SARAJEVO (Bosnia and Herzegovina), March 12 (SeeNews) – Standard & Poor's (S&P) said it has affirmed its 'B/B' long- and short-term foreign and local currency sovereign credit ratings on Bosnia and Herzegovina, with a stable outlook.
"The stable outlook on Bosnia and Herzegovina balances our assessment of a solid cyclical upswing in economic activity against our concerns that political maneuvering ahead of the general election in October 2018 could result in notable gridlock--characterized by derailed structural reform momentum and disruptions in external debt inflows--and ultimately curtail growth potential," S&P said in a statement late on Friday.
The ratings agency said it also took into account its expectations that Bosnia and Herzegovina's income levels will continue to improve amid the economic upswing.
It noted that it could raise the ratings on the country if external financing flows proved resilient and the political setting recovered its reform agility, resulting in maintained, solid growth momentum.
"Ratings upside could stem from a lessened impact of structural, depopulation-related matters on wealth levels. Less antagonistic relations across BiH's multilayered governments, exemplified by upheld reform stringency and smoother discourse, would also be credit-positive", S&P explained.
On the other hand, it could lower its rating if political developments in 2018 create a bottleneck that reverts progress made under the reform agenda so far, hinders external financing, and notably reduces the growth momentum.
S&P also said:
"Our ratings on BiH are supported by the sovereign's steady economic growth, which supports indirect tax revenues that BiH uses to service its external debt, together with its relatively low and predominantly concessional debt burden. BiH's stable fiscal position and our assessment that the sovereign will continue to contain its budget deficits during periods of less-available external financing also underpin the ratings.
The ratings are constrained by the country's divisive politics, which frequently bring policymaking to a standstill. We also factor in BiH's limited monetary policy flexibility and its still low income levels.
Moreover, while external financing channels have recently turned benevolent, sustained and notable current account deficits give rise to substantial external financing needs that weigh on the ratings.
Institutional and Economic Profile: Divisive politics remain a key obstacle to economic transformation despite recent reform success
- Successful reform implementation has put the International Monetary Fund's (IMF's) extended fund facility (EFF) back on track and unlocked external financing.
- Political tensions have intensified as the constituents gear up for the general election in October. This is likely to make 2018 a lost year in terms of meaningful reform, creates uncertainties regarding the predictability of concessional debt inflows, and challenges fiscal policymaking and the transition to investment-led growth.
- Despite the unpredictable domestic politics, we expect economic growth to remain solid, supported by private consumption, a positive external environment, and large-scale public investment projects.
In late 2017, Bosnian policymakers legislated an excise tax hike that meets a key requisite to complete the first review under BiH's current three-year €550 million EFF, with the IMF securing the disbursement of €75 million and the possibility of additional two tranches in June and September this year. The IMF program is an important anchor for the country's structural reform agenda, and its positive momentum enables BiH to access external financing for key infrastructure projects. As such, several external financing channels have opened up to fund meaningful growth-enhancing infrastructure investment over the coming three years. In this regard, we note that in February the European Bank for Reconstruction and Development signed a memorandum of understanding to disburse a three-year €700 milllon loan to finance highway construction throughout the country.
BiH's multilayered institutional set-up hinders effective policymaking and complicates meaningful progress toward being granted EU candidate status (BiH applied in early 2016). While we expect the European Council to deliver an opinion on the progress of BiH's accession to the EU toward the end of the year, we do not anticipate any notable traction in the short term. In particular, confrontational political rhetoric continues to impede the longer-term effectiveness of reforms necessary to secure structural improvements in the business sector and the labor market to strengthen growth potential and bolster income levels. Moreover, while we expect BiH's wealth levels to continue to improve, we observe that the headline number appears stronger due to the ongoing decline in population and the debate over the handling of population statistics.
We anticipate that the frequent confrontations along party lines and between the country's constituents will intensify ahead of the general election this October. Importantly, aspects of the election law need to be rectified, following a July 2017 court ruling, and the amendments would need parliamentary approval before elections can move ahead as planned. This requires swift resolution since the general election would have to be called in May for it to take place in October. We believe that failure to reach an agreement could extend delays to the planned elections, hampering the performance of the executive and legislative institutions. We do not exclude that the the orderly formation of government following the general election could be compromised. Moreover, while calls for a referendum on the independence of Republika Srpska have been muted lately, we do not rule out that further attempts could resurface and create additional political tensions.
Nevertheless, we do not expect these factors to materially deter BiH's growth trajectory, which we believe is experiencing a solid cyclical upswing. Furthermore, we believe that the international community will continue to support BiH on its European integration path.
We have revised up our growth projections for BiH in line with our base-line expectation that a resumption of external financing will spur key infrastructure investments. In our view, investments, alongside solid exports, will increasingly contribute to growth over the medium term. We forecast a growth path for the country of 3.2% on average over 2018-2021. However, the pick-up in infrastructure investment is also likely to bolster imports of machinery, which will probably weigh on net exports and ultimately on growth. As in the past, we project that private consumption will be a key growth contributor, financed by substantial remittances inflows. We also observe that foreign direct investment (FDI) jumped in 2017 to 2.2% of GDP from 1.6% in 2016. Still, this increase was primarily driven by existing companies reinvesting their profits and less by new green-field investments. We view weaknesses in the business sector and political uncertainty as key deterrents to further private investment.
The labor force survey indicated that the unemployment rate was at 20.5% in 2017, down from 25.4% in 2016. The significant decline is driven by an increase in employment, but also from a fall in the activity rate and a reduction of the labor force. Domestic private-sector development is hampered by the availability of skilled and educated labor--a shrinking pool because of the migration of working-age people to the EU and other neighboring countries. While we expect improvements in the country's labor market due to the improved investment and growth prospects, continuing emigration and aging are set to be an obstacle.
Flexibility and Performance Profile: Resumed external financing facilitates investments, but current account deficits are widening
- We project the current account deficit to widen through 2021 as infrastructure investments drive imports.
- Renewed availability of external funding is resulting in increasing external indebtedness.
- Although BiH's currency board arrangement has stabilized the structural reform agenda, it restricts monetary policy flexibility.
The moderate external indebtedness of BiH at year-end 2017, compared with that of other sovereigns we rate, reflects the government's reduced external borrowing due to constrained financing availability of international concessional inflows and the resulting investment delays in 2016-2017. In addition, due to an externally consolidating banking sector in recent years, as well as increasing levels of foreign exchange reserves in order to cover monetary liabilities, we position the country's narrow net external debt at a comfortable 31% of current account receipts in 2017. Nevertheless, even though we expect international concessional inflows to pick up in 2018-2020, we incorporate an element of uncertainty to their predictability and note that, absent such flows, BiH faces external issuance constraints. Even so, the improved external financing environment will drive an increase in BiH's external indebtedness, with narrow net external debt returning to levels over 40% of current account receipts by 2021, according to our forecast.
We expect imports to increase on the back of externally financed infrastructure investments. We therefore project a gradual widening of the current account deficit to more than 7.0% of GDP in 2021 from 5.2% of GDP in 2017. At the same time, gross exports continue to grow robustly and the country has enjoyed a record tourist season in 2017, notably thanks to vacationers from the Middle East. We estimate debt-creating inflows to pick up in 2018 to, net of amortization, about 2.1% of GDP together with net foreign direct investment of 1.9% of GDP, and inflows to the capital account making up the rest. Further structural reforms in the business sector could also help attract more FDI, which we currently project at 2.2% of GDP in 2018-2021.
Financing constraints due to disruption in the EFF program in 2017 prompted the general government to cut public expenditures markedly, especially on investments, to bring the general government position into meaningful surplus for the full year. However, we assume that the fiscal deficit will reach up to 1% of GDP annually over the forecast horizon because of likely higher spending this year linked to the upcoming election, increased investments as official funding returns, and pressure on social security expenditure.
We believe that the constituents' governments would have access to the domestic capital markets to cover temporary deficits if there was a disruption in concessional funding inflows. Importantly, we have seen that, historically, they have cut investment spending in the absence of concessional inflows, and we expect them to do so again if needed to balance their budgets. However, we see BiH's vulnerability to shifts in official funding as a risk, and we believe external financing pressures could again heighten if reform progress was derailed, deterring concessional financing inflows.
Net general government debt decreased in 2016 and 2017, chiefly due to availability constraints and delayed investments. However, we expect it to increase again over our forecast horizon, with net general government debt climbing to slightly more than 30% of GDP by 2020.
The majority of government debt will continue to be denominated in foreign currency and primarily concessional. All revenues from the constituents' governments are collected by the state-level Independent Taxation Authority (ITA) and redistributed to the entities net of external debt service on the basis of a consumption-linked coefficient. BiH's budgetary procedures thus explicitly prioritize external debt service payments above all other outlays.
BiH has a currency board regime and its currency, the konvertibilna marka (BAM), is pegged to the euro. The currency board contributes to macroeconomic stability and has successfully contained inflationary pressures, necessary elements for the implementation of the structural reform agenda. While appropriate for the country so far, it restricts policy response, in our view. We also view the high share of loans denominated in, or indexed to, foreign currency (more than 50% of total system loans) as constraining the monetary flexibility of BiH's central bank. Although reserves covered monetary liabilities through 2017, the central bank cannot act as a lender of last resort under BiH law. We understand that BiH is committed to maintaining the independence of the central bank and preserving the stability of the currency board, which entails full coverage of the monetary base by the central bank's foreign currency reserves.
At the same time, BiH's banking system appears relatively well capitalized and nonperforming loans (overdue 90 days or more) have decreased to 10.0% of total loans as of December 2017. The consolidation trend in the banking sector ended at mid-year 2017 and private sector lending has been picking up. This lending has largely been financed by domestic deposits. Vulnerabilities at smaller domestic banks with weaker corporate governance practices have surfaced over the past couple of years, but we recognize that the recent adoption of new banking legislation in both entities, in line with EU directives, as a step toward improved supervision."