SARAJEVO (Bosnia and Herzegovina), March 10 (SeeNews) – Ratings agency Standard&Poor's (S&P) said on Friday it affirmed its 'B/B' long- and short-term foreign and local currency sovereign credit ratings on Bosnia and Herzegovina, with a stable outlook.
"Despite delays to the completion of the first review of the extended fund facility arrangement with the International Monetary Fund, we expect Bosnia and Herzegovina (BiH) to continue to strive to fulfill the current arrangement's conditions, albeit with occasional considerable lags during its duration", the ratings agency said in a statement.
"Moreover, despite the risk of lower external financing inflows and sluggish structural reform progress, mirrored by steady but comparably low economic growth, fiscal discipline remains in place while debt at the state level benefits from favorable concessional terms and conditions", it judged.
S&P also said:
"The affirmation is based on BiH's sound fiscal performance and expected decreasing general government deficits, as well as robust indirect tax revenues that the country uses to service its external debt. The ratings are also supported by BiH's still comparably low debt burden, benefitting from favorable predominantly concessional terms and conditions. The ratings on BiH are constrained by the country's political divisions, the country's rising external indebtedness and substantial external financing requirements, as well as its limited monetary policy flexibility and comparably low per capita income levels.
In February 2017, the decision of the Bosniak member of BiH's tri-partite state presidency to appeal an International Court of Justice Ruling on genocide during the 1992-1995 war sparked tensions among BiH's constituent ethnicities, as the decision had not been previously agreed on.
The risk of an ensuing political blockade over the coming weeks is still elevated, and comes at a time when the authorities need to fulfill several prior actions in order to complete the first review under BiH's three-year €550 million extended fund facility (EFF) with the International Monetary Fund (IMF). This underlines how BiH's multilayered and fragile institutional set-up and persisting divisions between the different entities' governments complicate policymaking, because the legislation for complying with the IMF's conditionality--for example an increase on excise tax on fuel--has already been delayed and its implementation is currently at risk due to the current political deadlock. Nevertheless, despite delays to the completion of the first review of the EFF arrangement with the IMF, we expect BiH to continue to fulfill the current program's conditions, albeit with occasional considerable lags.
Reform progress and institutional stability would also be crucial to any meaningful progress toward being granted EU candidate status, following BiH's membership application in early 2016. BiH already benefits from sizable EU and World Bank funding and technical assistance, and we understand that the World Bank's financial assistance in the form of a development policy loan in 2017 would not necessarily be linked to the IMF's conditionality and that the EU would extend budgetary support to back BiH's long path of alignment with the block. However, confrontations along party lines and between the country's constituent entities remain frequent and will likely intensify ahead of the general elections in the third quarter of 2018.
In the absence of disbursements from the IMF's EFF program, we anticipate that the entity governments would be--as in the past--forced to close their budget gaps and rely on the domestic capital markets to cover their financing needs.
While we think that the governments could rely on domestic banks to cover their financing needs in 2017, and external financing pressures should remain subdued, we consider the EFF program as a very important anchor for the country's structural reform agenda. Failure to fulfill the conditionality under the arrangement would therefore mean that the realization of crucial infrastructure projects would be threatened, hindering the shift toward more investment-driven economic growth and stifling the growth potential of the economy.
Under our current assumption of delayed progress on the authorities' reform agenda, economic growth in 2017-2020 will continue to be driven by net exports and private consumption, supported by remittances. We have lowered our economic growth forecast compared with our previous projections, as we think that the progress on structural reform, including improvements in the business environment, which is mostly instilled by international lenders' conditionality will likely be slow, and we therefore now project real GDP growth of 2.6% on average per year during 2017-2020 compared with around 3% in our previous base case. That said, the labor market has improved over the course of 2016. The unemployment rate decreased to 25.4% from 27.7% in 2015, although it remains at a very high level. This improvement reflects an increase in employment registered in BiH--and not merely net outward migration, which we expect to continue as long as the country's economic perspectives remain dim.
As a result of the likely lower imports growth we see as being related to foreign-financed investment projects, we have lowered our forecast for the current account deficit in 2017-2020. We expect a gradual widening of the current account deficit to 7% of GDP in 2020 from 4% of GDP in 2017.
Furthermore, the lower external indebtedness of BiH in 2017-2020 compared with our previous forecast reflects lower external borrowing by the government as a result of potential constraint on international concessional inflows. We believe that these trends are reflective of the country's external vulnerability to shifts in official funding and external financing pressures from underlying political risks to EFF program implementation.
Furthermore, we continue to expect the country's external indebtedness to trend higher, with narrow net external debt increasing to over 50% of current account receipts by 2020. At the same time, we estimate debt-creating inflows (net of amortization) will amount to about US$225 million (1.4% of GDP) and net foreign direct investment (FDI) will amount to US$250 million (1.5% of GDP) in 2017, with inflows to the capital account making up the rest. We think that structural reforms could also help attract more FDI which we currently project at just under 2% of GDP in 2017-2020, in particularly we believe that political uncertainty continues to hamper investor confidence.
We project the consolidated general government fiscal deficit will narrow to 0.8% of GDP in 2020, compared with 1% in 2017. Our fiscal forecast therefore anticipates a slower reduction of general government deficits than the government's projections agreed in the context of the EFF arrangement. In the absence of disbursements under the EFF, the entities will likely curtail capital investment spending in order to balance their budgets. If there were no disbursements for a prolonged period, we anticipate that the decline in public investment could have a negative effect on economic growth and in turn also on tax revenues. Furthermore, we would expect the further build-up of arrears on the entities and lower levels of government under such a scenario. Importantly, indirect tax revenues have shown sound growth in 2016, and they are used to service BiH's state level external debt before they are allocated to the various government entities. As a result of the gradual budgetary consolidation, we expect general government debt to stabilize at about 40% of GDP by 2020. We expect that the majority of government debt will continue to be denominated in foreign currency over our forecast horizon through 2020.
At the same time, we highlight that external government debt is primarily concessional.
The banking system appears relatively well capitalized and represents a limited contingent liability for the government, in our view. Nonperforming loans (NPLs; loans overdue 90 days or more), although on a decreasing trend over the past 12 months, remain at 12.1% of total loans as of Sept. 30, 2016. We understand that, while BiH's banking system is stable, some banks may be undercapitalized. Vulnerabilities at smaller domestic banks with weaker corporate governance practices have surfaced over the past couple of years, for example at Banka Srpske (owned by the government of the Republika Srpska, one of the country's two autonomous entities) in late 2015, which has, however, been resolved as precondition of the IMF arrangement. In that regard, we also note the recent adoption of new banking legislation, in line with EU directives, in both entities as a step toward improved supervision.
BiH has a currency board regime and its currency, the konvertibilna marka (BAM), is pegged to the euro. The currency board provides stability and has been successful in containing inflationary pressures. While appropriate for the country, 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 by 1.07x as of end-December 2016, 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 adequate coverage of the monetary base by the central bank's foreign currency reserves.
OUTLOOK
The stable outlook on BiH reflects our assessment of the balance of risks between the exacerbated political uncertainty that is putting compliance with international financing conditionality at risk and the country's relatively stable fiscal performance.
We could lower the ratings if the availability of external financing for BiH's current account deficit was called into question--potentially alongside a protracted period of nonavailability of foreign financing--and government financing constraints emerged. Although the state's external debt repayments are funded by indirect tax receipts, under such a scenario the debt-servicing risks could rise. In case of delays in payments to official creditors, as well as difficulties with debt service at the entities levels, we could lower the ratings by more than one notch.
An easing of tensions between BiH's two entities, improved relations with and within the state institutions, and increased effectiveness of policymaking would, in our view, gradually enable reform implementation, reduce dependence on foreign financing, and ultimately benefit the investment and business climate. If such developments were to translate into prospects for more sustained economic growth, we could in turn consider raising our ratings on BiH."