Albania 'B+/B' Ratings Affirmed; Outlook Stable

  • We expect Albania's real GDP will expand by nearly 4% on average through 2022.
  • While we anticipate ongoing commitment to fiscal consolidation and a resulting gradual reduction of the still-high public debt-to-GDP ratio, public-private partnership (PPP) projects continue to pose a significant fiscal risk.
  • Additionally, weak headline credit growth and high euroization highlight key challenges for the central bank's monetary policy.
  • We are affirming our 'B+/B' sovereign credit ratings on Albania.
  • The outlook is stable.
RATING ACTION
On Feb. 1, 2019, S&P Global Ratings affirmed its 'B+/B' long- and short-term 
sovereign credit ratings on Albania. The outlook remains stable.

OUTLOOK
The stable outlook reflects our view that Albania's economy will expand by 
just under 4% over the next years; fiscal deficits will remain limited; and 
gradually narrowing current account deficits will predominantly be covered by 
solid foreign direct investment (FDI) inflows over the next three to four 
years.

A period of sustainable economic growth, improvements in the business 
environment, FDI inflows, and a reduction in the size of the informal economy 
could lead to a positive rating action over the next two years. We would 
consider taking a positive rating action if fiscal consolidation strengthened 
beyond our base case leading to a more pronounced downward trajectory for 
public debt, or lower interest costs relative to government revenues. 

In turn, we might take a negative rating action if we observed material fiscal 
slippages, potentially resulting from higher fiscal deficits or 
materialization of contingent liabilities from PPP projects. We could also 
lower the rating if we assessed that the monetary policy transmission 
mechanisms of the Bank of Albania (BoA, the central bank) had weakened, for 
example due to a more prolonged period of repressed credit growth.

RATIONALE
The ratings are constrained by Albania's relatively weak institutional 
framework; modest income levels; its large net external liability position, 
resulting from persistent current account deficits; still relatively high 
general government debt burden, significant parts of which are either 
denominated in foreign currency or short term in nature; and limited monetary 
policy flexibility, owing to extensive euroization and high informality. The 
ratings are supported by elevated growth rates, bolstered by the favorable 
outlook for FDI as well as the government's demonstrated commitment to fiscal 
consolidation anchored by the enhanced fiscal framework (Organic Budget Law).

Institutional and Economic Profile: The government, undeterred by a recent 
cabinet reshuffle, will pursue its structural reform agenda, supporting 
economic growth
  • Despite the recent replacement of several cabinet members, we expect the government will move ahead with structural reforms, but delays in implementation are possible.
  • Strong aspirations of EU membership provide an anchor for institutional reforms, particularly regarding the judiciary.
  • The Albanian economy will expand by nearly 4% over the next years on the back of strong domestic demand and service exports.
We do not expect that the recent replacement of seven ministers--the 
equivalent of half the cabinet--is indicative of or will translate into a 
change in the current government's policy direction. Our expectation is that 
the Socialist party--the sole winner of the 2017 elections--under Prime 
Minister Edi Rama will ensure policy continuity and implement structural 
reforms regarding the economy, public administration, and particularly the 
judicial sector. These are anchored by the government's efforts to prepare for 
potential EU accession. At the same time, the reform momentum could slow over 
the coming months as the new ministers assume their posts.

EU accession remains a political priority of the current administration and 
will provide a policy anchor for the government as it aims to fulfill 
requirements for EU membership. The administration has already made efforts to 
enhance the rule of law and combat the informal economy. Last year's Sofia 
declaration determined that EU accession negotiations for Albania will likely 
start in 2019. However, given strong sentiments in specific EU countries 
against further geographic expansion of the EU, we think that Albania's 
accession is unlikely before 2025.

More specifically, the strong EU membership aspirations also spurred the 
government to pass the judicial reform last year, which aims to create a more 
independent judiciary. The reform has the potential to sustainably improve the 
country's business environment, for example, by increasing the effectiveness 
of property rights enforcement. The vetting body was established last year and 
will progress with its assessments. Currently, more than half of the judges 
evaluated have been dismissed from their judiciary duty, and we view this as a 
strong indication that these key reform efforts will be sustainable, even 
though comprehensive reform and restructuring of the judicial system will 
require more time. Further structural reforms are necessary to strengthen 
Albania's still-weak institutional framework, in our view. In general, the 
country has a considerable shadow economy, with prevalent corruption and 
constrained effectiveness of the rule of law.

We project that Albania's formal economy will expand by an average of 3.7% in 
real terms between 2019 and 2022, albeit still from a relatively low level of 
development. A number of large-scale investment projects have raised economic 
growth rates in recent years, and will likely be completed in 2019. This 
includes the Trans-Adriatic Pipeline (TAP), which will connect Albania with 
Italy and the Caspian Sea, as well as the construction of a hydropower plant. 
The completion of these projects will result in higher production capacity of 
the energy sector. In addition, the tourism sector posted very solid growth 
rates over the past two years, and we see clear development potential in this 
area. We consider that strong domestic demand, with rising consumption, will 
be a primary growth engine over the next years, also aided by rising 
employment levels.

In the long term, reform implementation could support an improved business 
environment and help the country to attract additional FDI. This would help 
unlock Albania's economic potential, for example in the areas of energy, 
agriculture, and tourism. Ultimately, the country would also benefit from 
attracting FDI in higher value-added sectors, such as business services and 
information and communication technologies, and it has started to do so, but 
from a low base.


Flexibility and Performance Profile: Public debt is on a downward path, but 
monetary flexibility is still limited 
  • We expect narrow fiscal deficits over the next years as the authorities are committed to the debt brake law.
  • High public debt remains a key credit risk, although the debt burden continues to gradually shrink.
  • Monetary policy effectiveness is constrained by high levels of euroization and shallow capital markets.
We expect Albania's fiscal performance will remain relatively strong over our 
forecast horizon through 2022. The country has outperformed its budget and our 
previous expectations in the past year, and we note that Albania fiscally 
outperforms its Western Balkan peers in the same rating category. This is a 
result of the healthy growth outlook and the government's adherence to the 
debt brake law. We forecast general government deficits to average 2% of GDP 
annually over 2019-2022. Revenue growth should remain solid on the back of 
strong economic performance and coordinated tax mobilization efforts. That 
said, the shadow economy continues to weigh on public revenues, and 
sustainable improvement on revenue intake will hinge on continuous 
improvements to tax administration and compliance. In this respect, the 
implementation of a new property tax this year could be instrumental.

The administration has shown stricter cost control than in previous years, but 
specific downside risks remain. The government is actively pursuing several 
PPP infrastructure projects with local construction companies. While we 
acknowledge high infrastructure needs for the country, the risk framework 
governing these projects is currently not yet sufficiently developed and many 
of these proposals remain unsolicited tenders. Annual expenditures for PPP 
projects currently stand at an estimated 2%-5% of government revenues, but the 
full amount of potential financial risks for the administration is impossible 
to evaluate.

Nevertheless, we expect that stronger overall fiscal consolidation will lead 
the government's net debt stock to decline to about 60% of GDP by the end of 
2022. The authorities are actively pursuing efforts to increase debt 
sustainability, which is currently challenged by refinancing and foreign 
exchange risks. The average maturity of debt, while increasing over the past 
years, is still relatively short at 2.25 years. This is particularly the case 
for domestically issued debt, about half of which needs to be refinanced 
annually. About one-half of Albanian government debt is denominated in foreign 
currency and unhedged, bearing the risks of marked exchange rate fluctuations. 
Additionally, Albania's banking sector still holds the largest share of 
domestic debt, around one-quarter of banks' total assets. While we see no 
borrowing constraints for the public sector in the domestic market, the 
government will likely also continue to look for opportunities to fund itself 
abroad at longer maturities, especially given the successful placement of a 
Eurobond last year at rather favorable terms. We expect that the 
aforementioned risks will further abate as the government's debt burden 
declines. In contrast to government statistics, we include in the country's 
debt burden our assessment of unresolved arrears, currently estimated at 1.5% 
of GDP.

Although we expect the government will be the only significant sector to issue 
external debt, Albania's external vulnerabilities, reflecting large external 
financing needs and an increasing stock of external liabilities, remain high. 
We have revised down our estimate of the country's current account deficits; 
we now expect that they will decline to 6.3% of GDP by 2022 from currently 
above 7.0%. These deficits also relate to large-scale, import-intensive 
investment projects, which are mostly foreign funded; the most important ones 
will likely conclude in 2019. At the same time, the current account was 
supported by buoyant receipts from the tourism sector and strong remittance 
inflows (some 6%-7% of GDP annually) from Albanians employed in the EU, namely 
in Italy and Greece. We expect net FDI inflows will remain Albania's main 
external financing source for current account deficits, particularly via 
large-scale investment projects. For example, the TAP project, totaling €1.5 
billion (11% of GDP in 2018), has been executed over the past two years and 
will likely be finalized by 2019.

While foreign liabilities have been rising, Albania's external borrowings from 
abroad have traditionally been relatively low, reflecting external funding 
constraints in the past and currently very low willingness of the private 
sector to borrow abroad given more favorable domestic funding conditions. We 
expect narrow net external debt to remain close to a modest 9%-12% of current 
account receipts (CARs) throughout our forecast horizon. Nevertheless, 
Albania's large net external liability position, which we expect will be above 
120% of CARs from 2020, still exposes the country to a change in investor 
sentiment should FDI flows stop or even reverse.

We observe continued consolidation in the financial sector as subsidiaries of 
Greek banks are withdrawing from the market. Veneto Bank's subsidiary will be 
acquired by fellow Italian bank Intesa Sanpaolo's subsidiary and Societe 
Generale Albania will be acquired by Hungarian banking group OTP. We do not 
consider these developments indicative of a broader trend of foreign banks 
leaving the market, since exiting banks represent only a minor share of the 
financial sector and more sizable foreign banks show no indication of 
significant disinvestments.

At the same time, banks have reduced the share of nonperforming loans (NPLs) 
on their balance sheet to below 12%, largely due to write-offs. Despite 
still-high disparities between financial institutions, this represents a 
pronounced decrease from the 25% peak in September 2014. This has not caused 
financial stress due to banks' sufficient provisioning and generally high 
liquidity. With a reported average tier-1 ratio of 16%-17% for the banking 
system, overall capitalization remains well above minimum requirements.

The deposit-funded financial sector has strengthened its position as a net 
external creditor. The steady rise of the financial sector's net foreign 
assets--partly reflecting high liquidity--illustrates Albania's limited 
lending opportunities and banks' low risk appetite in recent years. Even when 
considering the impact of NPL write-offs on overall credit growth figures of 
the economy, new credit growth remains subdued. We expect growth of domestic 
credit will trail nominal GDP growth over our forecast horizon.

Shallow capital markets and extensive euroization of the financial system 
further impair the effectiveness of Albania's monetary policy, as is the case 
for several economies across the region. BoA's de-euroization strategy has 
resulted in a decrease of euro-denominated credits, but deposits in foreign 
currencies will likely remain above 50% of total deposits through 2021 based 
on high euro inflows. Loans in foreign currencies have been decreasing in 
recent years, and we expect that they will remain below 50% of total loans in 
the coming years, given the BoA's strong policy focus on containing 
foreign-currency lending and a relatively large stock of euro-denominated 
NPLs.

We still consider the BoA's exchange rate regime more stable than peers' in 
the same rating category. The Albanian lek remains a generally free-floating 
currency, and we expect exchange rate interventions by the central bank will 
remain intermittent and limited. The BoA has generally remained tolerant to 
the continuous upward pressure on the lek relative to the euro for the past 
several years, but decided to actively intervene in the market as a response 
to turbulences in the foreign exchange market in the second quarter of last 
year. However, this did not break the generally appreciating trend of the lek 
relative to the euro last year.

The central bank's policy rate now stands at a historically low 1%. Despite 
its very accommodative monetary policy, BoA's track record of meeting its 
inflation targets remains relatively limited over the past years. In the 
absence of stronger-than-anticipated lek depreciation, we project inflation 
will likely remain closer to 2% in the foreseeable future and not reach the 3% 
target rate before 2023.