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Rating action

Scope Ratings GmbH (Scope) has today assigned Serbia first-time long-term foreign- and local-currency issuer and senior unsecured debt ratings of BB+ with Stable Outlooks. Scope has also assigned short-term issuer ratings of S-3 in foreign- and local-currency with Stable Outlooks.

Summary and Outlook

Serbia’s BB+ rating is supported by its economic resilience and solid medium-term growth prospects, underpinned by its credible macroeconomic policy framework and a steady inflow of net foreign direct investment (FDI). In addition, Serbia’s rating benefits from its moderate public debt, supported by prudent fiscal policy and the continuation of reforms to enhance the fiscal framework.

However, the Russia-Ukraine war is exerting downward pressure on Serbia’s small, open economy via higher inflationary pressures, lower business and consumer confidence, and foreign trade and supply chain disruptions – all of which pose downside risks to the near-term growth.

In addition, the BB+ rating is constrained by persistent wide current account deficits, a high degree of banking sector euroization, a large share of public debt denominated in foreign currency (euros and dollars) and institutional weaknesses.

The Stable Outlook reflects Scope’s view that the Serbian economy will be able to weather the near-term economic fallout from the Russia-Ukraine war without any substantial deterioration in credit fundamentals.

The rating/Outlook could be downgraded if, individually or collectively: i) Scope observed a steady increase in public debt-to-GDP over the medium term, as a result, for instance, of looser fiscal policies, weaker growth prospects and a currency deprecation; ii) Serbia’s external vulnerabilities increased, due, for instance, to worsening market conditions or a widening of imbalances, putting pressure on forex reserves and leading to a further build-up of external debt; and/or iii) an external shock or heightened and sustained geopolitical risks undermined Serbia’s macro-financial stability.

Conversely, the rating/Outlook could be upgraded if, individually or collectively: i) public debt-to-GDP were set on a firm downward path over the medium term, supported by fiscal consolidation; ii) medium-run growth prospects improved due to structural reform; iii) external vulnerabilities were curtailed, such as via a reduced share of public and private debt in foreign currency, a sustained reduction in net external debt and a further build-up of foreign-exchange reserves; and/or iv) Serbia’s institutional weaknesses were redressed more durably, such as via tangible progress in the longer-run accession to the EU.

Rating rationale

The first driver of the BB+ rating relates to Serbia’s economic resilience and solid medium-term growth prospects.

Serbia achieved a pre-pandemic level of output much faster than most of its sovereign peers. The economy recovered strongly from the pandemic crisis, growing 7.4% in 2021 – driven by a recovery in industrial production, construction and the services sector – which followed a mild contraction of 0.9% in 2020. Real GDP growth in Q1 2022, estimated¹ at 4.2% YoY, was only slightly below pre-war expectations. Scope forecasts that Serbia will grow by 3% in 2022 before stabilising at 4% in 2023, broadly in line with the economy’s growth potential of 4%-4.5% over the medium term, underpinned by planned infrastructure investment projects and steady FDI inflows.

The improved macroeconomic profile includes a relatively stable exchange rate, adequate forex reserves and pre-crisis low and stable inflation. The National Bank of Serbia (NBS)’s gross forex reserves stand at EUR 14.1bn at end-April, albeit down from EUR 16.5bn at end-2021, mainly due to forex sales totalling EUR 155m in April and EUR 2.27bn net in the four months of 2022² to maintain the dinar’s stability. The level of NBS forex reserves, nonetheless, covers five months’ worth of Serbia’s import of goods and services and around two times its short-term external debt, which are well above IMF adequacy thresholds of 100% of short-term debt or the equivalent of three months’ worth of imports.

At the same time, the war in Ukraine represents a substantial exogenous shock to Serbia’s small, open economy, disrupting supply chains, raising near-term inflationary pressures and adversely affecting investor and consumer confidence. Headline inflation surged to 9.6% YoY in April 2022, the fastest rise in almost nine years and well above the NBS target of 3% (±1.5%). However, core inflation remained markedly below headline inflation, at 5.5% YoY in April³. Scope forecasts average yearly headline inflation close to the double-digit mark in 2022, at 9%. The Russia-Ukraine war is adding to strong inflationary pressures in the short term due to higher prices for energy, commodities and food. To curb inflation and anchor medium-run inflation expectations, the NBS has started tightening its policy – hiking up the key rate twice by 50bps, to 1.5% in April and to 2% in May. Inflation levels are projected to normalize towards the NBS’ tolerance band of 4.5% in 2023, without negative repercussions for the country's credit fundamentals.

Looking at external factors, headline trade exposures to Russia and Ukraine are material but not extensive. Russia accounts for less than 4% of Serbia’s total goods exports and slightly more than 5% of its goods imports with almost half being oil and gas imports. Ukraine makes up less than 1% of exports and imports of goods.

Scope does not expect any major disruptions of Russian gas supply to Serbia via the pipeline on Bulgarian territory. However, an EU embargo on Russian oil and gas could have negative implications for Serbia, as these commodities are supplied to Serbia through EU countries, including Bulgaria, Croatia and Hungary. Serbia imports almost 90% of its gas and 60% of its oil from Russia. More recently, Serbia agreed a new three-year natural gas supply deal with Russia.

The second driver underpinning the BB+ rating is Serbia’s moderate public debt, anchored by fiscal prudence.

Scope expects the Serbian government to remain committed to fiscal discipline despite increasing budgetary pressures stemming from the near-term growth slowdown as well as the need for fiscal support to households and businesses to tackle inflation, including via a temporary 20% cut to the excise on petroleum products. The general government deficit is forecast to reach 3.5% of GDP this year, mostly unchanged compared to 2021. Scope incorporates revenue and expenditure-side inflation relief measures of 1pp of GDP in its 2022 projections. The deficit is projected to narrow to 2% of GDP in 2023 and 1.5% of GDP by 2024, assuming a phasing out of support measures from 2022 and a convergence of real GDP growth with its medium-run potential.

Based on an expected gradual reduction in the medium-run budget deficit, Scope projects that general government debt will stabilise at 57% of GDP in 2022 and decline to 55% of GDP by 2023.

The credibility of the government’s medium-run fiscal consolidation agenda is supported by its good pre-crisis track record of fiscal prudence and an ongoing engagement with the IMF. Serbia agreed an unfunded 30-month Policy Coordination Instrument with the IMF in June 2021⁴, which provides an anchor to the medium-term fiscal policy framework. Serbia is developing a new fiscal rules framework in consultation with the IMF, planned to become effective with the 2023 budget. The new system will stipulate a lower ceiling for the budget deficit and define key elements, such as debt thresholds, escape clauses and correction mechanisms.

Debt affordability has also improved in the pre-crisis period due to more favourable market conditions and a strengthened debt management. Net interest payments relative to general government revenue are estimated at 4.5% this year, down from 7.1% in 2016. After developing the necessary legal framework⁵, Serbia issued its debut green Eurobond of EUR 1bn in September 2021, with a maturity of seven years and a coupon rate of 1.00%, the lowest to date. The bond attracted investor demand exceeding EUR 3bn. The upcoming access to Euroclear⁶ settlement in 2022 will further support the market conditions for Serbia’s debt.

Despite these credit strengths, Serbia’s rating remains constrained by several credit challenges.

Firstly, Serbia’s small, open economy is vulnerable to external shocks and is reliant upon external financing. Scope expects Serbia’s current account deficit to widen to 6% of GDP this year, from 4.4% of GDP in 2021, mainly due to the impact of increasing commodity prices. The agency’s projection of a medium-run current account deficit at around 5% of GDP reflects the high investment needs of a developing economy with relatively low domestic savings and a structural goods-trade deficit. At the same time, we do not expect major risks on the financing side, as net inflows of FDI are projected to finance current account deficits in the next few years. Since 2015, net FDI inflows have exceeded the current account deficit, reaching EUR 3.6bn (6.8% of GDP) in 2021. Over 2019-2021, most FDI inflows came from EU countries (57%), while China increased its share to 15%.

Persistent wide current account deficits have led to a sizeable net external liability position (negative net international investment position), which equalled 83.9% of GDP at end-2021, significantly below the average for sovereign peers. Around 60% of total liabilities relate to inward FDI, which decreases the risk of money flight during times of global market distress.

Secondly, a high foreign-currency share of public and private debt constitutes a risk for financial stability. Around 74% of general government debt was in foreign currency at the end of March, of which 58% was in euros and 11% in dollars⁷. This makes debt and interest vulnerable to exchange-rate volatility. The risk is mitigated by a track record of a relatively stable exchange rate. In addition, a large share of fixed-rate debt (84%), relatively long maturities (around 80% of RSD government securities have a maturity of five years and over), and a high share of multilateral and institutional debt holders (around 45% of government external debt) represent important mitigating factors.

The euroisation of deposits and loans remains high at almost 60% of the total. At the same time, Serbia’s mostly foreign-owned banking sector presents low contingent liability risk to the sovereign balance sheet, also considering the recent acquisition of the largest state-owned bank Komercijalna Banka by Slovenia's NLB Group. The banking sector remains well capitalised and liquid with a system-wide Tier 1 capital of 19.7% of risk-weighted assets and a loan-to-deposit ratio of 85% at end-2021. The non-performing loan ratio fell to 3.5% at end-February, from 3.7% at end-2020 (and from a peak of 21.6% at end-2015), driven by the successful implementation of non-performing loan resolution activities.

Finally, Scope expects economic and foreign policy continuity following the victory of President Vucic and his SNS party in April's presidential and parliamentary elections. Serbia’s proposed new fiscal rules and IMF policy support demonstrate a commitment to balancing fiscal discipline and growth while anchoring medium-term fiscal expectations. However, Scope expects only gradual progress on other major structural reforms, including of public administration, state-owned enterprises (SOEs) and the reduction of long-standing public sector inefficiencies. Although the debt of SOEs has been incorporated in general government debt, which lowers additional contingent liabilities, financial support to the large and inefficient SOE sector is likely to continue and affect public finances as restructuring is progressing slowly.

In Scope’s view, a broader normalisation of relations between Serbia and Kosovo and substantial reform around the rule of law, the most crucial preconditions for Serbia's EU accession, are likely to remain a longer-term challenge. Scope therefore expects the accession target date of 2025 to be delayed considerably.

Core Variable Scorecard (CVS) and Qualitative Scorecard (QS)

Scope’s Core Variable Scorecard (CVS), which is based on the relative rankings of key sovereign credit fundamentals, provides a first indicative rating of ‘bbb-’ for Serbia. Serbia receives no positive adjustment for reserve currency considerations. As such, the ‘bbb-’ indicative rating can be adjusted by the Qualitative Scorecard (QS) by up to three notches depending on the size of relative qualitative credit strengths or weaknesses compared to a peer group of countries.

For Serbia, no relative credit strengths are signalled under the QS. The following relative QS credit weaknesses are indicated: i) current account resilience; ii) financial imbalances; iii) institutional and political risks; and iv) environmental risks.

Combined relative credit strengths and weaknesses generate a one-notch downward adjustment and indicate BB+ long-term rating for Serbia.

A rating committee has discussed and confirmed these results.

Factoring of Environment, Social and Governance (ESG)

Scope explicitly factors in ESG sustainability issues during the ratings process via the sovereign methodology’s stand-alone ESG sovereign risk pillar, with a 20% weighting in the quantitative model (CVS). Under governance-related factors, Serbia scores weakly according to the World Bank’s Worldwide Governance Indicators. Here, it lags behind the scores of sovereign peers – with performance on voice and accountability, control of corruption and political stability having declined over the past five years. Furthermore, in the QS complementary governance assessment, Scope evaluates ‘institutional and political risk’ as ‘weak’ compared with that of Serbia’s sovereign peer group. This is based on limited progress on the rule of law and the absence of tangible progress towards a sustainable settlement with Kosovo.

Socially related factors are captured under the sovereign methodology in the CVS by accounting for the economy’s average rate of labour force participation as well as the average level of income inequality (captured via the ratio for the income share of the 20% of persons with the highest incomes to the 20% of persons with the lowest incomes) compared to that of sovereign peers. Serbia’s longer-term labour market growth is hindered by demographic trends, reflecting an ageing population and emigration, which constrain the labour supply. The old-age dependency ratio (those aged 65 years or over as a percentage of those aged 15-64) increased to 33% in 2020, from 29% in 2016. At the same time, there has been some improvement in migration flows, which is attributable to the immigration of highly skilled workers and foreign students more recently.

Environmental factors are explicitly considered in the ratings process via an environment sub-category of the ESG risk pillar. Serbia opened the ‘Green Agenda and Sustainable Connectivity’ cluster in accession talks with the EU in December 2021, which is related to transport, energy, trans-European networks, environmental protection and climate change. Serbia will use the receipts from the EUR 1bn green Eurobond to finance projects from its environmental and climate agenda, including the construction of water plants, flood protection, waste management, recycling infrastructure, subways and energy efficiency. At the same time, Serbia has a high energy intensity, nearly four times the EU average. Electricity production in the country relies heavily on coal (around two-thirds of electricity generated in 2021 came from lignite coal), which is a challenge given the priority of significantly reducing emissions. Despite strong growth in wind power in recent years, it accounted for only 2.6% of electricity generated in 2021.

Rating committee
The main points discussed by the rating committee were: i) Serbia’s growth outlook, exposure to the Russia-Ukraine war; ii) fiscal dynamics and debt sustainability; iii) labour market and demographics; iv) external sector developments; v) financial sector developments; vi) ESG; and vii) peers.

Rating driver references
1. Statistical Office of the Republic of Serbia
2. National Bank of Serbia
3. National Bank of Serbia
4. International Monetary Fund (IMF)
5. Ministry of Finance of the Republic of Serbia
6. Euroclear
7. Ministry of Finance of the Republic of Serbia, Public Debt Administration

Methodology
The methodology used for these Credit Ratings and/or Outlooks, (Rating Methodology: Sovereign Ratings, 8 October 2021), is available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
Information on the meaning of each Credit Rating category, including definitions of default, recoveries, Outlooks and Under Review, can be viewed in ‘Rating Definitions – Credit Ratings, Ancillary and Other Services’, published on https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://scoperatings.com/governance-and-policies/regulatory/eu-regulation. Also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA): http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope Ratings’ definitions of default and Credit Rating notations can be found at https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Guidance and information on how environmental, social or governance factors (ESG factors) are incorporated into the Credit Rating can be found in the respective sections of the methodologies or guidance documents provided on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
The Outlook indicates the most likely direction of the Credit Ratings if the Credit Ratings were to change within the next 12 to 18 months.

Solicitation, key sources and quality of information
The Credit Ratings were not requested by the Rated Entity or its Related Third Parties. The Credit Rating process was conducted:
With Rated Entity or Related Third Party Participation  NO
With Access to Internal Documents                               NO
With Access to Management                                         NO
The following material sources of information were used to prepare the Credit Ratings: public domain.
Scope Ratings considers the quality of information available to Scope Ratings on the Rated Entity or instrument to be satisfactory. The information and data supporting these Credit Ratings originate from sources Scope Ratings considers to be reliable and accurate. Scope Ratings does not, however, independently verify the reliability and accuracy of the information and data.
Prior to the issuance of the Credit Rating action, the Rated Entity was given the opportunity to review the Credit Ratings and/or Outlooks and the principal grounds on which the Credit Ratings and/or Outlooks are based. Following that review, the Credit Ratings were not amended before being issued.

Regulatory disclosures
These Credit Ratings and/or Outlooks are issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0. The Credit Ratings and/or Outlooks are UK-endorsed.
Lead analyst: Levon Kameryan, Associate Director
Person responsible for approval of the Credit Ratings: Giacomo Barisone, Managing Director
The Credit Ratings/Outlooks were first released by Scope Ratings on 3 June 2022.

Potential conflicts
See www.scoperatings.com under Governance & Policies/EU Regulation/Disclosures for a list of potential conflicts of interest related to the issuance of Credit Ratings.

Conditions of use / exclusion of liability
© 2022 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings GmbH, Scope Ratings UK Limited, Scope Analysis GmbH, Scope Investor Services GmbH, and Scope ESG Analysis GmbH (collectively, Scope). All rights reserved. The information and data supporting Scope’s ratings, rating reports, rating opinions and related research and credit opinions originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data. Scope’s ratings, rating reports, rating opinions, or related research and credit opinions are provided ‘as is’ without any representation or warranty of any kind. In no circumstance shall Scope or its directors, officers, employees and other representatives be liable to any party for any direct, indirect, incidental or other damages, expenses of any kind, or losses arising from any use of Scope’s ratings, rating reports, rating opinions, related research or credit opinions. Ratings and other related credit opinions issued by Scope are, and have to be viewed by any party as, opinions on relative credit risk and not a statement of fact or recommendation to purchase, hold or sell securities. Past performance does not necessarily predict future results. Any report issued by Scope is not a prospectus or similar document related to a debt security or issuing entity. Scope issues credit ratings and related research and opinions with the understanding and expectation that parties using them will assess independently the suitability of each security for investment or transaction purposes. Scope’s credit ratings address relative credit risk, they do not address other risks such as market, liquidity, legal, or volatility. The information and data included herein is protected by copyright and other laws. To reproduce, transmit, transfer, disseminate, translate, resell, or store for subsequent use for any such purpose the information and data contained herein, contact Scope Ratings GmbH at Lennéstraße 5, D-10785 Berlin.