March 4 (SeeNews) - S&P Global Ratings said it has affirmed its 'B' long-term foreign and local currency sovereign credit ratings on Bosnia and Herzegovina, as well as its 'B' short-term ratings on the Balkan country.
The rating outlook has remained positive on the prospects of local authorities making progress with structural reforms and reaching an agreement with the IMF on a funded arrangement in the next 6-12 months, S&P said in a statement last week.
"Despite longstanding political fragmentation, Bosnia and Herzegovina's (BiH's) economy has continued to grow," the credit ratings agency said, adding it forecats real GDP growth of 2.7% on average through 2023 and net general government debt remaining below 30% of GDP.
In January, Bosnia's Council of Ministers said it should as soon as possible adopt the country's 2020 budget in order to facilitate the continuation of the existing arrangement with the International Monetary Fund (IMF) and clear the way for a new deal with the international lender.
In September 2016, the IMF approved a three-year 553.3 million euro ($614.5 million) loan under a Extended Fund Facility (EFF) to support Bosnia's economic reform agenda.
However, its implementation has been blocked after Bosnia failed to form a new government and state institutions more than year following the October 2018 general election. The country's new government, headed by Tegeltija, was eventually voted in office in December 2019.
In the absence of a regular budget act, the Council of Ministers adopted on December 30 a temporary budget for the first quarter of 2020 to support the state institutions and ensure that the country's international obligations are being serviced.
S&P also said in the statement:
"The positive outlook reflects the potential for BiH authorities to move ahead with structural reforms and to agree to a funded arrangement with the IMF over the next 6-12 months. Reforms could include reducing the labor cost burden on business and enhancing governance of the country's sizable state-owned enterprise (SOE) sector. The outlook also reflects upside rating potential should economic growth turn out stronger than we forecast.
We could raise the ratings on BiH if domestic policy settings improved, with a move toward less confrontational and more consensus-based politics oriented on promoting economic growth and structural reforms, possibly underpinned by a funded IMF program. We could also raise the ratings if economic growth strengthened.
We could revise the outlook to stable or lower the ratings in the event of material escalation of domestic political tensions that hampered economic growth and posed risks to BiH's already-fragile institutional settings. One example of such a development could be putting the country's Central Bank or Indirect Tax Authority mandates into question, thereby endangering the so far well-functioning mechanisms related to the timely servicing of the state's external debt.
Rationale
Our ratings on BiH remain constrained by the country's modest income levels. GDP per capita, forecast at $6,500 in 2020, remains comparatively low in a global setting and notably lower than most other European countries. The ratings are also constrained by the country's complex institutional arrangements and confrontational nature of domestic politics. We also note the absence of monetary flexibility stemming from the currency board arrangement vis-à-vis the euro.
The ratings on BiH remain supported by the favorable structure of state debt. We expect net general government debt levels to stay below 30% of GDP over the next four years. Almost all external debt (which accounts for more than 70% of gross general government debt) is due to official bilateral or multilateral lenders and is characterized by long maturities and favourable interest rates. In our view, this lower leverage awards BiH some fiscal space, partially offsetting lack of monetary flexibility given the hard peg to the euro.
Institutional and economic profile: Complex institutional setup and confrontational domestic politics but the economy continues to grow
The state-level BiH government has finally been formed, 14 months after the general election.
We expect domestic politics to remain volatile and unpredictable, given the difficult set-up and occasional calls of Republika Srpska (RS) for secession.
Despite a slowdown, Bosnia's economy continues to grow and we forecast average real GDP growth of 2.7% over the next four years.
Bosnia's complex institutional settings owe their existence to the Dayton peace accord, which ended the 1992-1995 war. The country is de facto composed of two entities with large degree of autonomy--the Federation of Bosnia and Herzegovina (FBiH) and Republika Srpska (RS)--in addition to the small self-governing Brcko District. Each entity has its own parliament, government, and banking regulator with extensive mandates. A high degree of political volatility and the frequently confrontational decision-making has been and remains a defining characteristic of domestic BiH politics.
A state-level BiH government was finally formed in December 2019, 14 months after the October 2018 general elections. The process has been protracted, with the main disagreements centered on BiH's stance toward NATO, with membership generally supported by the FBiH authorities but consistently opposed by the RS government.
Beyond state-level arrangements, political developments on the sub-entity level also remain complex. While the RS entity-government was formed shortly after the October 2018 elections, the temporary administration continued in the FDiH until this year with a number of disagreements persisting around the electoral law. This has hampered the formation of a more permanent administration.
In our view, there are a number of policy areas where RS and FBiH have common ground. For example, there is a broad political consensus on the necessity of structural reforms, further integration and closer cooperation with the EU, as well as desire to agree on a new funded arrangement with the IMF. We also understand that the respective banking regulators are in close coordination and most banking regulations and new initiatives are aligned. This is important given that most banks operate across the country with branches in both entities.
Nevertheless, consensus is often difficult, even when stances appear similar. This is partially because the entities have incentives to gain leverage in negotiations by blocking progress in some areas and some confrontational announcements might appeal to the local electorate. A recent example of this is the ruling by BiH's constitutional court that the farm lands previously belonging to Yugoslavia are now legally property of the state, rather than the entities, which contradicts a law passed earlier by the RS parliament. As a result, political tensions have risen once again, with the leader of the largest RS party, SNSD's Milorad Dodik, calling for secession from Bosnia and blocking his party's representatives participating in state-level institutions. In our view, this could partially relate to the upcoming local elections in the autumn, but even if the threats are not followed though, this could delay structural reforms and agreeing on the arrangement with the IMF. However, these threats have been aired in the past and we believe that upside reform momentum remains.
Positively, we believe that working mechanisms allow BiH institutions to function even through periods of political uncertainty. For example, the state level budget for 2019 was only adopted in December, but the financing has continued on a proportional quarterly basis in line with the adopted 2018 budget. We also believe that the state's external debt servicing procedures have strengthened in recent years and operate regardless of whether the budget is adopted. Specifically, all indirect tax revenue (which constitutes the lion share of overall tax revenue) are collected by state-level Indirect Tax Authority and then redistributed back to the entities net of funds for foreign debt service and financing for functioning of state institutions. This setup essentially prioritizes external debt service and reduces the risk of payment delays, like the one in January 2012 when BiH was late repaying some official creditors. This mechanism does not apply to debt contracted by the individual entities, only to foreign debt owed by the state-level government.
Also, despite persistent uncertainties, the economy grew an average of 3.5% over the past four years. We estimate that growth slowed moderately in 2019 to 2.5%, reflecting somewhat weaker economic performance of BiH's key trading partners as well as one-off domestic developments, including the closure of a long-time loss making aluminium plant (Aluminij Mostar) and maintenance work on a refinery. High-frequency data suggests a decline in BiH's industrial production in 2019 but quarterly real GDP estimates point to continued growth.
We expect domestic demand to support economic growth, which we forecast will average 2.7% through 2023. We also see upside potential for BiH's tourism sector, which continues to expand: in U.S.-dollar terms, services receipts in the balance of payments have risen by an average of 5% annually since 2015. Finally, we see some upside should the political situation stabilize and a funded arrangement be agreed to with the IMF, but the likelihood of that is uncertain. We anticipate that the main reform areas that any new agreement with the IMF will cover will be in the areas of improving SOE governance, addressing the stock of social contributions outstanding and tax arrears, as well as measures to strengthen the labor market. Even then, we anticipate that growth over our forecast horizon is unlikely to reverse BiH's net emigration outflows.
Flexibility and performance profile: Low net general government debt provides some policy headroom absent an independent monetary policy
We estimate that BiH's net general government debt amounted to 25% of GDP at year-end 2019 and expect it will continue to decline toward 23% over the medium term.
We forecast moderate current account deficits will average just under 4% of GDP through 2023 financed through net foreign direct investment and capital account inflows.
The existing currency board arrangement vis-à-vis the euro anchors inflation but restricts the country's monetary policy flexibility.
BiH's fiscal performance remains the main factor supporting the sovereign ratings. We estimate that last year the general government budget recorded a surplus of 1.7% of GDP following earlier surpluses from 2015-2018. While the recurring surpluses partially reflect the difficult political setup and resulting delays to budget adoption and agreeing on spending priorities, they still reflect a degree of fiscal discipline. This is particularly visible if fiscal data is dissected into entity-level performance because both the RS and FDiH have been running fiscal surpluses, despite the ability to directly borrow in local currency from domestic banks.
As a result, net general government debt declined to an estimated 25% of GDP at the end of 2019 from 35% in 2015, and we expect it will further moderate to 23% over the medium term. Almost all external debt (which accounts for more than 70% of gross general government debt) is due to official bilateral or multilateral lenders and is characterized by long maturities and favorable interest rates. In our view, this lower leverage awards the country some fiscal space partially offsetting lack of monetary flexibility given the hard peg to the euro.
BiH's budgetary procedures explicitly prioritize external debt service payments above all other outlays. Foreign debt is serviced through a mechanism where all revenue from the constituent governments is collected by the state-level Indirect Tax Authority and redistributed to the constituent governments net of external debt service on the basis of a consumption-linked coefficient. While there have been disagreements about the indirect tax-revenue sharing formula and the coefficient, we understand that the authority's setup is not questioned by either of the entities' governments.
Risks continue to stem from BiH's large and inefficient public enterprise sector. Most SOEs appear to be in relatively poor financial state and have substantial arrears to the government in the form of nonpaid social contributions and taxes. They appear to be a drag on economic growth and state resources but reforming them remains difficult for political reasons. Until recently, there was no reliable data on the overall stock of SOE debt but a working paper by the IMF published in autumn 2019 put them at 26% of GDP. This number is likely an overestimate of any contingent liability for the government because most of this debt appears attributable to various levels of government through lending to SOEs and unpaid taxes. Positively, the government has shown reluctance to support SOEs under stress, which has protected budgetary resources. For example, Aluminij Mostar closed recently, with several commercial banks writing off their exposures to the entity.
We do not view BiH's balance of payments risks as elevated, reflecting the moderate external indebtedness, compared with that of other sovereigns we rate. This is partially a function of past fiscal surpluses but also restricted availability of international financing and the resulting investment delays in the past three years.
BiH de facto runs a balanced current account, although headline current account deficits have averaged close to 4% of GDP in recent years. This is because a large proportion of the deficit pertains to reinvested earnings that are further booked as inflows on the net FDI account, while the remaining portion of the deficit is covered through capital account flows (representing EU grants) as well as positive net errors and omissions (likely representing unrecorded money transfers from Bosnians working abroad). We expect the current account will remain in a contained deficit averaging 3.8% of GDP through 2023 and with a similar funding structure.
BiH has a currency board regime, under which the konvertibilna marka is pegged to the euro. The currency board contributes to economic stability and has contained inflationary pressures. That said, it restricts policy options, in our view. Although reserves covered monetary liabilities exceeding 100% through 2019, the central bank has limited ability to conduct an independent monetary policy. We forecast that the currency board arrangement will continue and CBBH (the central bank) will continue to closely follow the European Central Bank's monetary decisions.
In June 2019, the tripartite presidency dismissed two Serb members of the central bank's managing board. The Court of BiH is reviewing this to see if there were proper grounds for dismissal, because it raises concerns of political interference into monetary policy. In our observation, there have so far not been any practical implications on the monetary policy decision-making bodies stemming from the dismissal, because the central bank can function with three of five board members.
BiH has a conventional banking system, dominated by subsidiaries of foreign banking groups, similar to other West Balkan states. The banks are largely domestic-deposit-funded and we estimate that they remain in a net external creditor position. We forecast that domestic credit will continue to increase by close to 6%, while nonperforming loans have declined to under 8% from a peak of 16% in 2014.
We also positively view the quality of domestic banking system's regulation. The financial sector regulators in the two entities appear to coordinate their work and are closely aligned on new initiatives and rules. Although there is no full transparency, we understand that there is a funded deposit insurance scheme that has been deployed in a number of cases in recent years when smaller domestic banks had to be closed down, with no fiscal implications."
($=0.900390 euro)