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Panama has rising fiscal deficits, despite strong growth: Moody's

Photo: Rita Willaert, Flickr

Text: Moody's

Credit Strengths

- A dynamic service-based economy with a track record of sustained high growth

- A favorable debt profile with low refinancing risk and no exchange rate risk

- Vital global role of the government-owned Panama Canal

Credit Challenges

- Repeated waivers to public spending caps undermine credibility of fiscal controls

- Rising fiscal deficits, despite strong growth

- Limited space for economic policy management due to dollarization

Rating Rationale

Panama's Baa2 sovereign ratings incorporate high (-) economic strength, moderate (+) institutional strength, high fiscal strength, and moderate (-) susceptibility to event risk.

The country's economic strength balances the small size of the economy, a GDP per-capita in line with the Baa median, and prospects for robust - though slowing - economic growth. The Panamanian economy has doubled in size over the last 7 years. Average annual GDP growth of 9.1% during that period was the highest in Latin America and among the highest worldwide. Strong economic growth has been driven by a sharp increase in investment. Panama's investment ratio was 27% of GDP over the past six years, up from 19% between 2002 and 2007, while foreign direct investment averaged slightly below 10% of GDP.

In addition to increased traffic through the Panama Canal and robust activity in the Colon Free Trade Zone, growth has been supported by favorable evolution in the construction, mining, and transport sectors, as well a burgeoning tourism industry. Medium-term growth prospects should remain strong owing to the expansion of the Panama Canal and the government's infrastructure investment plans. Together, these developments should improve Panama's position as a regional logistics hub.

Moderate institutional strength reflects Panama's medium scores for World Bank governance indicators together with two key economic and governmental institutions that lay the foundations for the country's economic success: dollarization and the Panama Canal Authority. By ensuring stability, dollarization is the bedrock upon which the Panamanian economy has developed. Together with the Canal, it is one of the key driving forces behind Panama's emergence as a regional financial center. Though Panama has a relatively weak score for control of corruption and faces recurring questions over judicial independence, these concerns have clearly not discouraged investment.

The Panama Canal Authority is the country's most important public sector institution. Since the Canal was transferred to Panamanian hands in 1999, management has been highly professional and its governance independent of political interference. Additionally, two important institutional arrangements in the fiscal arena are the Social Fiscal Responsibility Law (SFRL) and a sovereign wealth fund (Fondo de Ahorro de Panama, or FAP), although they have had a limited and somewhat questionable track-record. Over the past few years, authorities have repeatedly circumvented the deficit ceiling defined by the SFRL through a series of waivers and changes.

While we recognize that policy flexibility is required to respond to special conditions, the frequency of changes and waivers to the fiscal rule reaffirms our view that Panama's fiscal arrangements lack credibility and, consequently, fail to enhance policy predictability. Until the government establishes a track record of strict adherence to the terms of these fiscal controls, they will provide limited credit enhancement. Moreover, we do not expect the sovereign wealth fund to generate significant net savings.

Panama's high government financial strength incorporates moderate - but persistent - fiscal deficits, declining debt ratios, and a favorable government debt profile. As a result of strong economic growth, government debt to GDP fell from a peak of 66% of GDP in 2005 to roughly 41% in 2013, coming in line with the Baa median. The ratio of general government debt to revenues has been cut by almost half over the same period, dropping to 169% in 2013. Despite steady growth in a narrow tax base, the government accounts deteriorated steadily from a peak surplus of 3.4% of GDP in 2007 to a deficit of 3.0% in 2013.

Nevertheless, government deficits remain moderate compared to many of Panama's rating peers. Additionally, given the country's strong economic growth, we expect debt/GDP will continue to fall, albeit more gradually than in previous years. It is important to note that recent fiscal deterioration has largely been attributable to increased capital spending, which rose from 27% of total central government spending in 2009 to 39% in 2013 and should help pave the way for continued strong economic growth.

Panama's moderate susceptibility to event risk reflects the country's very high degree of economic openness; dependence on foreign financing revealed by current account deficits that have averaged nearly 10% of GDP over the past five years; relatively heavy reliance on a single asset (i.e., Panama Canal); and lack of a lender of last resort.

However, these potential risks are somewhat mitigated. Even though Panama's economic openness exposes it to external economic conditions, it has not been significantly affected by continued global economic weakness as reflected in its strong economic performance in recent years. Even during the height of the global financial crisis in 2009, the economy grew by nearly 4%. Possible concerns about the current account deficit are allayed by the high level of foreign direct investment the country receives. While the country's economic growth remains dependent upon continued high levels of external financing, dollarization eliminates the risk of a balance of payments crisis. However, the absence of monetary policy also limits the authorities' ability to respond to negative shocks and has prevented them from effectively addressing the expansionary effects of loose monetary policy in the US. As a result, Panama has faced greater risks of overheating than of a recession over the past several years. Despite this, fiscal policy has become increasingly expansionary.

Our assessment of political event risk reflects the country's political stability and policy predictability, notwithstanding the repeated waivers of and changes to the fiscal rule. There are important policy differences between the main political parties, but none of them espouse radical economic ideas. While the probability of a disruption to the Canal's operations is very low, the economic consequences of such an event could potentially be severe. Financial risk is low thanks to the government's favorable debt profile, which features an average maturity of roughly 13 years and the absence of exchange rate risk. While the banking system lacks a lender of last resort (another consequence of dollarization), this risk is mitigated by its strong liquidity and robust capital ratios.

Rating Outlook

Panama's stable outlook considers Moody's expectation that growth will remain solid if not quite as strong as it was from 2011-13, and that the pace of improvement of the government's debt metrics will slow unless the government demonstrates significantly greater fiscal discipline than it has done in recent years.

What Could Change the Rating - Up

The rating could face further upward pressure if the current infrastructure investments sustain the economy's growth momentum and the government reverses the recent deterioration in its fiscal performance.

What Could Change the Rating - Down

The rating could face downward pressure if the government's fiscal performance continues to deteriorate and the economy suffers a sharper than expected slowdown.

Recent Developments

Former Vice President Juan Carlos Varela, from the opposition Partido Panameñista (PP), won the presidential elections on May 4th with 39% of the vote and assumed office on July 1, 2014 for a five-year term. The opposition victory highlights the relative strength of functional democratic institutions in Panama. However, there is fairly significant risk of a gridlock since legislative elections, also on May 4th, resulted in a fragmented National Assembly. Out of the 71 seats in the unicameral legislature, the now-ruling PP won only 11 seats, while Cambio Democrático (CD) won 29 seats and the Partido Revolucionario Democrático (PRD) secured 21 seats. The new PP government now requires considerable political ability to form alliances in order to pass reforms and legislation.

In April, a national strike by construction workers demanding salary increases paralyzed the Panama Canal expansion project. Also, earlier this year a dispute between the Panama Canal Authority and the construction consortium temporarily halted progress on the expansion project, which is now slated to be complete by December 2015. Although work has since resumed, further delays in the expansion project cannot be ruled out, raising the possibility that the completion date could be pushed to 2016.

After growing at an average rate of nearly 11% in 2011 and 2012, Panama's economy showed signs of cooling off as GDP increased 8.4% in 2013. Going forward, we expect the economy will continue to slow down. Still, with GDP growth moving to 5.5% in 2014 and 6.2% in 2015, Panama's rates will remain the strongest in Latin America and among the highest globally.

Facing lower growth will pose important challenges to Panama's fiscal accounts, testing the authorities' ability to keep the fiscal deficit from widening further. As per the SFRL, the government deficit ceiling for 2014 was originally set at 2.7% of GDP. However, following the widening of the fiscal deficit to 3.2% of GDP during the first half of 2014, the government asked Congress to revise up the limit to 3.9% in October. Congress approved this request and added 0.2 percentage points to the ceiling (taking it to 4.1% of GDP) to account for additional spending of $95 million to pay for public works already contracted. An important challenge for the new administration will be to construct a track record of complying with the fiscal responsibility rule, which aims to halve the deficit to 2% of GDP by 2015. While it will be challenging to cut the fiscal deficit by 2.1%, potential congress gridlock hinders the government's ability to easily revise the fiscal deficit limit.

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