SARAJEVO (Bosnia and Herzegovina), September 10 (SeeNews) –
S&P Global Ratings said it has affirmed its 'B/B' long-term and short-term foreign and local currency sovereign credit ratings on Bosnia and Herzegovina (BiH), with a stable outlook.
"Political tensions and divisive strategies will likely delay the forming of a functioning state parliament after the October elections, which, together, with a recent derailing of the International Monetary Fund (IMF) program raises concerns for investments, foreign investor sentiment, and structural reform capacity", the S&P said in a statement issued late on Friday.
However, despite the rising tensions, increasingly unpredictable political environment and likely institutional gridlock, S&P forecasts the real economy will be largely unscathed over the coming two years, with a 3% annual growth rate through 2021 and steadily rising wealth levels.
The rating agency also said:
"OUTLOOK
The stable outlook on BiH balances, on one hand, our assessment of risks related to a potential suspension of state-level legislative functions following the October 2018 general elections, with, on the other hand, our expectation that the servicing of foreign debt will stay isolated from institutional turbulence. In addition, we expect the real economy to retain a stable growth trajectory through this upcoming period of high political uncertainty and likely prolonged gridlock on reform momentum. We factor in our expectations that BiH's income levels will continue to improve amid the economic upswing, even though the likely suspension of a functioning legislative body, a derailed structural reform momentum, and potential decreases in external debt inflows could ultimately curtail growth potential.
We could raise the ratings on BiH if external financing flows proved resilient and the political setting stabilized and recovered its reform agility, and if the IMF program bounced back on track, resulting in strengthened growth momentum by supporting investments and markedly lifting income levels. Less antagonistic relations across BiH's multilayered governments, exemplified by continued rigorous reforms and smoother discourse, would also be credit-positive.
We could lower the ratings if political developments in 2018-2019 lead to notable and extended government deadlock, produce public unrest, and reverse the progress made under the reform agenda so far. Downside momentum would similarly build if the failure to resume IMF endorsement hinders external financing, delays necessary infrastructure investments, and reduces growth momentum.
RATIONALE
The ratings are constrained by the country's divisive politics, which frequently bring policymaking to a standstill, most recently exemplified by increasing tensions that are escalating to the point that the Oct. 7 elections will likely be inconclusive. We also factor in BiH's limited monetary policy flexibility and its still low income levels. Moreover, sustained current account deficits give rise to substantial external financing needs that weigh on the ratings.
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, and which we believe will remain insulated from the expected institutional gridlock. Moreover, the sovereign's relatively low and predominantly concessional debt burden adds a component of stability, which underpins the ratings, together with BiH's to-date stable fiscal position and our assessment that the sovereign will continue to contain its budget deficits during periods of less-available external financing.
Institutional and Economic Profile: Frail institutional foundations and divisive politics
- Inadequately assessed fiscal reform initiatives could threaten fiscal sustainability and has derailed the IMF's extended fund facility (EFF).
- Political tensions and divisive strategies are set to produce inconclusive elections in October 2018, challenging fiscal policymaking, while halting any meaningful short-term reform activity and the transition to investment-led growth.
- Despite the unpredictable domestic political environment, we expect economic growth to remain solid, supported by private consumption, a positive external environment, and public investment projects.
In July 2018, the IMF decided to postpone disbursements under its EFF, based on its assessment that proposed fiscal measures in BiH threatened to sidetrack fiscal stringency, a key requisite for continued IMF program endorsement. Even though the postponement of the €38 million tranche will not significantly hurt BiH's fiscal situation, in our view, 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, the continued postponement of the IMF program could lead to overall negative external financing sentiment. Moreover, we anticipate that the resumption of negotiations with the IMF will likely drag on, since the October elections could delay the formation of a functioning state government.
We observe that the frequent confrontations between political parties and between the country's autonomous entities has intensified ahead of the general election. More importantly, the court-mandated adoption of a revised election law has not taken place, and we believe it very unlikely that a negotiated solution will be brokered among the political parties before the Oct. 7 election day. As it stands, the situation is very unpredictable and we expect an ensuing gridlock after the elections to lead to significant entity-level distress where one of the autonomous regions, the Federation of Bosnia and Herzegovina, is set to stand without a properly elected House of Peoples, ultimately spilling over to the state level, which would see itself similarly missing a functioning legislative body. Therefore, BiH could be in a position wherein no laws requiring parliamentary approval could be adopted. In this scenario, the state level budget execution will be curtailed, meaning a situation of temporary financing will be enforced, reform momentum will be sidetracked, and the resumption of talks with the IMF will be delayed. We do not exclude that the formation of government following the general election could be a lengthy and unpredictable process. In addition, 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.
BiH's multilayered institutional set-up hinders effective policymaking and complicates meaningful progress toward being granted EU candidate status (BiH applied in early 2016). We don't anticipate any significant progress regarding the EU in the short term, but we believe that the international community will continue to support BiH on its European integration path. However, 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.
That said, we do not expect the escalating political disruption to materially deter BiH's growth trajectory. We forecast 3.1% growth on average over 2018-2021. We have moderated our growth projections slightly, taking into account our expectation of lower investments, dampened foreign investor sentiment, and diminished economic activity in 2019 and beyond from the increased uncertainty surrounding the 2018 elections. That said, our base-case expectation is that the real economy will maintain a solid growth cycle where the economy is largely unscathed by the likely political and institutional deadlock. Over the longer term, absent structural reforms, BiH's growth is not likely to be high enough to stem outward migration or successfully transform the economy. As they stand, the locked political positions are not conducive to constructive economic policy-making and will fail to generate the reforms needed to unlock the country's potential.
While the derailed IMF program represents a deterrent for external financing flows, we observe that some important external financing has been locked in for the short term, such as a European Bank for Reconstruction and Development three-year €700 million loan to finance highway construction throughout the country, which will to some extent sustain key infrastructure investments. As in the past, we project that private consumption will be a key growth contributor, financed by substantial remittance inflows. We also observe that foreign direct investment (FDI) increased in 2017 to 2.2% of GDP from 1.6% in 2016. Still, this improvement was primarily driven by existing companies reinvesting their profits and less by new investments.
The most recent labor force survey indicated that the unemployment rate has continued to reduce, standing at 18.4% in 2018, compared with 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 neighboring countries and the EU.
Flexibility and Performance Profile: Domestic political uncertainty complicates fiscal policymaking and could deter external financing
- The likelihood of political deadlock after the October 2018 elections is increasing, which could complicate fiscal policymaking and mute medium-term investments.
- We expect central government foreign debt service to benefit from an institutionalized mechanism that prioritizes debt service ahead of other fiscal outlays.
- BiH's currency board arrangement anchors its structural reform agenda, but restricts monetary policy flexibility.
Financing constraints due to disruption in the EFF program in 2017 prompted the general government to cut public expenditures markedly, especially investments, to bring the general government position into meaningful surplus for the full year. In the first half of 2018, revenues from taxes and indirect taxes have developed strongly in tandem with the growing economy and are set to boost general government balances to an only-modest deficit of 0.4% of GDP. However, given the uncertainties surrounding the ability to legislate and execute budgetary decisions after the 2018 October elections, the fiscal trajectory is difficult to assess. We expect that the political deadlock could be meaningful and that BiH's budget execution could move into a situation of provisional financing. In practice, the expenditures for sustaining public institutions and fiscal measures will be subject to caps related to the existing budget allocations and revisited regularly throughout the budget year. We anticipate that these considerable constraints will limit budget execution and spending predictability. Even so, we observe that recently announced fiscal reforms, such as the proposed law on benefits for war veterans, are difficult to assess in terms of their calculated fiscal impact. It is likely that the outcome could be materially more costly than the preliminary calculations by government, resulting in medium-term fiscal pressure from age-related expenditure.
Importantly, outstanding general government debt is low and foreign debt is serviced through a mechanism where 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. We consider this mechanism vital in terms of containing risks associated with a period of budget execution uncertainty after the elections. The majority of government debt is and will continue to be denominated in foreign currency and primarily concessional. Net general government debt decreased to 27% of GDP in 2017, chiefly due to availability constraints and delayed investments. We expect it to remain at similar levels through 2021.
We believe that the entity-level 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 stagnation persists, deterring concessional financing inflows.
The moderate external indebtedness of BiH, 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 low 28% of current account receipts in 2017. Following the increasing political turbulence, and anticipating post-election gridlock, we have lowered our expectation of international concessional inflows in 2019-2021. In this regard, we note that, absent such flows, BiH faces external issuance constraints. As such, we now forecast only a mild increase in BiH's external indebtedness, with narrow net external debt returning to over 37% of current account receipts by 2021.
Consequently, we now expect imports to decline through the forecast as externally financed infrastructure investments temper. We therefore project a current account deficit 5.5% of GDP in 2021 (compared with 7.2% in our previous forecast) from 4.8% of GDP in 2017. We estimate debt-creating inflows, net of amortization, to stand at about 1.5% of GDP on average through 2021, together with net FDI of 2.0% 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, but that seems unlikely given the expected halt to reform momentum.
BiH has a currency board regime under which 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 options, in our view. 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. Nonperforming loans (overdue 90 days or more) have decreased to 9.3% of total loans as of the second quarter 2018. The consolidation of banks' balance sheets ended at mid-year 2017 and private sector lending has been picking up. This lending has largely been financed by domestic deposits, which exceed outstanding loans, as reflected in a loan-to-deposit ratio of 93%. Vulnerabilities at smaller domestic banks with weaker corporate governance practices have surfaced over the past couple of years, but we recognize the recent adoption of new banking legislation in the two autonomous governments--the Federation of Bosnia and Herzegovina and Republika Srpska--in line with EU directives, as a step toward improved supervision."