at end-June and the provisions ratio high at 113%. A majority of the sector is controlled by foreign-owned institutions reducing contingent liability risk. Deposits are growing at 10% and the denar share of total deposits has increased slightly to 61.3%, while the share of total loans is flatter at 58.5%. Credit growth has averaged 7.5% this year, and we expect an increase to around 8.5% next year driven by strengthening demand.
The Outlook is Stable. Consequently, Fitch's sensitivity analysis does not currently anticipate developments with a high likelihood of leading to a rating change. The main risk factors that, individually or collectively, could lead to an upgrade are:
- Implementation of a medium-term fiscal consolidation programme consistent with a reduction in the public debt/GDP ratio.
- An improvement in medium-term growth prospects without creating macro-economic imbalances, for example through implementation of structural economic reform measures.
- Further improvement in governance standards, reduction in political risk, and progress towards EU accession.
The main risk factors that, individually or collectively, could lead to a downgrade are:
- Adverse political developments that affect governance standards and the economy.
- Fiscal slippage or the crystallisation of contingent liabilities that increases risks to the sustainability of the public finances.
- A widening in the current account deficit that exerts pressure on foreign currency reserves and/or the currency peg against the euro."
