The stable outlook reflects the ratings agency's view that multiple risks arising from the Russia-Ukraine conflict over the next 12 months are counterbalanced by North Macedonia's proactive policymaking as well as its moderate government debt and contained interest costs, S&P said in a statement on Friday.
The global rating agency also said in the statement:
"Downside scenario
We could lower the ratings if North Macedonia's balance of payments performance proved weaker than we expect, leading to a higher depletion of international reserves and possibly presenting risks to the stability of the denar peg. This scenario could entail the additional risk that domestic residents increasingly convert deposits from local into foreign currency, but this is not our baseline scenario. The ratings could also come under pressure if fiscal deficits worsened beyond our expectations in the medium term, leading to a protracted build-up of government leverage in contrast to our current projection of net general government debt stabilizing at close to 53% of GDP through 2025.
We could raise the ratings if structural reform implementation strengthened North Macedonia's institutional settings while its fiscal performance improved, with net general government debt trending down, alongside robust GDP growth.
Our base case is that North Macedonia will weather the macroeconomic headwinds from the Ukraine-Russia conflict. This includes the economic uncertainties associated with the German economic slowdown, given that roughly half of North Macedonia's goods exports go directly to Germany. Our base case also factors in the pressures associated with rising energy prices, which led to a significant widening of the current account deficit to 13.4% of GDP in the first quarter of 2022.
Valuation effects, external debt payments, energy-related import pressures, and a lack of government external borrowing have led North Macedonia to draw down on its gross foreign exchange (FX) reserves; these fell to €3.20 billion in July (roughly 3.6 months of imports) from €3.64 billion at end-2021.
Still, we currently do not expect these elevated balance of payments pressures will undermine the stability of the denar-euro peg. This is driven by our assumption that:
Investment inflows will remain strong. This is evidenced by a net FDI inflow of €100 million in the first quarter of this year.
The government plans to issue Eurobonds in the coming months to fund the fiscal deficit, and this will likely support foreign reserves.
IMF and broader IFI support will be likely be forthcoming. North Macedonia requested an IMF Precautionary and Liquidity Line (PLL) in April, which is currently pending staff approval.
Overall, our ratings on North Macedonia remain constrained by the weak yet improving institutional framework, comparatively low GDP per capita, increasing government debt predominantly denominated in foreign currency, and limited monetary flexibility due to the denar peg.
The ratings are supported by what we view as a highly capitalized banking sector, as well as still-moderate net general government debt levels and contained costs of servicing it. We forecast annual government interest expenditure at about 5% of government revenues, which we view as reasonably modest in an emerging market comparison.
Institutional and economic profile: Formal EU accession talks have finally begun, but the short-term economic outlook has deteriorated
Growth will slow significantly in 2022 due to a range of factors mostly stemming from the Russia-Ukraine conflict, but we expect recovery to strengthen from 2023.
North Macedonia's direct trade and financial linkages to Russia and Ukraine are limited, but inflationary and other indirect factors will have an impact.
EU accession talks have begun but the process remains fraught with hurdles.
We forecast North Macedonia's real GDP growth to slow to 1.5% in 2022, from 4.0% in 2021, on lower external demand (primarily from the EU) aggravated by the indirect effects of the Russia-Ukraine conflict--primarily in the form of higher energy prices. We also think weaker domestic household consumption due to high inflation and tighter credit conditions will contribute to weaker growth this year. In our view this will be partially mitigated by government consumption and investment growth stemming from higher government spending and investment. Downside risks to our forecast include potential political instability from a remote chance of snap elections and an escalation in the Ukraine-Russia conflict that could cause commodity prices to surge even further. From 2023 onward, we expect growth to strengthen and average 2.7%.
High-frequency indicators including retail trade and business surveys support our view that economic momentum has decelerated in recent months. In addition, monthly average gross wages increased by 9% in May 2022 compared to the previous year, mainly due to an increase in the minimum wage. However, real wages growth remains negative because of inflation, which will weigh on consumer demand.
North Macedonia's trade and financial links with Russia and Ukraine are limited. Nonetheless, it has some energy exposure to Russia. Most natural gas imports come from Russia, but this only comprises about a 10% share of North Macedonia's total energy mix. Moreover, approximately 8% of oil imports originate from Russia. Despite Russia halting gas supplies to Bulgaria, North Macedonia continues to receive gas from Russia via pipelines in Bulgaria.
Accession talks between the EU and North Macedonia started in July 2022. Progress hinges on parliament's approval of a French-backed proposal that was created to encourage Bulgaria to withdraw its veto on North Macedonia's EU membership bid. Under the proposal, North Macedonia must amend its constitution to acknowledge a Bulgarian minority, among other measures. As a result, the first of two intergovernmental conferences (IGC) between North Macedonia and EU have been held. The second IGC will only be held once North Macedonia's constitution is changed in accordance with the French-backed proposal. Under Macedonian law, constitutional amendments require 80 out of 120 votes in favor for any proposal to pass. Given the political polarisation and the number of votes required for the French proposal to pass, we don't expect the second IGC to be held soon. Bulgaria could also again block North Macedonia's bid for EU membership. Nevertheless, we still consider that the country's EU membership bid should serve as an anchor for structural and institutional developments over the longer term, supporting its economic prospects.
Flexibility and performance profile: Sizable twin external and fiscal deficits in 2022
We expect the general government deficit to remain elevated at 5.1% of GDP in 2022, followed by gradual fiscal consolidation over the next four years.
We forecast that North Macedonia will post a current account deficit of 8.3% of GDP in 2022, the highest since 2008, owing to higher costs of energy imports.
International reserves have come under pressure since the beginning of the year, but we expect buffers to be primarily replenished by external borrowing and incoming net FDI inflows. North Macedonia could get additional financing from the IMF if balance-of-payments pressures increase.
The government recently approved a supplementary budget that raised the fiscal deficit to 5.3% of GDP in 2022, from 4.2% in the initial budget. Extra spending has been earmarked for public sector wages, agricultural sector subsidies, higher pensions, and liquidity support for companies. Targeted support has also been offered to help citizens cope with increased living costs. Given the new budget and the government's record of under-use of budgeted capex, we expect the fiscal deficit to remain elevated at 5.1% of GDP in 2022--slightly down from 5.4% in 2021. The budget deficit will be financed via a mix of domestic and foreign borrowing (Eurobonds) as well as previously accumulated liquidity.
Thereafter, we expect the general government deficit to average approximately 3.2% through to 2025. The government's fiscal consolidation efforts will continue to face challenges including the economy's large informal sector and the indirect effects of the Russia-Ukraine conflict. We project net general government debt to rise from 52.6% of GDP in 2022 and stabilize by 2025.
We also note that roughly 75% of government debt is denominated in foreign currency, which could present risks particularly in a scenario of the pegged exchange rate regime coming under increasing pressure, but this is not our baseline. We consider that the adoption of the Organic Budget Law, which outlines a set of fiscal rules (similar to the eurozone's Maastricht criteria) and the establishment of an independent fiscal council should help North Macedonia's budgetary consolidation. We also note that North Macedonia's costs of servicing government debt remain contained and we expect will average around 5% of government revenues over the next four years, significantly lower than most emerging markets.
North Macedonia's exports to Germany accounted for 47% of total exports in 2021. It is also a net energy and food importer. Given our expectations of an economic slowdown in Germany and elevated hydrocarbon prices in 2022 and 2023, we expect North Macedonia's current account deficit to widen significantly to 8.3% of GDP in 2022, from 3.4% in 2021. After 2022, we expect the current account deficit to decline gradually, averaging 4% of GDP until 2025.
The 2022 external deficit will be financed by a mix of foreign reserves depletion, net foreign direct investment (FDI) inflows, and external government borrowing. Thereafter, net FDI inflows will once again become the main component of financing future external deficits. We expect net FDI to rebound and average 3% of GDP through to 2025 following a pandemic-related drop in investment. But changes in the supply chain represent a risk, particularly in the automotive sector as it transitions away from the combustion engine, at least in Europe. Nevertheless, the government is aiming to preserve the country's FDI attractiveness. For instance, it recently announced the opening of its first high-tech economic zone--Skopje III--which aims to be a national hub for new technologies and clean manufacturing. The zone offers incentives similar to other free economic zones, including a 10-year holiday on corporate and personal income tax. Currently, companies operating in North Macedonia's free economic zones are focused on the electronic and auto sectors, and a large proportion of inputs are still imported rather than sourced domestically, which limits the free zones' wider integration into the domestic economy.
We anticipate no changes to the pegged denar-euro exchange rate regime. However, the central bank's foreign reserves have come under pressure since the beginning of the year due to increases in the energy import bill and decreases in the values of security holdings. Consequently, foreign reserves have decreased by €446 million since the end of 2021 to €3.2 billion in July. We expect pressure on the National Bank of the Republic of North Macedonia's (NBRNM) foreign reserves to emerge again later in the year as winter begins but then to gradually subside as energy prices moderate from the current highs in 2023-2024.
We deduct from our calculation of usable reserves the FX held as part of bank's required reserves, and an amount equivalent to the monetary base, because we believe the latter would be required to defend the peg. To mitigate the issue, the authorities have requested a two-year PLL from the IMF and negotiations are ongoing. Additionally, we consider that North Macedonia benefits from connections with international financial institutions and access to their financing facilities. For example, the EBRD recently granted a €100 million liquidity support line in the form of loan to the national energy company JSC Elektrani na Severna Makedonija. Lastly, we expect the authorities to return to the Eurobond market later this year.
Inflation has increased in recent months, primarily due to higher energy and food prices, to 16.0% in July from 6.7% in January, and is now at its highest since June 1995. Similarly, core inflation increased to a new peak of 7.2%, showing that inflation is more entrenched. We expect inflation to average 14% this year and decline thereafter as price pressures ease. Lastly, in line with the European Central Bank's monetary policy tightening, the NBRNM has hiked its policy rate by a cumulative 125 basis points so far this year.
North Macedonia's financial sector linkages with Russia are limited and the authorities did not have to intervene to manage the fallout of sanctions on Russian bank subsidiaries. This set North Macedonia apart from countries like Slovenia, Croatia, and Bosnia and Herzegovina. Pressures within the banking system emerged nonetheless, with a short-lived episode of deposit withdrawals in March. This has since subsided. That said, the euroization of deposits has edged up with the share of deposits in foreign currencies rising from 42.8% in December 2021 to roughly 45.4% in June 2022. In response, the NBRM has reduced the reserve requirements (RRs) in denar to 5% and increased RRs in foreign currency to 18%. Moreover, a counter cyclical buffer of 0.5% has been introduced, which comes into effect in August 2023. We do not expect significant additional deposit withdrawals or their conversion to foreign currency in our current base case. The nonperforming loans ratio remains low at 3%, and the capital adequacy ratio is stable at 17%."
