OREANDA-NEWS. Fitch Ratings has affirmed Andorra's Long-Term Issuer Default Rating (IDR) at 'BBB'. The Outlook is Stable. Fitch has also affirmed the Short - Term IDR at 'F3' and Country Ceiling at 'A-'.

KEY RATING DRIVERS

Andorra's 'BBB' IDR reflects the following key rating drivers:

Andorra is a small, wealthy and politically stable economy. Its ratings balance the principality's wealth, strong public finances and a flexible labour market against poor frequency and quality of data and risks associated with a large banking sector and heavy reliance on the performance of the banking and tourism sectors.

Andorra's bank resolution authority (AREB) successfully concluded the sale of the bridge bank 'Vall Banc' to JC Flowers, an American investment company, in July 2016. The bridge bank had been set up by AREB to receive customer accounts and assets that had proven legitimacy, with the intention of winding down the now defunct Andorran bank, BPA.

Vall Banc has since resumed normal business operations in euros and will service transactions in USD shortly. The bank is also fully compliant with its regulatory requirements, holding a liquidity ratio of 140% and capital adequacy ratio of 26% in mid-July. Deposit flight following its opening was limited to around EUR1m a day initially, and has since been offset by cash inflows.

The authorities are continuing to analyse customer accounts at the now defunct 'bad bank' BPA, with 93% of clients and 70% of funds and credits of cleared accounts already transferred to Vall Banc. In April 2016, AREB applied a bail-in affecting holders of hybrid instruments with EUR64m of preferred shares used to absorb losses at BPA. Subordinated issues were unaffected, but most of the major shareholders, senior managers and related parties of major shareholders have been included in the bail-in exercise.

Following the bail-in exercise for BPA, AREB subscribed to EUR60,000 in capital, becoming the sole shareholder of BPA, and leaving BPA with a negative net worth of EUR32m, which should be offset by the recovery value of BPA's assets. The BPA crisis was triggered when US government agency FinCEN identified BPA for alleged money-laundering activities in March 2015, leading to the Andorran authorities intervening swiftly to resolve the bank. In February 2016 FinCEN announced it would not be taking further action relating to BPA's case, which Fitch interprets to mean no financial penalties will be levied by the US agency.

The BPA crisis has had a limited impact on the viability of the three largest Andorran banks. Total deposits and assets under management contracted slightly immediately after the crisis but have both grown by 2.9% yoy in 2015 (including transfer of accounts and funds from BPA and Vall Banc). Andorran banks have begun the first of eight annual payments (1% of total deposits) to contribute to the resolution fund. Banks are additionally required to ring-fence 1% of deposits in highly liquid assets to contribute towards Andorra's deposit protection scheme.

The general government budget balance has improved in recent years following the government's comprehensive tax reforms in 2011-2015. The general government surpluses (1.8% of GDP in 2015) are driven by large social security surpluses, with significant dividend revenue from state-owned utility monopolies contributing to the narrowing of the central government deficit. Poorer macroeconomic performance for 2015 resulted in lower-than - expected indirect tax collection, but was offset by better-than-expected collection from a new income tax and an increase in SOE dividend revenues to EUR23.5m in 2015 (0.9% of GDP) from EUR10.2m in 2014.

We forecast public debt/GDP at end-2016 to be moderate at 40.8% and consistent with the 'BBB' median. Liquid assets amounting to 45.5% of GDP at end-2015 and accruing to the social security and pension reserves mitigate public finance sustainability risks, but are ring-fenced from financing the central government deficit. Fitch forecasts public debt/GDP to peak in 2016, before falling slightly to 39.6% in 2018.

Contingent liabilities for the government are significant due to the size of the banking sector relative to the economy (total banking assets were about 7x GDP in 2015), and are concentrated in three domestic banks and two foreign-owned banks. The average Viability Rating of the Fitch-rated Andorran banks is 'bbb', with the lack of a credible lender-of-last-resort increasing banking sector risks.

In the event of a systemic banking crisis, Fitch would expect significant banking sector contingent liabilities to materialise on the sovereign's balance sheet. The economy could also be dragged into recession in such a scenario. The government also faces an outstanding lawsuit brought by BPA's former owners. Possible financial damages could amount up to EUR360m (14.2% of GDP) if the government loses the case and could add to the government's debt/GDP.

The impact of the BPA crisis resulted in real GDP growth slowing to 0.8% in 2015 (2014: 2.3%). The slowdown was most pronounced in the industrial sector (-10.5%), agriculture (-4.9%) and financial services (-3.5%), following an average growth rate of financial services of 10% yoy in 2012-14. In contrast, real estate and tourism were the main drivers of growth in 2015. Fitch expects a broad-based recovery for 2016, with real GDP growth accelerating to 1.3%.

SOVEREIGN RATING MODEL (SRM) and QUALITATIVE OVERLAY (QO)

Fitch's proprietary SRM assigns Andorra a score equivalent to a rating of 'A-' on the Long-Term IDR scale.

Fitch's sovereign rating committee adjusted the output from the SRM to arrive at the final Long-Term IDR by applying its QO, relative to rated peers, as follows:

- Macroeconomic factors: -1 notch, to reflect weak policy coherence stemming from Andorra's euro-ised economy and lack of a lender-of-last-resort in the context of a large banking sector. Low frequency and poorer quality of macroeconomic data relative to peers also weigh on the macro factors.

- Structural factors: -1 notch, to reflect the large banking system and bank regulatory framework that is weaker than the EU and rated peers, which expose the economy to risks of a bank crisis, skewing the distribution of risks to the downside.

Fitch's SRM is the agency's proprietary multiple regression rating model that employs 18 variables based on three year-centred averages, including one year of forecasts, to produce a score equivalent to a LT IDR. Fitch's QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable or not fully reflected in the SRM.

RATING SENSITIVITIES

The Stable Outlook reflects Fitch's assessment that upside and downside risks to the rating are currently balanced.

The main factors that may individually or collectively lead to a negative rating action are:

-Worsening creditworthiness of the three large Andorran banks, increasing the risk of contingent liabilities crystallising on the sovereign's balance sheet or a large adverse impact on the real economy.

-A sharp deterioration in economic growth, particularly if it leads to an increase in government debt/GDP.

The main factors that may individual or collectively lead to a positive rating action are:

-Successful economic diversification of the economy away from reliance on tourism and financial services, which would provide the economy with greater buffers against shocks to these industries.

-Increased foreign ownership of the Andorran banks would diversify the sources of support capital available to the banks, reducing the risk of banking contingent liabilities materialising on the sovereign balance sheet.

-Improvement to data reporting in terms of frequency and availability, showing a stronger position than is currently assumed.

KEY ASSUMPTIONS

Fitch has not included the potential cost of financial damages from the lawsuit brought by BPA's former owners against the government in the general government's debt/GDP forecasts.