"We expect Albania's high economic growth rates to support ongoing fiscal consolidation, which is likely to result in a gradual reduction of the country's high public debt burden," Standard & Poor's said in a rating update on Albania posted on its website.
The stable outlook reflects the expectation that Albania will continue to gradually progress toward strengthening its institutional framework, building up on the country's past cooperation with international institutions, such as the International Monetary Fund (IMF), and due to preparatory efforts in the EU accession process, S&P said.
Standard & Poor's also said:
"The stable outlook reflects our expectation that the government of Albania will maintain its commitment to fiscal consolidation, particularly on the revenues side, supported by steady economic growth and the authorities' increased capability to enforce tax compliance. Lower risks associated with the country's gradually declining debt-to-GDP ratio will also help to reduce the government's interest bill as a share of government revenues. At the same time, the country will continue to strengthen its institutions ahead of the EU accession process, and we expect its external financing position will not deteriorate.
We could raise the ratings if structural reforms established a stronger track record of more robust institutions and strengthened economic growth prospects. A positive action could also follow should ongoing fiscal consolidation efforts result in a faster-than-expected decrease in government debt.
We could lower the ratings if we observed deterioration in government finances--for example, due to a significant deviation from our current forecast--alongside resumed constraints on borrowing conditions. We could also lower the ratings if we saw a marked deterioration in Albania's external position and ability to fund its high current account deficit.
The ratings on Albania reflect the country's steady progress toward fiscal consolidation, despite political tensions in mid-2017, aided by steady economic growth and reform progress. We believe that the policy anchor provided by the International Monetary Fund's Extended Fund Facility arrangement (IMF EFF) that concluded in February 2017 strengthened Albania's fiscal framework. In particular, the formalized deficit brake, the "organic budget" law, and generally enhanced institutional oversight helped to prevent the renewed accumulation of arrears and secured the country from a fiscal slippage ahead of this year's general elections. A prudent fiscal framework, political commitment, and declining interest spending will likely enable the government to set the country's currently high public debt burden on a gradual downward trajectory. Overall, we note that Albania fiscally outperforms its peers in the same rating category. The current exchange rate regime is more stable than peers', and Albania has improved its institutional set-up.
Despite high pre-election tensions, the July general elections went smoothly, pointing to Albania's capacity to reach political compromise. The Socialist party emerged as the winner and will form the new government, which we expect will deliver policy continuity. In particular, we expect the government will advance in widening structural reforms, thus building on recent improvements in the nation's institutional framework. Aided by its cooperation with international organizations--such as the IMF (which expressed willingness to renew its engagement with Albania after the EFF program concluded in February 2017) or the EU, in the run-up to the EU accession process--the Albanian government has made significant efforts to strengthen the rule of law and combat the informal sector.
We note that last year's judicial reform has the potential to create a more independent judiciary. This will improve the country's business environment, for example, by increasing the effectiveness of enforcement of property rights and offering a more effective bankruptcy resolution process.
We expect that Albania, coming from a low base, will be able to generate solid economic growth rates of about 3.8% per year on average in real terms during 2017-2020. Growth will primarily stem from strong domestic demand, with rising consumption and private investment, in our view. Economic development in 2017 will also benefit from two large investment projects in the energy sector, for which most of the construction will occur this year. Progress on the Trans-Adriatic Pipeline (TAP), which will connect Albania with Italy and the Caspian Sea, appears on track, with completion expected by year-end 2018 and costing an estimated €1.5 billion. An improved business environment and stronger institutions will help the country to attract more foreign direct investment (FDI) in energy, tourism, and agriculture.
The government will continue on a path of fiscal consolidation as general government deficits are projected to decline to merely 1% of GDP in 2020. Revenue growth has been solid as tax revenues have consistently risen by over 8% over the past 18 months on the back of rapid nominal GDP growth and stronger tax enforcement. At the same time, the shadow economy continues to weigh on revenues, leaving room for improvements in tax compliance.
On the expenditure side, we acknowledge efforts to prevent the accumulation of government arrears through tighter monitoring. Successful implementation and adherence to the "organic budget" law, which stipulates limits on government spending in an election year, also delivered sound results. The government is currently in surplus for the first half of 2017. However, we forecast a deficit of 1.9% of GDP for the full year 2017, which will be significantly lower than in 2013-2014 when election-driven arrears subsequently resulted in financing pressures for the government.
Fiscal consolidation will reduce Albania's general government net debt to slightly above 62% of GDP in 2020 from 72% at the end of 2016. Partly benefiting from a global decline in interest rates, Albania reduced its interest payments to 8.9% of general government revenues in 2016 from over 11.7% on average in 2012-2015. The interest bill (as a share of general government revenues) will likely remain suppressed in the medium term as the revenue base of the budget expands.
Although the average maturity of government debt has lengthened considerably over the past three years, for the domestic portion of debt, average maturity remains relatively short, at slightly above two years. Domestic debt currently accounts for around 54% of the total public-sector debt stock and approximately 49% of total government debt is denominated in foreign currency. Albania's banking system still holds the largest share of domestic debt, and about 24% of the banking system's assets are government securities. However, higher revenue growth, generally improved government finances, and lower risks associated with Albania's still-high public debt stock have markedly reduced interest payments.
At the same time, Albania's external vulnerabilities remain high. The current account deficit has slightly contracted recently due to higher exports, but we still forecast it will average a high 9.6% of GDP over the coming four years. We expect FDI to remain the key external financing source since a number of large FDI projects remain in the pipeline. For example, the TAP project has stayed on schedule. Given that the largest share of the TAP investments, totalling €1.5 billion, will be executed in 2017, we estimate the FDI inflow at 9% of GDP in 2017. Further FDI inflows are related to Albania's energy sector, particularly projects in the hydropower sector. The improvement of the institutional environment could, therefore, help by attracting a broader base of FDI inflows in the coming years. Albania's DFI projects are very import-intensive, which is the primary reason behind material trade imbalances.
Remittances present another major source of foreign financing and we estimate a relatively steady, but declining, transfer balance of above 7% of GDP over our forecast horizon (compared with an average 13% of GDP over 2004-2008). Albania has been hit by the economic developments in Greece, where a significant Albanian diaspora lives, but migration of Albanians to other countries will help by further diversifying remittance sources.
Albania's external indebtedness is relatively low, as financing for the current account deficit has historically been more in the form of net foreign investment than in debt-creating inflows. Narrow net external debt of the country, by our definition, has even significantly decreased at the end of 2016 to 13% of current account receipts (CARs) due to higher external assets of the financial sector and we expect this ratio to remain close to 10% in the near-term and to slightly pick up at the end of our forecast horizon. At the same time, we see a risk that Albania's large projected FDI flows could drop or reverse in the coming years, especially as Albania's net external liability position is much weaker than its narrow net external debt position, surpassing it by over 110% of CARs in 2017.
The deposit-funded financial sector has strengthened its position as a net external creditor. This ongoing rise of the financial sector's net foreign assets--partly reflecting high liquidity--mirrors the country's limited lending opportunities for banks in recent years. We estimate domestic growth of bank credit to the entire domestic sector at merely 2% over the next years. Generally, the high share of foreign currency in the economic system hinders the effectiveness of Albania's monetary policy, as it does in several economies across the region. Despite the Bank of Albania's (BoA's) efforts to achieve de-euroization, deposits in foreign currencies will remain well above 50% of total deposits. However, loans in foreign currencies have decreased over the past years and could dip below 50% of total loans over the next years.
Since the second quarter of 2016, the BoA has maintained a rather accommodative policy to try and meet its 3% target inflation rate. Nevertheless, the central bank missed the target again in 2016. We project that the target inflation rate will not be reached before 2019.
At the same time, we acknowledge some progress toward the reduction of nonperforming loans in the banking system to 18% at the end of 2016 from its peak of 25% in September 2014, although mainly driven by write-offs. Capital buffers and liquidity in the banking system remain comfortably above minimum capital requirements. Subsidiaries of Greek banks maintain a sizable presence in Albania and the authorities have taken measures to limit exposure to their parents and prevent contagion risks to the rest of the sector.
The lek remains a free-floating currency, which has more recently been underscored by strong upward pressure. The BoA has intervened only marginally in the foreign exchange market in the past years, primarily with the intent of increasing its foreign currency reserves in line with its targets. The central bank's only significant open market operations included three-month liquidity injections to help enforce its policy rate, which remains historically low at 1.25%."
