OREANDA-NEWS. Fitch Ratings has affirmed Cabo Verde's Long-term foreign and local currency Issuer Default Ratings (IDR) at 'B' with Stable Outlooks. The Short-term rating has been affirmed at 'B' and the Country Ceiling at 'B+'.

KEY RATING DRIVERS
Cabo Verde's ratings are supported by well-functioning domestic institutions and good governance. Sustained implementation of the government's current Growth and Poverty Reduction Strategy (GPRSP III) is intended to help Cabo Verde foster private sector development by addressing the country's critical infrastructure needs, albeit at the cost of weak and deteriorating public finances. However, the ultimate impact of the public investment programme (PIP) on growth remains uncertain.

The affirmation and Stable Outlook also reflect the following factors:
Economic prospects are linked to the eurozone and improving economic conditions in the single currency area into 2015 should support Cabo Verde's key tourism industry and also boost remittances and foreign direct investment (FDI). High frequency economic data suggest GDP growth improved in 2014 to around 1.5% (Fitch estimate) from a four-year low of 0.5% in 2013. Tourism declined, with the negative impact from the outbreak of Ebola in some countries felt mostly in 3Q14, though visitor numbers have started picking up in recent months. FDI and remittances rebounded last year supporting growth. The effect of the volcanic eruption in the island of Fogo and the recent drought has so far been limited. Growth will accelerate further but is expected to remain well below the average 7% achieved in the 10 years to 2008. Fitch expects growth to average 4% over the next 10 years.

The lack of up-to-date national accounts data makes it difficult to assess current GDP growth rates, and also makes assessing Cape Verde's medium-term growth potential challenging. GDP data for 2013 and 2014 are still not available.

The recovery should support a pick-up in inflation. Prices grew by 0.1%y/y in January after falling for the previous nine months. The weak inflationary environment reflects a combination of lower global commodity prices, soft domestic demand and lower imported inflation from the eurozone. There are no signs of deflation, such as delayed consumer spending or expected future price declines. Prices will rise gradually as the main drags unwind through 2015. Monetary policy has become more accommodative in recent months with further rate cuts and lower minimum reserve requirements for banks but the monetary transmission mechanism remains weak with credit stagnant and high bank lending rates to firms.

Fiscal consolidation remains the government's medium-term objective, but Fitch expects the debt burden to continue to rise over the next two years. Active reforms, including improvements to tax administration have been made to expand the sovereign's tax base. The government's consolidation strategy also assumes the gradual reduction of investment programmes. However, the effective consolidation of government expenditure is constrained by a high share of mandatory spending.

Budget targets have slipped and data is published with a lag and is often revised. The government expects the fiscal deficit to be around 9% of GDP in 2014, which is 1ppt higher than budgeted and broadly unchanged from 2013. Revenues particularly underperformed expectations on lower growth and inflation, tax arrears and structural weakness in tax collecting. The government maintains its ambitious commitments under the 2015 budget to lower the deficit to 7.3% in 2015 and to 3.4% in 2018. Fitch's projections remain broadly unchanged from its previous ratings review and envisage slippage from official targets into the medium term. The agency expects the fiscal deficit to average 7.9% between 2014 and 2018. This reflects several factors: past fiscal slippages (as reflected by larger deficits in 2013 and 2014 than originally budgeted), weaker than expected official growth, lower future external budget support from international donors, and continuation of PIP.

Even under official government forecasts, public debt to GDP (GGGD) is expected to peak at 114% of GDP in 2016, more than double the 'B' median of 47%. The debt ratio has already increased by 50ppt from 2008 to the official estimate of 107% in 2014 due to large fiscal deficits and weak economic growth. The depreciation of the euro also contributed to some increase in the nominal value of debt last year. With 29% of the debt stock denominated in foreign currency (other than the euro) public finances will remain vulnerable to exchange rate risk. Fitch expects the debt ratio will be higher than official forecasts on less optimistic growth projections and wider budget deficits.

The underlying state of the sovereign's external finances is weak and will likely worsen, increasing the vulnerability of the economy to external shocks, although this risk is mitigated by the concessional and long-term nature of external borrowing. Net external debt is significantly higher than both the 'B' and 'BB' rating medians. Nevertheless, the recent increase in foreign exchange reserves to over five months of imports should help offset some of the risks from rising external debt, at least in the near term.

Cabo Verde's external debt servicing cost is significantly below rating peers. As a share of foreign exchange receipts, we forecast it represents 4% for 2014, which compares with 9.8% for the 'B' median and 10.1% for the 'BB' median. This reflects the high proportion of concessional debt. The average maturity of the government's debt stock is more than 20 years and the average interest rate is low.

RATING SENSITIVITIES
The Stable Outlook reflects Fitch's assessment that upside and downside risks to the rating are currently balanced. The main risk factors that, individually or collectively, could trigger negative rating action are:
- Public finances materially worse than expected under the Fitch baseline projections.
- Weaker than expected medium-term growth potential that adds to pressure on the government debt-to GDP ratio. This includes the failure of the capital investment programme to improve infrastructure to support faster sustained medium-term growth.
- Evidence of reluctance from donors to extend further credit to Cabo Verde, in light of the worsening debt dynamics.

The main factors that, individually or collectively, could lead to positive rating action are:
- Evidence of public investment projects translating into higher economic growth and broad development of private sector activity which boosts confidence in medium-term growth prospects.

- Materially better than expected fiscal performance that provides greater confidence in delivering a sustained downward trajectory in the public debt-to-GDP ratio in the medium term.

KEY ASSUMPTIONS
Fitch assumes that the sovereign's public investment projects will continue so long as concessional financing is available, although we expect concessional financing to Cabo Verde to gradually reduce over time.

Fitch assumes the currency peg to the euro and support for the system from the Portuguese government will continue.

Due to a degree of dependency on eurozone developments, Fitch's macroeconomic forecasts for Cabo Verde are premised on the eurozone recovery staying on track. The recent depreciation of the euro will also increase the value of debt in 2015.