The key driver for the rating downgrade is the very material deterioration in Panama's fiscal strength driven by the severe economic shock from the pandemic. While most sovereigns have experienced some diminution in their fiscal strength, in Panama's case the erosion has been unusually large relative to rating peers. Given Moody's expectation that fiscal metrics will remain weaker than Baa peer medians for the foreseeable future, the rating agency has concluded that Panama's sovereign credit profile has suffered a step change for the worse relative to peers and that on a comparative basis a Baa1 rating is no longer warranted.

The stable outlook balances Panama's high economic growth potential and relatively favorable funding conditions against the challenges the authorities will face in adopting policies to arrest the upward debt trend and ultimately support fiscal consolidation.

Moody's regards the coronavirus pandemic as a social risk under its ESG framework, given the substantial implications for public health and safety.

Panama's long-term foreign-currency country ceiling was lowered to A1 from Aa3. In the context of full dollarization, Panama does not have a local currency country ceiling. In assigning a four-notch gap between the foreign-currency ceiling and the sovereign's ratings, Moody's considers that Panama's government has a relatively low footprint in the economy and financial system. The predictability and reliability of institutions and government actions is adequate and political risk is relatively low. In the context of dollarization, the risks derived from external imbalances are low and Panama is not exposed to a single commodity or productive sector. Additionally, given the long track record of dollarization, there are minimal transfer and convertibility risks.

RATIONALE FOR DOWNGRADE TO Baa2

The coronavirus pandemic led to a severe economic contraction in 2020. Real GDP fell 17.9% (20.7% in nominal terms), compared to our expectation of a 10% contraction last October -- Panama's GDP contraction was the second largest among Baa-rated peers. The sharp slowdown in economic activity weighed on government revenue, which fell 21.2% last year. On the expenditure front, the authorities aimed to reallocate resources within the budget rather than increase total spending to respond to the pandemic, but a ramp up in capital expenditures in the last quarter led to a 5.7% increase in overall spending last year. The fiscal deficit reached 10.1% of GDP, up from 3.1% of GDP in 2019.

Last year, Panama's government debt stock rose by $6 billion -- this included the funding of the fiscal deficit as well as additional borrowing to finance para-fiscal measures in response to the pandemic and $1 billion to pre-finance 2021. At $37 billion, government debt stood at 69.8% of GDP in 2020, up from 46.4% in 2019 and above the 62.1% Baa median. A debt increase of 23 percentage points (pps) of GDP far exceeded the average increase of 13pps reported by Baa-rated peers. Panama's debt affordability, as measured by the interest-to-revenue ratio, rose to 14.5% in 2020 from 10.3% in 2019 -- marking one of the largest increases among rating peers, and coming well above the 7.5% Baa median.

While most sovereigns experienced some worsening of their fiscal strength, Panama's sharp deterioration in fiscal strength was unusually large and has materially affected the sovereign's credit standing relative to Baa-rated peers. This undermined the key credit strengths that had led to the sovereign's upgrade to Baa1 in March 2019, at which point Panama's debt ratios were stronger than those of most peers. Moreover, Moody's considers that improvements on the fiscal front will be at best very gradual given its expectation that the government deficit will remain relatively large at around 7.5% of GDP in 2021 and that economic output will not return to 2019 levels until late 2023.

RATIONALE FOR STABLE OUTLOOK

The stable outlook reflects a balance between Panama's fundamental credit strengths; namely, a dynamic service-based economy with investment as the main growth driver and low government financing risk, against the challenges the authorities will face as they implement fiscal consolidation over the coming years.

Robust medium-term growth prospects remain a key factor supporting Panama's credit profile with Moody's expecting trend growth above 4% after 2021 -- the International Monetary Fund (IMF) and the government estimate potential growth of around 5%. Given Panama's role as a global trade hub and due to its strategic location, the country will continue to attract foreign investment, especially in the logistics sector. Additionally, the pipeline of public and private infrastructure projects, if followed through, will also support dynamic growth prospects. Medium-term growth of about 4% would place Panama's economic performance above that of most Baa peers and, if accompanied by a sustained reduction in fiscal deficits, would lead to the stabilization of government debt ratios.

In spite of facing higher-than-normal financing needs, Panama's continued strong market access has allowed the government to fund itself both domestically as well as by accessing cross-border financing at favorable rates -- the weighted average cost of debt fell to 4.0% in 2020 from 4.9% in 2018. Moreover, the $2.7 billion (4.7% of GDP) precautionary credit line Panama signed with the IMF in January 2021 provides an additional backstop against potential government liquidity risks.

The stable outlook also incorporates risks that could complicate the authorities' medium-term efforts to improve the fiscal accounts. In the absence of substantive and sustained progress on the fiscal front, Panama's credit metrics could continue to weaken, widening the gap with Baa-rated peers. Given Panama's low tax intake relative to regional and rating peers, Moody's expects that the authorities will aim to maintain high levels of public investment to support the economic recovery while contending with mounting fiscal pressures from rising current expenditures and from the weaker financial standing of the social security system, whose numbers have deteriorated more rapidly than what the government had initially anticipated.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

Moody's assesses Panama's exposure to environmental risks as moderately negative (E-3 issuer profile score). The country is exposed to weather effects like excessive rain or droughts. While this has not led to significant disruptions, it can affect the availability of water resources in the main urban areas, and for the agricultural sector and the Panama Canal. Given the importance of the canal for the economy and fiscal accounts, mitigation of water-related issues will remain a key challenge.

Exposure to social risks is moderately negative (S-3 issuer profile score). Panama still has favorable demographic dynamics. However, despite having one of the highest per capita GDPs on a purchasing power parity basis in Latin America, Panama has high income inequality. This disparity is particularly significant between urban and rural areas. Challenges related to the provision and quality of education also pose risks given the shortage of skilled labor that weighs on productivity growth.

The influence of governance on Panama's credit profile is neutral to low (G-2 issuer profile). The country has a moderate institutional framework, although it lags in terms of control of corruption. Although dollarization has supported broad macroeconomic stability, fiscal policy credibility and effectiveness has been weighed by a mixed track record of compliance with the fiscal rule.