MIAMI — Standard & Poor’s Ratings Services (S&P) affirmed its ‘BBB/A-2’ long- and short-term sovereign credit ratings on the Republic of Panama. The outlook on the long-term rating remains stable. In addition, S&P affirmed their ‘AAA’ transfer and convertibility (T&C) assessment.

The ratings on the Republic of Panama reflect the country’s strong economic growth, increasing economic diversification, and moderate net general government debt burden. The ratings also take into account the sovereign’s vulnerability to sharp swings in global economic conditions, an underdeveloped but growing domestic capital market, and developing political institutions.

Panama is fully dollarized and therefore lacks an independent monetary policy and has no formal lender of last resort for the financial system.

Rapid growth, and investment in physical infrastructure, has helped to diversify Panama’s economy in recent years. GDP growth averaged 9.8% during 2010-2013, boosting per capita GDP during that period to nearly $10,000 from $7,800. A high level of investment, about 30% of GDP in recent years, is likely to continue driving economic growth at rates higher than in most of Latin America. The development of new sectors such as tourism, and eventually mining, could gradually strengthen Panama’s economic resilience. We expect that GDP growth will decline toward 6% on average over the next four years and
per capita GDP growth will remain above 4%.

Many years of rapid economic growth have helped moderate the government’s debt burden despite a pro-cyclical fiscal policy. General government debt is likely to be 35% of GDP in 2014 and may decline toward 33% in another two years. Net
general government debt, which includes assets in Panama’s sovereign wealth fund and other government liquid assets, is likely to be 15% of GDP in 2014 and stable in coming years.

Steady inflows of foreign direct investment (FDI) should continue financing most, if not all, of the current account deficit in 2014 and beyond. The current account deficit may decline toward 11% of GDP in 2014, from nearly 13% in the previous year, and fall below 10% over the next couple of years, still largely reflecting imports related to FDI projects and the country’s massive investment in infrastructure.

Panama has a small, open economy that depends on global conditions. Its banking sector has a net external asset position but remains exposed to an unexpected deterioration in external conditions. Panama has no central bank or formal lender of last resort. Nor does it have a deposit insurance system or other explicit mechanisms to provide temporary liquidity to distressed financial institutions, illustrating one of its rating vulnerabilities.

Additionally, the Financial Action Task Force recently placed Panama back on its “grey list” of countries with legal and regulatory shortcomings. We expect that the government will take steps to address regulatory shortcomings in the coming year.

The expansion of the Panama Canal, which will almost double its capacity, is 78% complete. The authorities estimate that the project will be finished in late 2015 or early 2016, setting the stage for higher economic activity through the canal. Delays and disputes with the canal’s contractor over cost overruns have hampered the expansion project. The consortium briefly stopped work in early 2014 and sought an added $1.6 billion due to claimed cost overruns. Work has resumed on the project and the overrun claims have been filed with dispute adjudication bodies for resolution, as specified in the canal expansion contract.

We expect continuity in key economic policies following the elections in 2014.

However, the new Administration of President Juan Carlos Varela lacks a majority in Congress, potentially weakening its ability to implement economic policies. The Varela Administration inherits a slowing economy and a deteriorating fiscal balance. It has to balance the need to contain fiscal slippage with a desire to maintain GDP growth and fulfill campaign promises to boost public services and physical infrastructure. Panama’s central government spends more than 10% of GDP on capital projects, giving it more flexibility compared with most governments to reduce the pace of future investments
without materially weakening long-term growth prospects or failing to provide basic public services.

As a fully dollarized economy, Panama’s monetary and exchange rate policy authority largely rests with the U.S. In our opinion, the likelihood of the Panamanian government ceasing to use the U.S. dollar as its local currency is low. Therefore, our T&C assessment is ‘AAA’, the same as that of the U.S.

OUTLOOK

The stable outlook incorporates our expectation that the Varela Administration will maintain Panama’s generally pro-business, pragmatic approach to economic policies, which has served it well in recent years in attracting investment and sustaining high rates of economic growth. We expect the government to moderately tighten fiscal policy in the next couple of years in line with
somewhat lower GDP growth prospects, resulting in a stable debt burden.

Strong private investment could largely compensate for a gradual decline in public-sector investment over the next three years. That, along with economic benefits of an expanded Panama Canal (likely starting in early 2016), would sustain high GDP growth over the coming decade. We could raise the rating if continued favorable GDP growth prospects result in a more resilient and prosperous economy with a declining debt burden and diminished vulnerability to external shocks.

On the other hand, an unexpected shock to the financial system could damage confidence in the country. Such an event, or other developments that hurt the country’s growth prospects, could weaken its credit profile. Deterioration in the management of public institutions, especially if it affects perceptions about the autonomy of the Panama Canal, would also hurt confidence.

The resulting slower medium-term growth prospects or an eroding fiscal and debt profile could result in a lower credit rating.