February 6 (SeeNews) - Standard and Poor's (S&P) said it has affirmed the 'B/B' long- and short-term foreign and local currency sovereign credit ratings on Bosnia and Herzegovina, while revising the country's long-term outlook to positive from stable.
"The positive outlook reflects our view that a potentially less confrontational domestic political environment should hold over the next year while BiH's external imbalances remain contained and the government's debt burden stays low at 22% of GDP by year-end 2023, with most debt owed to official creditors at relatively low interest rates and long maturities," S&P said in a statement on Friday.
The global ratings agency added that stability has improved in Bosnia and Herzegovina in recent months, with the comparatively timely formation of a state-level government after the October 2022 general election, and the country's economy is expected to continue to grow in 2023, although at a slower pace
Standard and Poor's also said in the statement:
"Overview
[...] In December 2022, BiH also received EU candidate status, while the likelihood of Republika Srpska--one of the two main entities comprising the country--withdrawing from key state institutions appears to have reduced.
We expect BiH's economic growth will slow to 1% in 2023, mirroring developments in key trading partners, but fiscal headroom remains, based on our estimate of net general government debt at a low 22% of GDP at year-end 2022.
We therefore revised our outlook on the long-term sovereign credit ratings on BiH to positive from stable and affirmed our 'B/B' ratings.
Rating Action
On Feb. 3, 2023, S&P Global Ratings revised its outlook on the long-term local and foreign currency sovereign credit ratings on Bosnia and Herzegovina (BiH) to positive from stable. At the same time, we affirmed the 'B/B' long- and short-term foreign and local currency sovereign credit ratings on BiH.
[...]
Upside scenario
We could raise the ratings over the next 12 months if the government's balance sheet remains strong and external imbalances remain moderate, despite weakening demand from key trading partners and the sometimes-unpredictable nature of BiH's domestic politics.
Downside scenario
We could lower the ratings if domestic political confrontations escalate, particularly if this leads to a rising likelihood of negative implications for government debt service--for example, by affecting indirect tax revenue or foreign currency reserves at the central bank.
Rationale
The outlook revision to positive reflects what we view as receding domestic political confrontation in BiH in the aftermath of the October 2022 general election. The state-level coalition government was formed less than four months after in January 2023, versus 14 months following the previous election in 2018.
Meanwhile, Republika Srpska's (RS; B/Stable/--) plans to withdraw from several state-level institutions (the Indirect Tax Authority [ITA], the judicial and prosecutorial council, and the armed forces) appear on hold, de-escalating the situation for now. Our baseline scenario remains that RS will continue within BiH on largely the same terms as previously for the foreseeable future.
We also note that BiH's economy has exhibited resilience to recent external shocks such as the COVID-19 pandemic and the sharp rise in commodity prices following the onset of the Russia-Ukraine conflict. We expect the current account deficit to remain elevated this year, but most funding will come from net foreign direct investment (FDI) inflows and a capital account surplus. Additionally, we estimate that the general government ran a balanced budget on a consolidated basis in 2022 and project only modest deficits averaging 0.6% of GDP through 2026.
The ratings on BiH are supported by the modest level and favorable structure of public debt. We expect net general government debt to remain at 20%-22% of GDP over the next four years. About 90% of external debt (which itself accounts for more than 70% of gross general government debt) is due to official bilateral or multilateral lenders at long maturities and favorable interest rates. Our sovereign ratings on BiH pertain to the state's ability and willingness to service financial obligations to nonofficial (commercial) creditors. To this end, we note that--bar a very small amount of commercial bank loans with long maturities and linked to specific projects--BiH's state-level government currently has no commercial debt.
BiH's cost of debt, as measured by interest expenditure to GDP of below 1%, is among the lowest of all rated sovereigns. In our view, this gives BiH some fiscal space, partially offsetting the lack of monetary policy flexibility, given the currency board arrangement of the konvertibilna marka (BAM; the national currency) to the euro. As a result, fiscal policy remains the government's main lever with which to influence domestic economic conditions.
Importantly, BiH's current state-level budgetary procedures explicitly prioritize external debt service payments. All indirect tax revenue from the entities (RS and the Federation of Bosnia and Herzegovina [FBiH]) is collected by the ITA and re-distributed to the entities once proceeds for external debt service and the functioning of state institutions have been provisioned for. All external debt repayments, except for external debt directly contracted by the entities, which we would consider local rather than central government debt, are made through the ITA. Additionally, if no budget is adopted, only foreign debt will be serviced, and expenditure is limited to that needed for the functioning of the institutions, up to 25% of the previous year's budget on a quarterly basis.
On Dec. 15, 2022, EU leaders unanimously agreed to grant BiH the status of a candidate country, more than six years after its initial application in early 2016. We consider that the potential for EU membership could help accelerate some reforms and keep more confrontational politics in check given the apparent popular support for EU membership across both RS and FBiH.
Despite recent improvements, our ratings on BiH remain constrained by its complex institutional arrangements and weak policy coordination between the two largest entities comprising the country--the FBiH and the RS--and the central government. Our ratings are also constrained by BiH's modest income levels. We estimate GDP per capita at $7,400 in 2022, which is well below that of most other European countries.
Institutional and economic profile: BiH's economic growth is set to slow in 2023, in line with key trading partners
A coalition government has been formed at the state level following the October 2022 general election, and in December 2022 BiH received EU candidate status.
Nevertheless, BiH's institutional arrangements remain fundamentally complex, and we expect finding consensus on some government policies will remain difficult.
We project economic growth will slow to 1.0% in 2023 from an estimated 4.2% in 2022, reflecting the weaker global macroeconomic backdrop.
BiH is a country with arguably the most complex institutional and governance arrangements in the world, and this constrains the sovereign ratings. The existing political structures owe their existence to the Dayton Peace Accords, which ended three years of war (1992-1995). In practice, the country comprises two entities--FBiH and RS--each of which has a large degree of autonomy, in addition to the small, self-governing Brcko District. Each entity has its own parliament, government, and banking regulator with extensive mandates. BiH's past politics have consistently been characterized by a high degree of political volatility and confrontational decision-making.
Following the latest state-level parliamentary, presidential, and entity-level elections in October 2022, there appears more consensus around the formation of the various governments than in the past. For example, after the 2018 general election, it took 14 months to form a state-level government. This time the state-level government was formed less than four months after in January 2023, comprising a coalition between Croat and Serbian parties, the Croatian Democratic Union of Bosnia and Herzegovina (HDZ) and Alliance of Independent Social Democrats (SNSD) respectively, as well as several Bosniak parties. The RS government, dominated by SNSD and its coalition partners, was formed in December 2022, while FBiH's government remains in the process of formation.
We also consider that previously heightened risks of RS withdrawing from state-level institutions have receded, at least in the short term. At year-end 2021, RS' leadership announced its intentions to withdraw from the ITA, judicial council, and armed forces, among others, with RS' parliament adopting a motion requiring the government to present specific steps to achieve these goals. However, in mid- 2022 the plans were postponed by six months with an uncertain future direction. We consider SNSD's participation in the state-level government to signify lower immediate risks. We also observe that no concrete technical steps toward more RS autonomy have been taken in respect of the three institutions so far.
That said, risks remain because RS did not recognize the constitutional court's decision to suspend the legislation and intends to proceed with the establishment of its own medicinal agency, which is planned to unilaterally take over the functions of a similar state-level agency.
Our baseline expectation remains that there will be no significant changes to the administrative organization of BiH. We previously analyzed the possible economic and ratings implications of RS' withdrawal from BiH state institutions under various hypothetical scenarios and believe the conclusions reached then remain broadly valid (see "Economic And Ratings Implications Of Republika Srpska's Potential Withdrawal From Bosnia's State-Level Institutions," published Nov. 17, 2021, on RatingsDirect).
Overall, despite the moderation of near-term political risks, we still expect reaching political consensus on many policies within BiH to remain difficult. The election results have again demonstrated a voter base split along ethnic lines with Party of Democratic Action (SDA), SNSD, and HDZ gaining a lot of support. Beyond coordination on a state level, political gridlocks have frequently occurred at the FBiH entity level. With an announced goal to address these issues, on the day of the election, the High Representative for Bosnia and Herzegovina used Bonn powers to impose a so-called functionality package, with changes to election law and constitution of FBiH.
In our view, disagreements will remain with RS, for example, opposing any transfer of competencies to the central government level, reducing the likelihood that the authorities would meet the conditionality associated with an IMF program, should they need one. More broadly, a complex setup with multiple parliaments and counterweights (dictating a certain minimal representation of ethnic groups within each parliament) and the large number of parties involved in decision-making slows policymaking.
BiH was granted EU candidate status in December 2022, almost seven years after the country officially applied to join. The related EU report points to necessary judicial, anti-corruption, and economic reforms, among others, that would be required to gain membership. We expect the negotiation process to be gradual and do not view EU membership as likely in the near future.
Beyond political developments, we consider that the economic outlook for BiH has deteriorated. Over 70% of its trade partners are in the EU, where we expect a major slowdown in 2023, with 0% growth in the eurozone, while some countries will experience a recession. Output in Germany, which remains BiH's key trade partner, is expected to contract 0.5% (see "The Economic Outlook For The Eurozone Faces A Reality Check, published Nov. 28, 2022). Based on high frequency data, we estimate that BiH's real growth was 4.2% in 2022 but project it will slow to 1% in 2023. Our forecast for 2023 mostly reflects carryover effects, with quarterly growth averaging close to zero throughout the year. In terms of components, we expect consumption to contract 0.5% in real terms year on year while investment and export growth decelerate to 1.5% and 2.0%, respectively, in 2023 from 18.0% and 22.0% estimated for 2022.
BiH's direct exposure to Russia and Ukraine via the trade channel is limited. Exports to and imports from Russia in 2021 constituted 0.8% and 3.0% of the totals, respectively, while Ukraine's share is even lower. Importantly, energy linkages with Russia are also significantly lower than in many other European countries. Specifically, BiH imports all its natural gas from Russia, but gas constitutes less than 5% of domestic energy needs and is mostly used for heating in the Sarajevo region. Almost all domestic electricity supply comes from hydro power and thermal power plants, with the latter operating predominantly on coal. BiH remains a net exporter of electricity. Additionally, BiH does not import crude oil, only refined oil products through third-party countries, such as Croatia and Serbia. We understand that it does not have any direct arrangements with Russia regarding oil supplies.
At the onset of the Russia-Ukraine conflict, BiH had some financial-sector linkages with Russia via two Bosnian subsidiaries of large Russian state-owned bank Sberbank--one operating in RS and the other in FBiH. After international sanctions were imposed on Sberbank, there was a deposit run at the two Bosnian subsidiaries, requiring the local regulator to intervene. The subsidiaries were subsequently sold to other domestic banks and confidence in the banking sector has since been largely restored. There was no involvement of the deposit insurance fund in the resolution process and no related budgetary financing either at the state or RS/FBiH level. We do not see any other substantial financial-sector linkages to Russia.
Flexibility and performance profile: Low net general government debt partially offsets the absence of monetary flexibility
We forecast BiH's general government deficit will average 0.6% of GDP over the next four years, following balanced budgets over 2021-2022.
Net general government debt will remain contained at close to 20% of GDP through 2026. About 65% of BiH's total debt stock is concessional.
BiH lacks an independent monetary policy given the existing currency board arrangement with the euro, which we expect will continue through our forecast to 2026.
Although there are limited reliable high frequency data available, we estimate that on a consolidated general government level, BiH recorded a balanced budget in 2022. Although RS recorded a deficit, FBiH recorded an offsetting surplus. One of the key factors driving this stronger-than-expected fiscal performance was the effect of inflation, which lifted government revenue across the board. For example, indirect taxes rose by about 17% year-on-year in 2022. In turn, this more than offset additional measures that entity governments announced to limit the impact of higher inflation on domestic households.
In our baseline forecast, we expect a small 1% of GDP general government deficit this year and a nearly balanced budget over the medium term, not least reflective of difficulties in adopting budgets and agreeing spending priorities in the federation and at the central government level.
We forecast that BiH will continue to benefit from its low net general government debt, which we estimate amounted to about 22% of GDP by year-end 2022, and interest costs will therefore remain low. The debt structure is also favorable. Over 70% of gross government debt is external, with the lion's share to official bilateral or multilateral creditors. RS has some commercial external debt outstanding in the form of Eurobonds, including a €168 million Eurobond maturing in June 2023 and a €300 million bond maturing in 2026. FBiH has almost no external commercial debt. BiH's largest external creditors are the World Bank, the European Investment Bank, and the International Monetary Fund, which together account for 60% of public external debt. The average time to maturity is seven years, and we project that interest payments will average about 2% of consolidated government revenue through 2026.
We estimate that BiH's current account deficit widened to 4.9% of GDP in 2022 from 2.3% of GDP in 2021, mostly on account of the higher cost of oil imports, as well as broader global inflationary pressures affecting goods imported into BiH. The deficits should gradually moderate closer to historical averages of 3% of GDP by 2025. As previously, we expect debt financing to account for only a small portion of current account funding, with most financing representing net FDI inflows; a capital account surplus (European pre-accession funds); and positive net errors and omissions likely reflecting unrecorded transfers from Bosnian citizens working abroad. Consequently, we project that BiH's net international investment position will remain stable, at about -30% of GDP (that is, a net external liability position).
Following the temporary deterioration in banking sector confidence over February-March 2022 relating to Sberbank subsidiaries operating in BiH, conditions have since improved, and deposits are expanding again. Reported nonperforming loans continue to decline, while the stock of domestic credit increased an estimated 4.5% in 2022, both in the household and corporate segments. BiH's financial sector remains largely conventional in nature, predominantly deposit-funded, and with a limited amount of external debt outstanding.
BiH maintains a currency board arrangement with the euro, whereby the exchange rate is fixed at BAM1.96 to €1. The currency board is an important economic anchor, but it curtails the central bank's ability to conduct an independent monetary policy. Under the existing exchange-rate arrangement, we also consider that the central bank effectively has no ability to act as a lender of last resort. We do not expect the existing exchange-rate arrangement to change in the future.
Like other countries, BiH has experienced a significant upswing in inflation, which we estimate at 14% last year. We forecast that inflation will gradually subside but remain elevated at about 7% in 2023, given our assumption oil prices will remain relatively high. Thereafter, inflation should gradually reduce toward 2.5% by 2025."