Publish in Perspectives - Monday, June 27, 2016
The COSCO Shipping Panama inaugurates the expanded Panama Canal on June 26, 2016. (Photo: Panama Canal Authority/ACP)
The Panama Canal expansion will boost GDP growth and sovereign rating, Fitch says.
The Panama Canal is at the center of Panama’s successful economy, underpinning its sustained growth outperformance and the ‘BBB’ sovereign rating. This strategic global asset has been successfully leveraged alongside business-friendly policies to position the country as a diversified logistics hub for the Americas. The Canal’s recently completed expansion provides an opportunity for the sovereign to bolster its credit strengths and improve other metrics.
Panama has transformed the Canal into a valuable for-profit entity since taking control of the waterway from the US in 2000. Under the management of the Panama Canal Authority (ACP), tolls have been gradually raised but global market share preserved, lifting tonnage volumes by 50 percent since 2000 but revenues by 240 percent. The Canal accounted for 4 percent of nominal GDP in 2015, but its significance is larger considering its spillovers into the broader Canal “cluster” (25 percent of GDP including ports, other logistics activities, and the Colón Free Trade Zone), contribution to public spending (10 percent of fiscal revenues), and the employment and tourism it supports.
With Canal traffic nearing capacity by the mid-2000s, and economies of scale incentivizing the use of larger vessels too big to use the Canal, the ACP embarked upon a major expansion project following a popular referendum in 2006. The $5.3 billion project has created a third set of locks to accommodate much larger ships, which doubles the Canal’s capacity and could lead to a 50 percent increase in tonnage by 2025, according to ACP projections. The expansion also coincides with a new toll system that seeks to tie the price more closely to value of the cargo (rather than ship capacity), and introduces an incentives program for carrier loyalty.
UNDERPINNING ROBUST POTENTIAL GROWTH
The Canal expansion will affect economic growth in Panama through direct and indirect channels. The projected 50 percent increase in tonnage by 2025 (from 340 million tons/year to 510 million) will provide a direct boost to real GDP growth rates over this period. ACP projections indicate this impact could be gradual as global carriers and ports adapt to the widened route, although it could be more concentrated in the coming years. Greater Canal volumes will be offset to some degree by the reduced construction activity that completion of the expansion project entails.
A larger impact could come from the spillovers the expansion will have in the broader Canal cluster of logistics, maritime and commerce service activities, although these are hard to quantify. Panama’s port infrastructure is undergoing significant investment alongside the Canal expansion, and plans to concession the major new Corozal port on the Pacific have recently moved forward. The ACP also has plans for investments in other ports, shipyards, a logistics park, and an LNG terminal. The large public works program includes investments in roads and bridges to integrate these facilities.
Panama’s open, service-based economy is sensitive to shifts in global demand and trade flows, and the Canal expansion could reinforce this exposure. Global trade volumes have ebbed in the past year on a mix of structural and cyclical factors including weakness in key economies, reduced US energy dependence, and Chinese manufacturers’ lower reliance on imported components. Canal activity has been relatively resilient against this backdrop so far, however, on firmer US demand and advantages in growing trade segments (propane, grains).
The expanded Canal may also be able to buck the broader trend of ebbing global trade flows due to its competitive advantage in liquefied natural gas (LNG), a trade segment poised for strong growth. The expanded Canal will be able to accommodate the large tankers needed to transport LNG, and the route will offer major savings in terms of cost and duration for shipments along the key US-to-Asia route expected to experience the greatest growth.
Fitch currently projects that Panama’s economic growth will rise to 6.5 percent in 2018, from 5.5 percent in 2016. This assumes a boost from greater Canal activity and related spillovers, and an offsetting reduction in construction activity. However, the key driver of the higher headline growth rate is the Cobre Panama copper mine project, which is an even larger investment than the Canal expansion at USD6.4bn and is slated to significantly lift exports once finished in 2018.
Real GDP growth is expected to average over 6 percent in 2016-2018, more than twice the ‘BBB’ median of 2.8 percent. This continues a longstanding trend of economic outperformance relative to peers, which (along with currency depreciations elsewhere) has led to a substantial divergence in per-capita income above the ‘BBB’ median. Panama’s level of income inequality has moderated somewhat but remains high relative to ‘BBB’ peers, however, and further progress in this area would support more robust improvement in the structural credit profile.
EXTERNAL ADJUSTMENT UNDERWAY AS EXPANSION FINISHES
Panama’s current account deficit averaging 10 percent of GDP in 2010-2015 is the highest among ‘BBB’ sovereigns. This has reflected a robust domestic investment cycle largely financed externally, capturing much more than the Canal expansion project. Most external financing has come in the form of foreign direct investment (FDI), which has also been the highest in the ‘BBB’ category. The current account deficit also moderated significantly to 6.5 percent of GDP in 2015 on moderation in public works projects and the decline in oil prices.
The completion of the Canal expansion should further reduce Panama’s current account deficit and bolster its external position. The expansion project explains some of the rise in capital imports in 2010-2014, and completion of the project will ease pressure on imports. Higher toll revenues from greater Canal tonnage will also boost service export receipts, and they represented 5 percent of GDP and 8 percent of current external receipts in 2015.
Fitch projects this boost from the Canal will contribute to a moderation in the current account deficit to around 5 percent by 2018. This still high level in relation to ‘BBB’ peers reflects a domestic investment cycle that remains robust, driven by projects in public works (for example the second line of the Panama City metro), electricity generation, and the Cobre Panama copper mine project. Fitch expects that it could be more than fully financed by FDI, as in 2015.
External indebtedness related to the Canal expansion is also relatively moderate, including $2.3 billion borrowed from multilateral banks and $450 million via a bond issuance in 2015 to finance completion of a third bridge over the Canal. This represents 8 percent of external debt (excluding the external liabilities of Panama’s international banking sector). Panama’s net external debt around 20 percent of GDP remains above the ‘BBB’ median of 4 percent, mostly reflecting the sovereign’s net external debtor position given limited local financing options and lack of traditional foreign exchange reserve holdings (due to dollarization). Fitch expects the net external debt ratio to moderate in the coming years on the lower current account deficit
A FISCAL WINDFALL, BUT NOT AS ORIGINALLY EXPECTED
The Canal contributes revenues to the Panamanian government via toll fees and an annual dividend payment. In 2015, these fiscal contributions totaled $1.1 billion (2 percent of GDP). The latest forecasts from the ACP indicate that fiscal transfers will reach $1.8 billion (2.7 percent of GDP) in 2018, dip slightly in 2019 as repayments begin on the multilateral loans taken out to finance the expansion, and rise to $2.9 billion by 2025 (3 percent of projected GDP).
These projections are significantly lower than those made in the 2006 Master Plan of the Canal expansion, however. At that time, fiscal contributions were forecast to reach $4.3 billion by 2025 (over 4 percent of GDP). The downward revision mainly reflects the 18-month delay in the opening of the Canal, which pushes back the ramp-up period for traffic and revenues.
The lower-than-expected fiscal windfall in percent-of-GDP terms has important implications for Panama’s fiscal framework. Changes made to the fiscal law (LRSF) in 2012 aimed to facilitate prudent management of the Canal windfall by requiring saving of proceeds in excess of a threshold of 3.5 percent of GDP deemed justified for spending purposes into a sovereign wealth fund (FAP2). It now appears unlikely that Canal transfers will reach this threshold, however, due to the downward revisions in Canal transfer projections in USD terms, higher-than-expected nominal GDP growth, and methodological revisions to the national accounts series. The FAP will not accumulate additional funds under this set-up, limiting future gains in fiscal flexibility.
Furthermore, if Canal transfers fall below 3.5 percent of GDP, the amended fiscal rules allow the government to make up the shortfall through additional borrowing, on top of the amount already authorized under the deficit ceiling. With Canal transfers now projected to fall short of 3.5 percent of GDP going forward, effective deficits could systematically exceed the ceilings, as the deficits “adjusted” for the shortfall remain in technical compliance. The authorities have acknowledged this shortcoming in the fiscal framework, but no reform appears forthcoming.
Although not as large as originally expected, the Canal windfall still presents important benefits for public finances. Because the current fiscal framework is centered on the “adjusted” deficit net of Canal transfers, it requires the revenue windfall to support consolidation instead of spending. Furthermore, gradual reductions in the legal ceilings (from 2 percent in 2015 to 0.5 percent by 2018, applicable to the “adjusted” deficit) will require additional consolidation efforts on top of this revenue boost. Fitch projects that the revenue boost and underlying consolidation will lower the non-financial public sector deficit to 1.3 percent of GDP by 2018, from 2.3 percent in 2015.
Fitch projects that the gradual reduction in the fiscal deficit could stabilize general government debt around 39 percent of GDP in 2016 and gradually reduce it thereafter. This could bolster public finances, as Panama’s general government debt level is already slightly below the ‘BBB’ median of 41 percent. The main risk to debt dynamics would be an unexpected deceleration in growth, which could hinder fiscal consolidation. General government liquid assets, including 2.3 percent of GDP already in the FAP, are relatively high for a non-commodity exporter.
Fitch assumes the administration will stay committed to the legal deficit ceilings given its efforts to improve fiscal credibility. It complied with the ceiling in 2015, undertook large capital spending cuts after taking office in mid-2014 to lower the deficit (but not enough to avoid lifting the ceiling), and is exploring ways of restraining high current spending growth. However, high social demands and an actuarial deficit in the social security system (CSS) could create pressure to spend the Canal windfall instead of save it. In 2015, President Varela publicly stated that higher Canal revenues could possibly be used to support the social security system.
AN OPPORTUNITY TO IMPROVE CREDIT FUNDAMENTALS
Fitch upgraded Panama’s Foreign-Currency IDR to ‘BBB’ in June 2011, and affirmed this rating with a Stable Outlook in February 2016. Driving the 2011 upgrade and supporting the rating since then has been Panama’s robust macroeconomic performance and rising per-capita income, and Fitch expects the Canal expansion to reinforce this credit strength.
The main constraints on Panama’s rating since 2011 have been in the area of public finances. Ambitious spending initiatives and issues in tax administration have widened the fiscal deficit to relatively high levels, reversing the downward trajectory of public debt ratios and prompting repeated hikes to the legal deficit ceilings that have eroded fiscal credibility. Fitch has noted that the Varela administration has made initial progress on fiscal consolidation and improving fiscal credibility. Furthermore, macroeconomic tensions that had built up in years of rapid growth (including high inflation and current account deficits) have also receded.
The Canal expansion offers an opportunity for fiscal improvements. Should ongoing fiscal consolidation be maintained, and the Canal windfall support fiscal consolidation as stipulated in the fiscal law, Fitch believes the debt ratio could resume a downward trajectory and fiscal credibility could improve. In the context of continued favorable growth and macro stability, this could be positive for Panama’s rating.
Excerpted from Fitch Ratings new report “Panama: Canal Expansion Poised to Boost Sovereign.” Republished with permission from Fitch.