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���������ֳ� - London - 28 Oct 2022: ���������ֳ� Ratings has affirmed North Macedonia's Long-Term Foreign-Currency Issuer Default Rating (IDR) at 'BB+' with a Negative Outlook.

A full list of rating actions is at the end of this rating action commentary.

Key Rating Drivers

Credit Fundamentals, Negative Outlook: North Macedonia's ratings are supported by favourable governance relative to the 'BB' median, and a credible and consistent policy mix underpinned by the longstanding peg to the euro. The EU accession process helps anchor policy and support exports and FDI inflows. These factors are balanced against the economy's small size, high exposure to exchange rate risk, for example due to the banking sector's euroisation and a high share of government debt denominated in foreign currency, and high structural unemployment.

The Negative Outlook reflects increased downside risks for growth, external and public finances since our April review, due to the indirect effects of the war in Ukraine on commodity prices, especially energy, potential energy supply disruptions, significant deterioration in the eurozone (70% of exports) growth prospects and tighter global financing conditions.

Slower Growth: Annual growth averaged 2.6% in 1H22, but the intensification of the energy crisis and our expectation of contraction in the eurozone (-0.1%) in 2023 will weaken domestic demand and result in a negative contribution from net trade. We forecast North Macedonia's economy to expand by 2.3% in 2022 and 2.1% in 2023 before recovering to 3.2% in 2024, reflecting some easing of geopolitical risks and energy price pressures, improving external demand and gradual fiscal consolidation.

Although North Macedonia is working towards diversification of its energy generation sources and imports and reduced the share of electricity produced with natural gas (19.5% in August vs 32% in 2021), downside risks to the growth outlook remain significant, if a prolonged war in Ukraine maintains high energy prices or supply disruptions. North Macedonia continues to receive all its gas imports from Russia.

Macro-Financial Stability, Higher Inflation: The long-standing 'de facto' peg to the euro is well-anchored, despite the shocks of the pandemic and war in Ukraine. Annual inflation rose to 18.7% in September due to energy and food prices, and we expect inflation to average 13.7% in 2022, more than double our previous forecast and against the 7.5% 'BB' median, before easing to an average of 3.7% in 2024. Additional commodity price shocks, a prolonged period of unanchored inflation expectations and wage pressures represent upside risks to our inflation trajectory.

The National Bank has increased its policy rate by 225bp to 3.5% since April, and we believe that authorities will continue to tighten monetary policy to anchor inflation expectations, maintain FX pressures in check and follow the ECB's tightening cycle. The banking sector maintains healthy fundamentals. Capitalisation (17.3% at 2Q2 with Tier 1 capital of 15.9%) is adequate and a new counter-cyclical capital buffer will be effective in August 2023. Non-performing loans remain low, at 3.2% in 2Q22. However, deposit euroisation (47%) remains above 'BB' rated peers (44%).

Higher External Deficits: The current account deficit will reach 8.9% of GDP in 2022, the highest since 2008 and more than double the forecast 4% deficit for the 'BB' median, reflecting a wider trade deficit driven by higher energy import costs. We view the increased external deficit as temporary, as reduced energy imports and weaker domestic demand will help bring the deficit down to 3.5% of GDP in 2024. We forecast net FDI to increase to 4% of GDP in 2022 and to finance the current account over the medium term, due to continued investments in the energy and auto sectors.

Reduced Near-Term FX Pressures: International reserves have recovered in 2H22 on the back of reduced demand by energy importers, National Bank FX purchases and external borrowing by the sovereign. We forecast reserves at EUR3.7 billion (three months of current external payments) in 2022. The announced two-year EUR530 million Precautionary and Liquidity Line (PLL) with the IMF will provide additional liquidity support, financing and could help channel additional official and external market funding. The EUR400 million repo facility with the ECB expires in January 2023.

Reform, IMF Support Fiscal Consolidation: ���������ֳ� has revised down its forecast 2022 general government deficit to 5.3% from 6.5% of GDP in April. Total announced measures to mitigate the energy crisis equal EUR750 million (5.7% of GDP) and have been partly accommodated due to strong revenue growth and lower execution of capital spending. We project the general government deficit to decline to 4.8% of GDP in 2023, balancing the weaker growth outlook against removal of certain energy support measures and continued under-execution in capital spending.

���������ֳ� considers that the approved organic budget law will help strengthen the country's fiscal framework, for example, through the introduction of fiscal rules and a fiscal council, and that the IMF programme could boost the credibility of the fiscal consolidation strategy by outlining specific measures to support revenue growth and keep current spending in check, supporting debt stabilisation.

High Debt, Exchange Rate Risk: General government debt will increase to 53.5% of GDP in 2022 and reach 55.9% by 2024, above the 54% projected median for the 'BB' category. Government guarantees of public entities (8.1% of GDP 1H22) are mainly related to road projects (5.7% of GDP). The majority of foreign-currency debt (76% of total) is euro-denominated. Currency risks are mitigated by the longevity and credibility of the exchange rate peg that is crucial for debt sustainability.

EU Negotiations Start, Uncertainty Remains: The adoption of the 'French proposal' has allowed North Macedonia to begin the preparation process for EU membership negotiations. Nevertheless, the agreement requires North Macedonia to adopt constitutional reform recognising Bulgarians as an ethnic minority to be implemented by 2023. High political polarisation regarding this condition, the current lack of enough parliamentary support and Bulgaria's unstable coalition politics, while still holding veto power, represent risks to the EU accession process, in ���������ֳ�'s view.

ESG - Governance: North Macedonia has an ESG Relevance Score (RS) of ''5[+]' for both Political Stability and Rights and for the Rule of Law, Institutional and Regulatory Quality and Control of Corruption. Theses scores reflect the high weight that the World Bank Governance Indicators (WBGI) have in our proprietary Sovereign Rating Model. North Macedonia has a medium WBGI ranking at 52 reflecting a recent track record of peaceful political transitions, a moderate level of rights for participation in the political process, moderate institutional capacity, established rule of law and a moderate level of corruption.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to negative rating action/downgrade:

-Macro & External Finances: Persistently high inflation, low growth and increased external vulnerabilities, for example due to a severe energy shock and large current account deficits net of FDI, which could in turn exert pressure on foreign currency reserves and/or the currency peg against the euro.

-Public Finances: Materially higher than forecast general government debt/GDP over the medium term, for example, due to weaker growth prospects or expectations of a more prolonged fiscal loosening.

-Structural: Adverse political developments that affect governance standards, the economy and EU accession progress.

Factors that could, individually or collectively, lead to positive rating action/upgrade:

-Macro & External Finances: Greater-than-expected macroeconomic and external resilience to geopolitical/energy risks and tighter financing conditions.

-Public Finances: Greater confidence that general government debt/GDP will stabilise in the medium term, for example, due to more resilient growth and progress towards fiscal consolidation.

-Structural & Macro: Improvement in medium-term growth prospects and/or governance standards, for example, due to progress towards EU accession and reduction in political and policy risk.

Sovereign Rating Model (SRM) and Qualitative Overlay (QO)

���������ֳ�'s proprietary SRM assigns North Macedonia a score equivalent to a rating of 'BB' on the Long-Term Foreign-Currency (LT FC) IDR scale.

���������ֳ�'s sovereign rating committee adjusted the output from the SRM to arrive at the final LT FC IDR by applying its QO, relative to SRM data and output, as follows:

- Macro: +1 notch, the positive notch adjustment offsets the deterioration in the SRM output driven by the pandemic shock, including from the growth volatility variable and high inflation exacerbated by the war in Ukraine. The deterioration of the GDP growth and volatility variables reflects a very substantial and unprecedented exogenous shock that has hit the vast majority of sovereigns, and ���������ֳ� currently believes that North Macedonia has the capacity to absorb it without lasting effects on its long-term macroeconomic stability.

���������ֳ�'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 FC IDR. ���������ֳ�'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 and/or not fully reflected in the SRM.

Best/Worst Case Rating Scenario

International scale credit ratings of Sovereigns, Public Finance and Infrastructure issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of three notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit /site/re/10111579.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

North Macedonia has an ESG Relevance Score of '5[+]' for Political Stability and Rights as World Bank Governance Indicators have the highest weight in ���������ֳ�'s SRM and are therefore highly relevant to the rating and a key rating driver with a high weight. As North Macedonia has a percentile rank above 50 for the respective Governance Indicator, this has a positive impact on the credit profile.

North Macedonia has an ESG Relevance Score of '5[+]' for Rule of Law, Institutional & Regulatory Quality and Control of Corruption as World Bank Governance Indicators have the highest weight in ���������ֳ�'s SRM and are therefore highly relevant to the rating and are a key rating driver with a high weight. As North Macedonia has a percentile rank above 50 for the respective Governance Indicators, this has a positive impact on the credit profile.

North Macedonia has an ESG Relevance Score of '4[+]'for Human Rights and Political Freedoms as the Voice and Accountability pillar of the World Bank Governance Indicators is relevant to the rating and a rating driver. As North Macedonia has a percentile rank above 50 for the respective Governance Indicator, this has a positive impact on the credit profile.

North Macedonia has an ESG Relevance Score of '4[+]' for Creditor Rights as willingness to service and repay debt is relevant to the rating and is a rating driver for North Macedonia, as for all sovereigns. As North Macedonia has track record of 20+ years without a restructuring of public debt and captured in our SRM variable, this has a positive impact on the credit profile.

Except for the matters discussed above, the highest level of ESG credit relevance, if present, is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or to the way in which they are being managed by the entity. For more information on ���������ֳ�'s ESG Relevance Scores, visit .

Additional information is available on

APPLICABLE MODELS

Numbers in parentheses accompanying applicable model(s) contain hyperlinks to criteria providing description of model(s).

• Country Ceiling Model, v1.7.2 (1)
• Debt Dynamics Model, v1.3.1 (1)
• Macro-Prudential Indicator Model, v1.5.0 (1)
• Sovereign Rating Model, v3.13.1 (1)

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