Despite a tighter liquidity position, the Serb Republic's solid revenue growth and constrained access to capital markets limit its budget deficit and debt accumulation, the global ratings agency said in a statement on Friday.
The Serb Republic is one of the two autonomous entities that form Bosnia and Herzegovina. The other one is the Federation.
We could lower the rating if we observed a further disruption in Republika Srpska's access to funding sources. This could result from substantial adverse changes in market conditions, management deficiencies, or a particular escalation in intergovernmental tensions. For example, the outcome of the trial of the Republika's President could diminish the willingness of external and domestic creditors to provide financing to the government. A less favorable economic environment and more rapid depopulation in the medium term could also constrain revenue generation and lead to further financial strain on the Republika.
We could raise the rating on Republika Srpska if more predictable coordination with other stakeholders in BiH leads to better funding conditions and sustained economic development. In combination with a more effective fiscal policy that is less tied to election cycles, these conditions could help Republika Srpska achieve a sustainable operating surplus and reduce its refinancing risks.
The rating affirmation on Republika Srpska reflects our view that its relationship with other constituencies in BiH will remain strained, but without any concrete actions toward secession in the next few years. The turbulent political environment and U.S. sanctions imposed on top officials in Republika Srpska visibly affect investors' appetite for Republika Srpska's debt. It has so far raised funding by issuing bonds domestically and borrowing from bilateral and multilateral institutions. At the same time, the intrinsic liquidity position is weakening further since the budget deficit in 2023 was partly covered with proceeds from short-term domestic debt issuance and cash reserves.
The improvement we expect in the budgetary performance is a result of constrained access to funding. We expect the operating balance to turn positive in 2025, while the overall deficit after capital expenditure will remain modest at about 3.5% of revenue in 2024-2026. As a result, Republika's debt burden should be moderate, with tax-supported debt to fall to about 100% of consolidated operating revenues by 2026. However, contingent liabilities will likely increase, since the most prominent investment projects will be financed off-budget, including those of key state-owned enterprises in transportation and electricity. If off-budget financing is not available, these projects are likely to be delayed.
Political tensions complicate the institutional framework, deter economic growth, and challenge fiscal sustainability
We assess the institutional framework under which constituent entities in BiH operate as volatile and unbalanced. Republika Srpska operates under complex and volatile political and financial arrangements with the central government of BiH and the country's other constituent entity, the Federation of Bosnia and Herzegovina (FBiH). Constant political tensions test the fragile balance of power between different authorities that is specified in the Dayton Accord and Constitution. Although all governments broadly agree on the need for institutional and economic reforms, even with the encouragement of EU membership talks, implementation is slow. Republika Srpska's political leadership regularly uses secession rhetoric in relation to state-level institutions and occasionally challenges decisions made by the Office Of High Representative of BiH. However, we continue to consider that the likelihood of concrete steps toward secession is low. Republika Srpska remains very dependent on availability of international financing, in particular from Serbia and Hungary.
The weaknesses of the institutional framework are partially offset by the constitutional entities' strong autonomy to oppose central level decisions and manage their own fiscal policies. As such, Republika Srpska sets the rate and base for about 60% of its revenue, including direct taxes and social security contributions. Moreover, a special mechanism ensures timely repayment of nearly half of Republika Srpska's debt, mostly owed to multilateral institutions. The State Indirect Tax Authority (ITA) collects indirect taxes, allocates them first for financing central government institutions and servicing external debt issued on behalf of the constituent entities. It allocates the residual amount to budgets of constituent entities and local governments.
We continue to view Republika Srpska's financial management as weak due to limited predictability of its budget policy, the lack of a formal liquidity policy, and still-weak control of government-related entities. In addition, a substantial loosening of its fiscal policy prior to the 2022 election constrains the entity's financial flexibility. The government, formed from representatives of eight parties, benefits from a comfortable majority in the Republik's parliament, ensuring smooth approval of budgets and financial decisions. The Alliance of Independent Social Democrats (SNSD) party, headed by incumbent president Milorad Dodik, leads the coalition.
We view positively the existence of a cap on the government's debt burden and annual deficit, as well as a relatively high level of disclosure on core government budget and debt operations. Republika Srpska's debt cannot exceed 60% of its GDP, while the deficit should stay within 3% of GDP. The government regularly publishes its latest strategy and annual budget documents on its website, as well as monthly financial statements. We assume Republika Srpska will remain committed to its fiscal rules.
Republika Srpska's economy is relatively poor in an international context and faces significant demographic challenges. We expect regional GDP per capita to exceed $8,000 in 2024, still about 10% below the BiH national average. We also project GDP growth to accelerate to a sound 2%-3% annually over 2024-2026, broadly in line with the national trend. The population is shrinking and also aging rapidly. A significant proportion of the working age population is migrating to developed Europe in search of higher wages and more employment opportunities. The recent increase in minimum wages doesn't appear to have had a significant impact on this trend. On the contrary, recurring political tensions inhibit investment to improve productivity, and higher labor cost might drive businesses out of the region and reduce employment opportunities. The economy is diversified, though, with manufacturing and trade (wholesale and retail) as leading economic activities. Power generation is a sector that requires significant investment to replace coal-fired generation with new hydro power stations and other renewable energy sources. Inflation has declined since its peak of about 17% in October 2022, and is set to drop below 3% from 2025.
Limited access to external funding restricts spending and debt buildup
In our view, regular political escalations in Republika Srpska and U.S. sanctions constrain the entity's access to external funding, which we now view as limited. Its internal liquidity position has weaken further due to reliance on domestic short-term funding and limited cash reserves to cover the budget deficit. We estimate that cash at the beginning of 2024 covered about 20% of annual debt service. However, we understand that Republika Srpska can refinance its domestic debt coming due with local banks, and payments to multilateral institutions are serviced timely via ITA and the central government. Funding constraints result in adjustments in budget spending, especially on capital projects, with the budget deficit set to shrink faster than we previously anticipated. Should access to funding improve, we expect the deficits and debt to rise again.
Lower borrowing, combined with sound revenue growth, will lead to a gradual improvement in budgetary performance, which will still remain rather weak. The government is increasing the minimum wage in the local economy to boost personal income tax and contributions to social security funds and this will contribute to faster revenue growth in the short term, although it could affect competitiveness in the longer term. We expect Republika Srpska to achieve a minor operating surplus by 2025 while the overall budget deficit will shrink to about 3.5% on average in 2024-2026. Republika's budget policy tends to follow the election cycle, with substantial increases in spending ahead of the general election. A need to maintain subsidies to state companies and healthcare institutions will pressure budgetary performance, especially if there are delays in disbursement of EU grants.
Limited access to funding will constrain the accumulation of Republika's debt, in our view. We anticipate that its tax-supported debt, which includes direct government debt, as well as debt of social security funds, public institutions, and a few state-owned entities (including the highways and motorways enterprises), will decrease below 100% of consolidated operating revenue by 2026. About 60% of tax-supported debt is external, while most of the debt is denominated at fixed interest rates. Given smaller-than-expected borrowings and interest rates set to decrease, we expect interest spending will remain below 5% of operating revenue.
In our view, Republika Srpska has limited risk related to contingent liabilities. However, this risk is set to increase due to long-term commitments with bilateral and multilateral institutions. This process may be fueled by potential delays in disbursement of EU and other grants in case of substantial political tensions. While we anticipate municipal debt will remain relatively small, debt of the state-owned enterprises will likely increase. Elektroprivreda, the state-owned electricity producer is embarking on a number of debt-funded development projects, which are guaranteed by Republika Srpska. Meanwhile, its railway company is going through restructuring and may require investment in the future, while motorway and highway companies continue to invest with large state financial backing. The Investment Development Bank and its funds may also play a more prominent role in financing development projects in the Republika Srpska."
