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S&P affirms Albania at 'B+/B', stable outlook

S&P affirms Albania at 'B+/B', stable outlook gary yim/Shutterstock.com

TIRANA (Albania), August 1 (SeeNews) - S&P Global Ratings said it has affirmed its 'B+/B' long- and short-term sovereign credit ratings on Albania, with a stable outlook.

Albania's real gross domestic product (GDP) growth is expected to moderate to about 3% over the next two years despite the negligible financial and trade ties to Russia and Ukraine, the global ratings agency said in a statement on Friday.

"Fiscal consolidation will be protracted, and we expect a deficit of approximately 4.5% of GDP in 2022," S&P said.

The central bank's foreign currency reserves remain strong, serving as an important buffer against external shocks, S&P said:

The ratings agency also said in the statement:

"The stable outlook reflects our expectation that potential risks arising from the Russia-Ukraine conflict are counterbalanced by Albania's strong external buffers. Furthermore, the country's solid growth prospects will support the government's fiscal consolidation efforts and allow it to broadly lower debt in the next few years.

Downside scenario

We could lower the ratings over the next year if, contrary to our expectations, the public debt stock continues to rise, due to factors that include high fiscal deficits or the materialization of contingent liabilities from public-private partnerships (PPPs).

Upside scenario

We could consider raising the ratings over the next year if Albania records significantly lower current account deficits that reduce external funding risks. We could also raise the ratings if the country's fiscal deficits are materially lower than we expect, lowering public debt levels and interest costs. This could happen through a comprehensive medium-term revenue strategy or reduced contingent fiscal risks. Other ratings upside triggers include improved long-term growth prospects.

Rationale

Our ratings on Albania are constrained by a moderately weak institutional framework, low GDP per capita, high public debt, and large external financing needs. Over half of government debt is in foreign currency or has a short duration that requires constant refinancing. Furthermore, the Bank of Albania's (BoA's) monetary policy transmission channel is limited by the economy's widespread euroization, high informality, and shallow capital markets.

The ratings are supported by Albania's moderate growth prospects and monetary flexibility through its free-floating currency and high reserves, which serve as important buffers against potential external risks. Lastly, despite the external shocks Albania has faced in recent years, we believe authorities will revert to their fiscally conservative position, lowering public debt.

Institutional and economic profile: After a strong start to the year, GDP growth is set to decelerate in 2022 due to the conflict in Ukraine

After a solid recovery in 2021, we expect growth to decelerate in 2022 but rebound thereafter. Albania has negligible trade and financial links to Russia and Ukraine.
Accession talks have started, but the country's path to full EU membership will be protracted. Albania's real GDP growth was robust in first-quarter 2022, up 6% compared with the same period a year earlier, thanks to strong household and external demand.

Despite this, we expect growth to decelerate to 2.2% due to monetary policy tightening, weaker external demand from the EU (Albania's main trading partner), and rising inflation weighing on domestic demand. Mitigating factors include strong investment and a carryover effect from 2021. Risks to the growth outlook include an escalation in the Russia-Ukraine conflict, tightening financial conditions, and weaker global economic activity. We expect growth to revert to about 3% from 2023 on strong investment, and external and domestic demand.

Albania's economy continues to be burdened by structural issues including infrastructure gaps, a weak legal environment, corruption, and labor market shortages. Nevertheless, anchored by the country's EU membership bid, the government has made steady progress to address these issues. For example, the Trans Adriatic Pipeline will gradually reduce Albania's over-reliance on hydropower, and judiciary vetting with assistance from the EU will improve the legal framework. Continued implementation of structural reforms could improve the business environment and attract foreign investment to Albania, allowing the country to sustain higher income growth.

In contrast with other countries in the region, Albania's trade exposure to Russia and Ukraine is negligible, which limits the conflict's impact on the economy. A large part of Albania's imports from Russia are composed of hydrocarbons and agricultural products. Before the conflict, Albania imported roughly 4% of its refined fuel from Russia. On the other hand, gas plays a minimal-but-growing role in the country's energy mix.

The Socialist Party of Albania continues to govern since securing a parliamentary majority in the April 2021 general election. Policymaking has been stable, focusing on fostering economic development with the aim of EU accession. Earlier in the year, protests were held across the Albania due to rapid increases in energy and food prices stemming from the Russia-Ukraine conflict. In response, the government introduced a package of social security measures and price freezes to ease the cost-of-living crisis for those citizens struggling.

EU accession has remained a key policy priority for successive governments since Albania attained candidate status in June 2014. Previously, the EU had grouped the country's accession bid with neighboring North Macedonia, which has had its own membership bid frozen by Bulgaria due to bilateral disputes. But thanks to a recent breakthrough between North Macedonia and Bulgaria, accession talks have started that enabled the EU and Albania to recently hold their first intergovernmental conference. However, given the experience of regional peers and enlargement fatigue in the EU, we believe Albania's path to EU accession will be protracted.

Flexibility and performance profile: Fiscal and external pressure will remain elevated this year, but will start declining thereafter

Albania's fiscal deficit will remain high at 4.6% of GDP in 2022, followed by fiscal consolidation in the following years.
The current account deficit will narrow gradually over 2022-2025 and will remain financed by net foreign direct investment (FDI) inflows.
Despite the Russia-Ukraine conflict, the Albanian lek has appreciated against the euro and remains backed by the BoA's monetary policy flexibility and high foreign currency reserves.

Albania's fiscal deficit narrowed to 4.5% of GDP in 2021 driven by a robust economic recovery and withdrawal of COVID-19-related support. We expect the budget deficit to remain at about 4.6% of GDP in 2022. Revenue is set to increase strongly on higher inflation boosting tax receipts. However, additional spending to help parts of the population deal with the economic fallout of the Russia-Ukraine conflict will offset any revenue windfall. In addition, there will be additional outlays for public investments due to rising input costs. Nevertheless, the deficit for this year is fully funded.

Due to the multitude of external shocks Albania has faced in recent years, we expect fiscal consolidation will be somewhat protracted. Of note, we expect that debt will stabilize in the next few years given that authorities will largely comply with their fiscal rules as stipulated by the Organic Budget Law (OBL) and the debt-brake rule. These require the government to achieve a primary balance from 2024 and a continuously declining debt-to-GDP ratio if it is above 45%. We think fiscal consolidation will only occur if Albania's economic growth recovers and further reforms to public finances are pursued. The government expects to implement a medium-term revenue strategy to boost revenue collection. At about 27%, Albania's fiscal revenue-to-GDP ratio is the lowest in the Western Balkans. We attribute the relatively low ratio to a large informal economy, and tax loopholes and exemptions.

We expect net general government debt will narrow to approximately 65% of GDP in the next three years. Albania's debt stock is somewhat high (compared with that of regional peers) and subject to refinancing and foreign currency risks. Average debt maturity has been increasing but remains relatively short. Moreover, about 51% of central government debt is in foreign currency and unhedged, making it vulnerable to exchange-rate volatility. The domestically issued debt is largely short-term. In addition, and despite a pickup in bank lending to the private sector in recent years, Albania's banking sector still holds the largest share of domestic government debt, which constitutes about 26% of the sector's total assets.

Authorities are continuing with their efforts to reduce contingent fiscal risks. Yet, off-balance-sheet PPPs continue to pose a fiscal risk. Albania has over 200 PPPs covering road infrastructure, power generation, and health care. Under the OBL, payouts to PPPs are limited to 5% of tax revenue in the previous year. Despite efforts to address Albania's infrastructure gap, in our view, the risk framework governing these projects is not sufficiently developed--particularly in terms of cost transparency. Consequently, potential fiscal risks from PPPs remain hard to predict and quantify.

Inflation in Albania has increased to its highest level since 1999, to 7.4% in June, from 6.6% in May. However, it remains low on a regional basis. The acceleration in inflation is mainly due to an increase in food and energy prices. As a result, the BoA has responded by hiking the policy rate a cumulative 75 basis points this year. We expect inflation to remain elevated and average 6.4% in 2022, then fall gradually back to BoA's inflation target band of 3% plus or minus 1% due to monetary policy tightening and weaker external prices pressures.

The BOA's monetary policy transmission mechanism remains impaired by shallow capital markets and extensive euroization in the economy (similar to regional peers). Roughly 56% of deposits are in foreign currencies; euros continued to be widely accepted in transactions, even in the formal economy. Nevertheless, the BoA has reduced the proportion of loans denominated in euros, to slightly below 50% of the total stock.

Despite tightening global financial conditions, the Russia-Ukraine conflict, and a slowdown in global economic activity, the Albanian lek (a free-floating currency) has appreciated against the euro. The lek's stability has reduced pressures on public finances and the domestic banking system.

Strong financial account inflows over the past decade has prompted stronger foreign currency reserves, as have the BoA's efforts to accumulate reserves. We expect usable reserves (that is, gross reserves net of required reserves on commercial banks' foreign currency liabilities) will cover about six months of current account payments over the next few years.

Albania's current account (CA) deficit narrowed to 7.7% of GDP in 2021, mainly due to a pickup in services exports, particularly tourism revenue, which offset higher imports and lower remittances. Tourism levels continue to recover; 12-month rolling foreign tourist arrivals reached 6.3 million in May 2022, close to the peak of 6.4 million in August 2019. We expect the CA deficit to widen to 8.2% of GDP in 2022, mainly due to higher commodity prices. Over the next few years, the CA deficit will narrow again as commodity prices decrease, tourism revenue recovers, and post-earthquake reconstruction activities fade. Strong financial account inflows via FDI will continue financing the external deficit until 2025.

Although BoA has withdrawn its support measures, Albania's banking sector is liquid, well-capitalized, and profitable. Nonperforming loans reached 5.4% of gross loans in May, compared with a peak of almost 25% in 2014. Overall, the risk of contingent liabilities remains low, but the banking sector remains highly euroized."

 
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