Moody’s Investors Service has today downgraded Montenegro’s long-term issuer and senior unsecured debt ratings by one notch to B1 from Ba3. The short-term ratings have been affirmed at Not Prime (NP). The outlook remains negative.
The key drivers for today’s rating action are:
- Fiscal risks related to the highway project, which will increase the government’s debt-to-GDP ratio. Cost overruns of the highway project could push the debt burden even higher, thereby reducing the country’s shock absorption capacity further.
- Beyond the deterioration expected from the highway project, the government’s pro-cyclical fiscal policy is set to weaken the government’s balance sheet further.
- The erosion in the country’s external buffers due to elevated and persistent external imbalances, reflected in an expected current account deficit of close to 20% of GDP.
The negative outlook reflects Moody’s view of downside risks to the B1 rating. These relate to risks associated with the government’s debt-funded growth strategy and the heightened policy uncertainty associated with the parliamentary elections to be held by October this year.
Moody’s has also lowered the long-term foreign-currency bond and deposit ceilings to Ba1 from Baa1 and to B2 from B1, respectively. The short-term foreign-currency bond ceiling has been lowered to NP from Prime-2 (P-2), while the short-term foreign-currency deposit ceiling has been assigned at Not Prime.
RATIONALE FOR DOWNGRADE TO B1
- FIRST DRIVER – FISCAL RISKS RELATED TO THE HIGHWAY PROJECT WHICH REDUCES SHOCK ABSORPTION CAPACITY
The financing of the priority section of the 170 km Bar-Boljare highway project triggers a significant increase in the government’s debt-to-GDP ratio. This raises fiscal risks and reduces fiscal shock absorption capacity. Today’s rating action follows the assignment of a negative outlook in October 2014 prompted at the time by concerns over the potential impact of the project on the government’s balance sheet and questions regarding its economic benefits.
The project’s overall costs are estimated at more than 23% of 2014 GDP, which will push the government’s debt burden to close to 80% of GDP by 2018. This is almost three times as high as the 28% of GDP reported in 2008, though the growth in debt during this period also reflects the crystallization of guarantees to former state-owned enterprises (SOEs) on the government’s balance sheet during the global financial crisis.
Moreover, given the challenging terrain on which the highway is being built, there is a significant risk of cost overrun. Moody’s analysis shows that a cost overrun of around 20% could push the government’s debt burden higher towards almost 83% of GDP. Moody’s also notes potential currency risks associated with the project, given that the loan to finance the largest part of the project is fixed in US dollars.
Finally, the economic impact of this project is unclear given that only the first, albeit most challenging, 41 km of the whole highway that will link the port of Bar with the Serbian border are currently being built. Long-term economic benefits due to better connectivity and more opportunities for businesses are in Moody’s view only likely to be fully realized once all sections, including a connecting road network within Serbia, are built. As a result of this first phase alone, supply side effects will be modest.
- SECOND DRIVER – ADDITIONAL FISCAL DETERIORATION DUE TO INCREASE IN CURRENT EXPENDITURES
The government’s pro-cyclical fiscal policy is set to weaken the government’s balance sheet beyond the deterioration expected from the highway project. Moody’s notes that the government has engaged in significant pre-election spending, and an already very rigid expenditure structure – pensions and wages account for around half of overall expenditure — will limit any fiscal adjustment after the elections. At the same time, commitments to the highway project constrain the government’s ability to cut capital expenditure for short-term fiscal consolidation gains. High fiscal deficits, coupled with revenue and spending constraints, are particularly credit negative given the limits of monetary policy in light of the economy’s ‘euroization‘.
Competition to attract investment among regional peers reduces the viability of changes to the tax system to increase revenue. Moody’s notes that Montenegro’s share of revenue to GDP at around 42% of GDP in 2015 is more than double the median value for Ba3 and B1 rated peers and the third-highest in the region.
Additionally, further risks to Montenegro’s fiscal position stem from potential guarantee calls and ongoing legal proceedings in litigation cases of former SOEs. While total outstanding guarantees at the end of 2015 stood at around 9.4% of GDP and are below the level observed during the crisis, unfavorable legal outcomes in some litigation cases could trigger substantial levels of unanticipated expenditures beyond potential guarantee calls.
- THIRD DRIVER – EROSION IN THE COUNTRY’S EXTERNAL BUFFERS DUE TO PERSISTENTLY HIGH EXTERNAL IMBALANCES
Moody’s expects that the erosion in the country’s external shock absorption capacity due to elevated and persistent external imbalances will continue over the next couple of years. Montenegro’s focus on large-scale investment projects, such as the highway, and the country’s high import penetration imply sizable external imbalances over the next years, further exposing the country to shifts in the external environment and changes in investor sentiment. Moody’s expects Montenegro’s current account deficit to average close to 20% of GDP over 2016 to 2018, one of the largest in Moody’s rated universe.
While part of the current account deficit will be funded by FDI inflows, the composition of the financial account will also reflect the cross-border loan from the Chinese Export-Import Bank in US dollars to finance 85% of the highway, in addition to a significant share of “Net Errors and Omissions”. The latter represent a significant component in the balance of payments and reflect mostly unrecorded cash payments in the tourism industry. Even after the completion of the highway project, the current account deficit is expected to remain sizable, given the high goods import dependence of other sectors, such as tourism.
RATIONALE FOR NEGATIVE OUTLOOK
The negative outlook reflects Moody’s view of the risks associated with the government’s debt-funded growth strategy. Sizable public financing needs and the economy’s reliance on foreign capital expose the country to changes in financing conditions, especially over the next three years as debt escalates due to the highway project. Given the challenging terrain in which the highway is built, there is a risk of cost overruns that could push the government’s debt burden up even further. The negative outlook also captures the policy uncertainty associated with the parliamentary elections to be held by October 2016, after the split of the longstanding governing coalition earlier this year.
WHAT COULD CHANGE THE RATING DOWN?
Evidence that the fiscal or external metrics continue to deteriorate, for instance due to cost overruns or as a result of the materialization of contingent liabilities, could lead to a downgrade, as could signs of reduced access to international capital markets in the roll-over of maturing liabilities. Weaker short-term growth as a result of delays to key infrastructure projects, declining FDI or tourism activity, for instance due to increased domestic political uncertainty, or a growth slowdown among trading partners in the EU and in the region, would also be credit negative.
WHAT COULD CHANGE THE RATING UP?
Conversely, evidence of fiscal consolidation that puts the debt trajectory on a sustained downward trend would place upward pressure on the outlook and eventually on the rating. Equally, a reduction in contingent liabilities, stemming from a combination of materially lower government guarantees, as well as lower risks from banks and SOEs, would also be credit positive. Moreover, improvements in external competitiveness, for instance following the implementation of FDI-funded projects in the tourism and renewable energy sectors, as well as a material reduction in external vulnerabilities or significantly higher growth rates following the boost in capital deepening, would support Montenegro’s sovereign creditworthiness.
- GDP per capita (PPP basis, US$): 16,123 (2015 Actual) (also known as Per Capita Income)
- Real GDP growth (% change): 3.2% (2015 Actual) (also known as GDP Growth)
- Inflation Rate (CPI, % change Dec/Dec): 1.4% (2015 Actual)
- Gen. Gov. Financial Balance/GDP: -3.1% (2014 Actual) (also known as Fiscal Balance)
- Current Account Balance/GDP: -13.4% (2015 Actual) (also known as External Balance)
- External debt/GDP: [not available]
- Level of economic development: Low level of economic resilience
In May 2016, a rating committee was called to discuss the rating of Montenegro, Government of. The main points raised during the discussion were: The issuer’s fiscal or financial strength, including its debt profile, has materially decreased. The issuer’s institutional strength/framework, have materially decreased. The issuer’s susceptibility to external shocks has materially increased.
Issuer: Montenegro, Government of
- ….LT Issuer Rating, Downgraded to B1 from Ba3
- ….Senior Unsecured Regular Bond/Debenture, Downgraded to B1 from Ba3
- ….Senior Unsecured Regular Bond/Debenture, Downgraded to B1 from (P)Ba3
- …. ST Issuer Rating, Affirmed NP
- ….Outlook, Remains Negative
Source: Moody’s Investors Service