September 17 (SeeNews) - Standard & Poor's affirmed Montenegro's B+/B rating, with a stable outlook, mostly due to the country's economic growth forecasts.
"The stable outlook balances the implementation risks of Montenegro's fiscal adjustment program over the next 12 months and the potential for a positive rating action if economic growth is stronger than our base case," S&P said in a statement late on Friday.
Although fiscal performance in the first half of 2018 fell short of the government target, we project broad fiscal consolidation to continue, with net general government debt levels declining from a peak of 65% of gross domestic product (GDP) next year, S&P said.
The agency could raise the ratings on Montenegro if multiple ongoing projects in infrastructure, energy, and tourism yielded better-than-expected results, improving the country's growth outlook and reducing balance-of-payments risks
On the other hand, ratings could be lowered if Montenegro's fiscal performance were materially weaker than the forecasts. This could be the case, for example, if new revenue measures adopted under the 2017-2020 fiscal strategy fell short of target. It could also be the case if the government found it difficult to control spending pressures, particularly given the general election in 2020. Additionally, ratings pressure could emerge if the flow of inbound foreign direct investment dried up or Montenegro faced unforeseen pressure from the gradual tightening of global monetary policy.
Standard & Poor's also said in the statement:
"RATIONALE
The ratings on Montenegro remain constrained by its high net general government debt burden, which we expect will peak at 65% of GDP in 2019. This is exacerbated by Montenegro's unilateral adoption of the euro, which leaves almost no room for monetary policy flexibility. The country also remains vulnerable to balance-of-payments risks, given the large net external liability position and persistent historical current account deficits.
The ratings remain supported by the country's favorable growth potential, given the possibilities for further development of tourism and the energy sector. The ratings are also supported by the country's comparatively strong institutional settings in a regional context and upside potential from structural reforms that will have to be implemented for Montenegro to become an EU member.
Long-time political strongman Milo Djukanovic won the April 2018 presidential elections. Montenegro continues EU accession negotiations but we expect only gradual progress. Growth rates will moderately weaken from 4.3% in 2017 as large infrastructure projects are finalized and fiscal adjustment takes hold. Nevertheless, we believe the country's long-term growth potential remains favorable, stemming from unexplored opportunities in the tourism and energy sectors.
Montenegro held presidential elections in April 2018. Despite announcing his candidacy less than a month before the ballot, the long-time political strongman Milo Djukanovic, of the Democratic Party of Socialists (DPS), won in the first round, securing over 50% of the votes. Djukanovic has been at the centre of Montenegrin politics for over two decades, having previously served as president and prime minister on multiple occasions. The May 2018 local elections also saw DPS secure the most votes in 10 out of 12 constituencies, further bolstering its position. We do not expect radical changes as a result of the recent elections and anticipate that Montenegro will continue on its EU accession path, having previously been admitted to NATO in 2017.
Early implementation of reforms that will bring Montenegro in line with the EU acquis represents upside, but we believe this process will be only gradual. Despite renewed momentum relating to the integration of the Balkans, in our view the 2025 EU accession date could be optimistic. We note that further progress by Montenegro could be hampered both by domestic developments and rising euroscepticism among the existing member states, which--under EU rules--will ultimately have to unanimously approve Montenegro's membership bid. Still, we believe the ongoing EU accession negotiations strengthen Montenegro's policy frameworks and we view the country's institutional settings favorably in a regional context.
Several domestic political and policy risks remain. We note the potential for instability, as highlighted by the events surrounding the 2016 general election, when an alleged coup took place. Subsequently, multiple opposition members faced allegations, with several parties boycotting parliament in the election aftermath. More recently, in April and May 2018, several journalists were attacked. On the policy front, we see risks regarding the government's adopted 2017-2020 fiscal strategy. Although our base-case forecast assumes a broad commitment to budgetary tightening, this could be difficult to achieve in the context of the upcoming 2020 general election. This is particularly the case given the coalition's current narrow majority in parliament.
Positively, despite some political noise, Montenegro's economy continues to develop. Output expanded by an annual average of 3.5% over 2015-2017 and by 4.5% in the first quarter of 2018, year-on-year. Montenegro's economy is primarily driven by tourism and related activities and strong visitor growth has contributed to broader economic dynamics. We note that the number of visitors rose by 16% over the first half of 2018 while overnight stays increased by close to 12%, partly helped by a cyclical upturn in Europe and ongoing recovery in Russia and the Commonwealth of Independent States.
We note that Montenegro's strong growth was also underpinned by the public-financed ongoing construction of a new highway. The government plans that, upon completion, the highway will link the coastal port of Bar with the Serbian border, connecting remote regions and improving road safety. Only the first section, a 41km segment north of the capital Podgorica, is so far under construction. Because of difficult terrain, the cost of the first section is high, estimated at close to 20% of 2018 GDP and largely financed by a U.S. dollar-denominated loan from China.
Aside from political considerations, the direct net economic benefits from the highway are uncertain. We believe that its construction has led to a notable accumulation of debt and erosion of fiscal headroom. This is particularly pertinent given that budgetary policy is the government's main lever to influence domestic economic conditions since Montenegro has no independent monetary policy, given the unilateral euro adoption.
To curb the increase in debt from the highway construction, in mid-2017 the government announced a fiscal consolidation strategy aimed at reducing the non-highway deficit. Consequently, we expect some moderation of growth rates to below 3%, as fiscal consolidation advances and the first highway section is complete in 2019.
We continue to view Montenegro's long-term economic prospects as favorable. This primarily stems from the multiple opportunities that exist in the tourism sector. A number of hospitality projects are currently being implemented, including several high-end coastal resorts. We also understand that there is untapped potential in winter ski tourism and energy generation.
We expect net general government debt to start declining from a peak of 65% of GDP in 2019 when the highway construction project is complete. Balance-of-payments vulnerabilities remain elevated, given the recurrent historical current account deficits and the resulting large net external liability position, which we estimate at 250% of GDP.
Montenegro has no monetary policy flexibility because it has unilaterally adopted the euro while not being part of the eurozone. Montenegro has historically posted recurring fiscal deficits. These have been a result of high social spending and transfers, as well as the substantial shadow economy, which eludes taxation. More recently, the deficits have widened as a result of the implementation of the highway project.
To control the upward public debt trajectory, the government has embarked on a fiscal consolidation strategy announced in mid-2017. The strategy includes a number of revenue and expenditure items, such as raising the VAT rates and excise taxes, as well as controlling public employment levels and spending efficiency. Most of the measures have received parliamentary approval as planned within the confines of the 2018 budget.
In our view, the fiscal targets outlined in the consolidation strategy are overly optimistic and unlikely to be achieved. Under the fiscal strategy, the government planned to reduce the general government deficit to 1.8% of GDP in 2018 before turning to a surplus from 2019. We have not changed our fiscal forecasts and maintain that Montenegro's deficit will equate to 4% of GDP in 2018-2019 before reducing from 2020. However, we note that budgetary performance appears to have slipped compared with original government targets. Over the first half of 2018, the general government deficit had already reached about 2% of GDP, above the original full-year target.
We understand that several developments have contributed to this outcome. These have included the difficulty in implementing the higher excise taxes adopted at the beginning of the year because tax evasion has intensified. As a result, the authorities had to reduce excises in an attempt to bolster collections. In addition, salaries have been adjusted for some public sector employees.
In addition to weaker headline fiscal performance, the government made a one-off payment of about €70 million (1.6% of GDP) to Italian utility company A2A. The payment relates to A2A's option that allowed it to exit its stake in Montenegrin electricity company EPCG and receive compensation from the government. We have not included this one-off expenditure within the 2018 general government deficit but instead accounted for it below the line. The increase in net general government debt in our projections for 2018 is therefore higher than the headline deficit implies.
More broadly, downside risks to the government's 2017 fiscal consolidation strategy could come from potential cost overruns on the first section of the highway, difficulty in controlling spending ahead of 2020 general elections, potential expenditure overruns at the local government level, and negative consequences in case of lower-than-expected growth.
Given our base-line forecast of continued gradual fiscal consolidation, we expect net general government debt will peak at 65% of GDP in 2019 and reduce thereafter. Positively, refinancing risks have reduced, in our view. Montenegro previously faced Eurobond redemptions totaling a substantial €1.1 billion over 2019-2021. In April 2018, the government issued a €500 million Eurobond that was partly used to buy back €360 million of debt maturing over 2019-2021. Moreover, in May, the authorities secured a World Bank guarantee-supported syndicated loan of €250 million. The Montenegrin government also plans to use the proceeds of the loan to meet debt redemptions coming due over the next three years. Montenegro primarily finances fiscal shortfalls on the foreign markets and close to 70% of commercial debt is held by non-residents. We expect this to remain the case in the future, which exposes the country to risks of European Central Bank (ECB) tightening monetary policy.
Montenegro's weak balance-of-payments position remains a key ratings constraint. The country has consistently posted double-digit current account deficits and we estimate the net external liability position totaled close to 250% of GDP at the end of 2017. Positively, Montenegro has seen substantial amounts of inbound foreign direct investment, averaging over 10% of GDP over the past five years. These investments are concentrated in real estate, tourism, and energy sector projects, and tend to be import-intensive. As such, the investments actually cause the current account to be in a recurrent deficit. Yet risks remain as the economy would contract if foreign direct investment unexpectedly dries up.
Moreover, Montenegro's external accounts show persistent and positive errors and omissions, which--following recent data revisions--average 2.5% of GDP over the past five years. These discrepancies may reflect unrecorded tourism export revenues and the underestimation of remittances from the large Montenegrin diaspora, among other factors. This could mean that the current account deficit may be lower than the reported data indicate. We also have limited information on Montenegro's external assets, and, as such, external ratios are likely to indicate higher net leverage than is actually the case. We understand that the authorities are in the final stages of producing comprehensive International Investment Position statistics, which they plan to publish by the end of the year. The work to improve external statistics is ongoing; this year both the current account deficit and net errors and omissions (E&O) have been restated and adjusted downward. We note that in the
past, net E&O amounted to a more substantial average of 5% of GDP over recent years compared with the current 2.5%.
Montenegro's unilateral adoption of the euro prevents the Central Bank of Montenegro from setting interest rates and controlling the money supply, and restricts its ability to act as a lender of last resort. While the central bank has some options to provide liquidity support to banks, its inability to create the currency needed in a stress scenario effectively prevents it from fulfilling a lender of last-resort function, in our view. Unilateral euro adoption also makes the country's economy highly sensitive to cross-border capital movements.
Montenegro's banking system appears broadly stable and liquid. Non-performing loans have declined to around 7% of the total, compared to 20% in 2013. Nevertheless, although the larger institutions are in a better position, we understand a number of smaller banks could be vulnerable. We still view the government's contingent liabilities from the banking system as limited, since we believe that only minimal support to cover the insured deposits would be
provided in the event of a bank default."