Bosnia and Herzegovina Outlook Revised To Positive On Solid Growth And Fiscal Outcomes At 'B' Level

  • Bosnia and Herzegovina's (BiH's) economy has proven itself more resilient to ongoing political tensions than we had previously expected.
  • We see potential for upward pressure on our 'B/B' ratings on BiH should a government be formed, reform momentum resumed, and the IMF program revived.
  • As a consequence, we are revising our outlook on BiH to positive from stable and affirming the 'B/B' sovereign ratings.
RATING ACTION
On March 8, 2019, S&P Global Ratings revised its outlook on Bosnia and 
Herzegovina (BiH) to positive from stable. At the same time, we affirmed the 
'B/B' long- and short-term foreign and local currency sovereign credit ratings 
on BiH.

OUTLOOK
The positive outlook reflects our view that, should a government be formed 
during the course of 2019, BiH's economic prospects could improve beyond our 
current base-case projections. Under this scenario, we anticipate authorities 
would regularize BiH's program status with the International Monetary Fund 
(IMF), which would in turn accelerate reforms and unlock financing for 
important infrastructure projects.

We could raise the rating on BiH over the coming 12 months if a lasting 
government is formed that promotes the resumption of structural reforms. Under 
this scenario, we would expect a reopening of dialogue with the IMF, and a 
renewed focus on restructuring BiH's large public nonfinancial companies, as 
well as new steps toward improving the quality and availability of published 
macroeconomic data. 

We would revise the outlook back to stable if a government is not formed, and 
reforms are not revived. 

RATIONALE
We revised the outlook to positive because most risks in our base-case 
economic and fiscal projections point to possible ratings upside, and because 
the formation of a government this year, alongside normalization of BiH's 
program with the IMF, would lead to meaningful improvement in several of the 
indicators underpinning the 'B' rating on BiH. 

The rating on BiH is supported by the sovereign's solid fiscal position, 
declining stocks of government debt, and the economy's steady growth 
prospects. The sovereign's moderate and predominantly concessional debt burden 
also benefits debt sustainability, underpinning the rating, together with our 
assessment that the sovereign will continue to operate a prudent fiscal 
policy, particularly during periods of constrained access to external 
financing.

The rating is constrained by the complexity of BiH's institutional framework, 
which involves parallel administrations with separate pension systems and 
revenue streams. We factor BiH's limited monetary policy flexibility and its 
still-low, albeit improving, income levels into the ratings assessment. 
Moreover, sustained current account deficits give rise to substantial external 
financing needs that weigh on BiH's creditworthiness, in our opinion. 

Institutional and Economic Profile: Frail institutional foundations and 
divisive politics
  • Last-minute formation of legislative bodies at the federal and state-level has broken a four-month institutional standstill and alleviated fiscal uncertainty while providing scope for resumption of structural reforms.
  • Political tensions remain and will continue to challenge fiscal policymaking, hamper large-scale reform activity including to BiH's vast state-owned enterprises sector, and delay the economy's necessary transition to investment-led growth.
  • We expect the economy will record steady but unimpressive growth rates, supported by private consumption and public investment projects.
Over the past nine months, two events have occurred that pose a risk to BiH's 
institutional and economic settings:
  • In July 2018, the IMF decided to suspend disbursements under its Extended Fund Facility (EFF), based on its assessment that proposed fiscal measures in BiH threatened to sidetrack fiscal stringency, a key requisite for continued IMF program endorsement. The program remains off track, but we expect the BiH government, when it forms, will resume talks with the IMF during 2019. Even though the postponement of the €38 million tranche will not significantly hurt BiH's fiscal situation, we see the IMF program as an important anchor for the country's structural reform agenda, and its positive momentum enables BiH to access external financing for key infrastructure projects. As such, a prolonged postponement of the IMF program could lead to overall negative external financing sentiment.
  • In October 2018, general elections proved inconclusive, which led to institutional gridlock until December 2018, when the Central Election Committee passed legislation making it possible to circumvent the election law, opening the way in February 2019 for legislative bodies to be appointed in both the autonomous entity Federation of BiH and at the state level. The appointment of functioning parliaments has defused risks of social tension while alleviating concerns of a prolonged period of parliamentary gridlock.
BiH's multilayered institutional set-up hinders effective policymaking and 
complicates any progress toward being granted EU candidate status (BiH applied 
in early 2016). Although BiH, after long deliberations and political wrangling 
among the multiple constituents, has supplied answers to an additional 
EU-mandated questionnaire, we don't anticipate any significant progress 
regarding EU candidacy in the short term. We believe that the international 
community will continue to support BiH on its European integration path and we 
expect the EU will deliver an opinion on the progress and timeframe for BiH's 
candidate status at some point in 2019. 

However, confrontational political rhetoric continues to impede the 
longer-term effectiveness of reforms necessary to secure structural 
improvements in the business sector and the labor market, to strengthen growth 
potential and bolster income levels. Moreover, while we expect BiH's wealth 
levels will continue to improve, we observe that the headline number appears 
stronger due to the ongoing decline in population. Moreover, a substantial 
shadow economy complicates the analysis. In this vein, the most recent labor 
force survey indicates notably improving unemployment rates, at 18.4% in 2018, 
compared with 20.5% in 2017, reflecting an increase in employment, but also 
from a fall in the activity rate and a reduction of the labor force. Domestic 
private-sector development is hampered by a shrinking pool of skilled and 
educated labor resulting from the migration of working-age people to 
neighboring countries and the EU. 

We believe, however, that BiH's economy can navigate through the current 
period of political uncertainty while still posting average annual GDP growth 
of just under 3%. At the same time, were this uncertainty to be removed by the 
formation of a government committed to renewing the IMF program, we think that 
growth performance would be boosted over the medium term, as positive 
confidence effects and better access to concessional financing would support 
infrastructure projects and private sector capital expenditure. 

While the derailed IMF program represents a deterrent for external financing 
flows, BiH has locked in some important external financing for the short term, 
such as a three-year €700 million loan from the European Bank for 
Reconstruction and Development to finance highway construction throughout the 
country, which will to some extent sustain key infrastructure investments. As 
in the past, we project that private consumption will be a key growth 
contributor, financed by substantial remittance inflows. We also expect, 
however, that foreign direct investment (FDI) will remain muted, driven 
primarily by existing companies reinvesting their profits, rather than by new 
investments. 

Flexibility and Performance Profile: Domestic disputes complicate fiscal 
policymaking
  • We expect BiH's foreign debt service will benefit from an institutionalized mechanism that prioritizes debt service ahead of other fiscal outlays.
  • The 2018-2019 delay in the government's formation mutes public investments in 2019 but locked in financing flows create stability.
  • BiH's currency board arrangement anchors its structural reform agenda, but restricts monetary policy flexibility.
 
The government budget came in at a surplus in 2015-2017, reflecting the 
financing constraints for the entity governments, budget restrictions, and 
wage freeze efforts, as well as underspending in 2017 due investments not 
taking place following delays of the IMF program. We expect a surplus also in 
2018 at about 1% of GDP, driven primarily by revenue improvements, contained 
expenditures, and some underspend on the capital account. In particular, the 
amendment of the law on excise duty in February 2018 led to strong growth in 
road tax revenues, which in combination with meaningfully increased indirect 
taxes (main source of revenue), were up 7.2% for the first nine months versus 
the same period last year. This will support the revenue side. Expenditures 
however have been relatively stable, largely reflecting a moratorium on 
expenditure and delays in investment.

Because of the gridlock in forming the government after the October 2018 
elections, BiH has been in a state of temporary financing since Jan. 1, 2019. 
This position has effectively curbed expenditure and fiscal policy execution. 
And even though we expect the situation will be resolved and a state-level 
budget for 2019 be approved in the short term, we anticipate that constraints 
on government expenditures will resonate throughout 2019. Hence, we factor in 
our expectation of lagging reform momentum, which will limit budget execution 
and spending predictability. These budgetary restrictions will likely spill 
over and cause some delays in investments and result in overall fiscal 
surplus. Over the longer term, we expect medium-term fiscal pressure from 
age-related expenditure accentuated by demographic dynamics and emigration.

BiH reached agreement on the Global Fiscal Framework for 2019-2021 in July 
2018, which sets fiscal targets and defines basic assumptions for budget 
planning through 2021. Expenditure for financing BiH's institutions was raised 
for the first time since 2012, to konvertibilna marka (BAM) 966 million from 
BAM950 million, to finance higher salaries for policemen. Conflicting 
interests sometimes make it difficult to assess the fiscal trajectory or 
fiscal impact of announced reforms. In the second quarter of 2018, the 
proposed law on benefits for war veterans, since then abandoned, resulted in 
the IMF halting its EFF program for BiH. We expect the approved budgetary 
framework will be implemented when the state of temporary financing expires in 
March 2019, and we will monitor the degree to which it adds predictability to 
BiH's fiscal planning. 

Importantly, outstanding general government debt is low and foreign debt is 
serviced through a mechanism where all revenues from the constituent 
governments are collected by the federal Independent Taxation Authority, and 
redistributed to the constituent governments net of external debt service on 
the basis of a consumption-linked coefficient. BiH's budgetary procedures thus 
explicitly prioritize external debt service payments above all other outlays. 
We consider this mechanism vital in terms of containing the risks associated 
with this period of budget execution uncertainty since the elections. The 
majority of government debt is and will continue to be denominated in foreign 
currency and primarily concessional. We project BiH will report net general 
government debt at 25% of GDP for 2018, chiefly due to availability 
constraints and delayed investments. 

We expect net general government debt will remain at similar levels through 
2022. We believe that the constituent governments would have access to the 
domestic capital markets to cover temporary deficits if there was a disruption 
in concessional funding inflows. We have seen them cut investment spending in 
the absence of concessional inflows, and we expect them to do so again if 
needed to balance their budgets. However, we consider BiH's vulnerability to 
shifts in official funding as a risk, and we believe external financing 
pressures could again heighten if reform stagnation persists, deterring 
concessional financing inflows.

The moderate external indebtedness of BiH, compared with that of other 
sovereigns we rate, reflects the government's reduced external borrowing due 
to constrained financing availability of international concessional inflows 
and the resulting investment delays in the past three years. In addition, due 
to an externally consolidating banking sector in recent years, as well as 
increasing levels of foreign exchange reserves in order to cover monetary 
liabilities, we position the country's narrow net external debt at a low 29% 
of current account receipts in 2018. We believe that the uncertainties 
surrounding the government's formation will temper external debt flows in 2019 
but we foresee that they will pick up in 2020 and thereafter as some 
uncertainty lifts once the government is formed. In this regard, we note that, 
absent such flows, BiH faces external issuance constraints. As such, we 
forecast a mild increase in BiH's external indebtedness, with narrow net 
external debt returning to over 34% of current account receipts by 2022.

We project BiH's current account will remain in a stable deficit of about 5.2% 
of GDP in 2022, with externally financed infrastructure investments remaining 
modest, keeping imports in check. We estimate debt-creating inflows, net of 
amortization, will reach about 1.0% of GDP on average through 2022, together 
with net FDI of 2.0% of GDP, and inflows to the capital account making up the 
rest. Further structural reforms in the business sector could also help 
attract more FDI, but that seems unlikely given the expected halt in reform.

BiH has a currency board regime under which the konvertibilna marka is pegged 
to the euro. The currency board contributes to economic stability and has 
successfully contained inflationary pressures, necessary elements for the 
implementation of the structural reform agenda. While appropriate for the 
country so far, it restricts policy options, in our view. Although reserves 
covered monetary liabilities through 2018, the central bank cannot act as a 
lender of last resort under BiH law. We understand that BiH is committed to 
maintaining the central bank's independence and preserving the stability of 
the currency board, which entails full coverage of the monetary base by the 
central bank's foreign currency reserves.

At the same time, BiH's banking system appears relatively well capitalized. 
Nonperforming loans (overdue 90 days or more) have decreased to 9.3% of total 
loans as of the second quarter of 2018. Consolidation of banks' balance sheets 
ended at mid-year 2017, and private sector lending has been picking up. This 
lending has largely been financed by domestic deposits, which exceed 
outstanding loans, as reflected in a loan-to-deposit ratio of 93%. 
Vulnerabilities at smaller domestic banks with weaker corporate governance 
practices have surfaced over the past couple of years, but we recognize the 
recent adoption of new banking legislation in the two autonomous 
governments--the Federation of Bosnia and Herzegovina and Republika Srpska--in 
line with EU directives, as a step toward improved supervision