Government of Georgia 'BB-/B' Ratings Affirmed; Outlook Stable
(The following statement was released by the rating agency)
• We believe the recent agreement on a program between the International Monetary Fund and Georgia will strengthen the Georgian authorities' reform agenda.
• At the same time, we project the country's per capita income levels will remain modest and external financing requirements elevated.
• We are affirming our 'BB-/B' sovereign credit ratings on Georgia.
• The stable outlook reflects our expectation that Georgia's fiscal and external performance will not deviate materially from our baseline forecasts over the next 12 months.
On May 5, 2017, S&P Global Ratings affirmed its 'BB-/B' long- and short-term foreign and local currency sovereign credit ratings on the Government of Georgia. The outlook is stable.
The affirmation reflects our expectation that our ratings on Georgia will continue to be supported by the country's relatively strong institutional arrangements and fiscal position, with net general government debt below 40% of GDP for 2017-2020. The ratings are primarily constrained by income levels--which remain low in a global comparison--and balance of payments vulnerabilities, including Georgia's import dependence, high current account deficits, and sizable external debt. We also believe that the ratings remain constrained by the limited monetary policy flexibility, owing to Georgia's shallow domestic capital markets and high levels of dollarization.
In our view, Georgia's economic policies and institutional arrangements remain among the strongest in the region. Historically, the Georgian authorities have largely maintained reform focus and prudent public finances despite considerable challenges at times, including a brief war with Russia in 2008 and the transition of power in 2012. We believe the recent signing of an Extended Fund Facility (EFF) agreement with the International Monetary Fund (IMF) bodes well for the continuation of these arrangements.
The governing Georgian Dream (GD) party's parliamentary majority should help facilitate the passage of important reforms. We also expect the focus on closer cooperation with the EU to continue. A number of milestones have already being achieved, including the signature of a Georgia-EU free-trade agreement that entered into force last year and the waving of visa requirements for Georgians wishing to travel to Schengen area that took place at the beginning of 2017. At the same time, there remain downside risks in Georgia's relations with Russia given the disputed status of the South Ossetia and Abkhazia regions. A secondary risk is the possibility of erosion in institutional settings were the GD to use its majority to marginalize domestic political opposition.
Following the government's request, the IMF approved an EFF arrangement for Georgia in mid-April. Under the EFF, Georgia will have access to special drawing rights (SDR) 210.4 million (about $285 million) over the next three years. Although the economy's current account deficit and external liabilities remain high, we believe the country is not in acute need of external support.
In fact, we see net foreign direct investment (FDI) inflows, which have consistently been in excess of 8% of GDP since 2014, and multilateral lending for infrastructure projects as the drivers of the current account gap, rather than the other way around. We understand that the government views the EFF as a means to anchor the existing reform agenda. Still, the financing available will certainly provide an additional external buffer should that be required.
The program goals include bolstering Georgia's fiscal position in conjunction with creating space for increased public investment, strengthening the financial sector, and implementing a number of structural reforms. It is closely aligned with the authorities' so-called four-point plan, which also focuses on improving education and governance reforms.
Although Georgia's economic growth has remained comparatively resilient, given the difficult regional economic environment, it amounted to 2.7% last year--among the highest in the region but still the weakest Georgia's annual performance since 2009. We expect that the planned implementation of reforms, recent signature of free-trade agreements with the EU and China, and the strengthening of growth of Georgia's key trading partners (including Russia and Azerbaijan) should support economic acceleration. We expect headline growth of 3.5% this year, followed by gradual improvement toward a 5.0% growth rate in 2019. Other factors supporting growth include:
• Strong investment dynamics expected over the next two years, underpinned by a number of public and private projects, including in the energy and tourism sectors; and
• Recovering consumption supported by moderate inflation levels, more stable Georgian lari exchange rate, and domestic credit growth.
At the same time, we expect Georgia's per capita income levels will remain modest throughout our four-year forecast horizon, largely reflecting the country's narrow economic base and the prevalence of exporting low value-added goods. This continues to constrain the sovereign ratings. The authorities' reform and development plans aim to capitalize on Georgia's strategic location to promote a regional transport and logistics hub as well as develop the country's agricultural potential and tourism. Nevertheless, most benefits would likely be only felt over the longer run.
We expect Georgia's fiscal policy to stay broadly in line with historical trends through 2020. The general government deficits averaged close to 2.5% of GDP over the last five years. As we anticipated, the deficit widened slightly last year to 2.8% of GDP reflecting higher current government spending in an election year as well as some capital expenditures on specific projects. Nevertheless, we forecast the deficits will fall back to average 2.5% of GDP over the next four years.
We previously highlighted the fiscal risk from the introduction of the so-called Estonian model from the beginning of 2017 whereby only distributed corporate profits are taxed. We believe this has now reduced as the government increased a number of excise taxes to offset the impact on revenues. We also think that the recently agreed arrangement with the IMF will help keep public finances in order.
Even so, downside risks to fiscal performance remain. In our view, budget deficits could widen if the projected pick-up in growth is derailed. Moreover, the public balance sheet remains exposed to foreign exchange risk, given that around 80% of government debt is in foreign currency. Consequently, several factors largely outside of government's control could raise the leverage level in the event of the lari exchange rate weakening. These include a weaker-than-projected trading partner growth or an increase in regional geopolitical tensions, for example, due to a deterioration of relations between Georgia and Russia or a worsening domestic political environment in Turkey.
Given our baseline expectation of a relatively modest depreciation of the lari over 2018-2020, we believe the annual rise in general government debt will slightly exceed the headline annual deficit. Overall, gross leverage will remain broadly stable with general government debt at about 43% of GDP over the next three years. We currently consider that the contingent fiscal liabilities stemming from the public enterprises and the domestic banking system are limited.
Georgia's weak external position remains one of the primary constraints on the ratings. The country's external current account deficit has remained persistently wide and reached an eight-year high in 2016 of over 13% of GDP. This has taken place against the background of still weak export and remittances performance. In our view, external risks are partly mitigated by a substantial portion of foreign debt pertaining to the public sector and benefitting from favorable terms and long repayment periods.
We also believe that the headline current account deficits somewhat overestimate Georgia's external vulnerabilities, given that they have been predominantly financed by FDI inflows in recent years. During 2013-2016, net FDI financed close to four-fifths of Georgia's current account deficit. FDI has been sizable in the transportation sector, reflecting several projects, including the expansion of the South Caucasus Pipeline (SCP) intended to bring gas from Azerbaijan to Turkey via Georgia. There are also several hotels being constructed in central Tbilisi. Most of these FDI-related projects are heavily import-intensive, contributing to Georgia's wide trade deficits.
However, there are still significant vulnerabilities. Specifically, while a hypothetical sizable reduction in FDI inflows may not necessarily lead to a disorderly adjustment involving an abrupt depreciation of the lari (due to a simultaneous corresponding sizable contraction in FDI-related imports), it will likely have implications for Georgia's growth and employment. The accumulated stock of inward FDI also remains substantial at about 170% of the country's generated current account receipts, exposing the sovereign to risks should foreign investors decide to leave, for example, due to changes in business environment or a deterioration in Georgia's economic outlook.
In our view, the ratings on Georgia also remain constrained by the limited flexibility of the National Bank of Georgia's (NBG) monetary policy. In particular, we believe the shallow domestic capital markets, as well as relatively high resident deposit and loan dollarization, hamper the NBG's ability to influence domestic monetary conditions through local currency liquidity. Nevertheless, we think there is potential for Georgia's monetary policy effectiveness to improve given the government's extensive focus on de-dollarization, promotion of local currency debt capital markets, and enhanced liquidity provision to the domestic banking system.
We consider that the more flexible exchange rate arrangement maintained by the central bank has largely facilitated Georgia's speedy adjustment to the evolving external environment. The NBG allowed the lari to depreciate by about 30% against the U.S. dollar in 2015, with only occasional interventions to smooth volatility. As a result, the NBG's foreign exchange reserves have been quite stable in the last few years, unlike some other regional sovereigns that have attempted to defend more rigid foreign exchange regimes. NBG's reserves have grown to $2.75 billion at end-2016 from $2.5 billion at end-2015. We project reserves to strengthen further over the next few years, partly owing to the EFF arrangement with the IMF.
In our view, the Georgian banking system has remained resilient over the last two years. Nonperforming loans have largely remained unchanged (in the 7%-8% range in 2014-2016) against the background of local currency depreciation, even though a substantial proportion of loans are in foreign currency. This is in contrast to developments in other regional economies, such as Azerbaijan or Kazakhstan, where vulnerabilities in the banking system have risen.
The stable outlook reflects our expectation that Georgia's fiscal and external performance will not deviate materially from our baseline forecasts over the next 12 months.
We could raise the ratings if growth materially exceeds our current forecasts or if we see significant improvements in the effectiveness of monetary policy that allows authorities a wider arsenal of tools to smoothen cyclical economic shocks over the next 12 months. We could also raise the ratings if Georgia's institutional settings and policymaking effectiveness improved.
We could lower the ratings if Georgia's external performance deteriorated over the next 12 months, in contrast to our current forecasts. We could also lower the ratings if fiscal performance weakened materially.