Fitch downgrades South Africa to BB- with a negative outlook

Fitch downgrades South Africa to BB- with a negative outlook

Fitch downgrades South Africa to BB- with a negative outlook. Image: Pixabay.

Fitch Ratings has downgraded South Africa’s Long-Term Foreign-Currency Issuer Default Rating (IDR) to ‘BB-‘ from ‘BB’. The outlook is negative.

The downgrade and negative outlook reflect high and rising government debt, exacerbated by the economic shock triggered by the COVID-19 pandemic. The very low trend growth and exceptionally high inequality will continue to complicate fiscal consolidation efforts.

The pandemic has severely hit South Africa’s economic growth performance, and GDP is expected to remain below 2019 levels even in 2022. A particularly tight lockdown in the second quarter, combined with the broader global and domestic fall-out of the pandemic, led to a sharp fall in output, but GDP had already been contracting in quarter-on-quarter terms since 3Q19. Recovery is on the way as the lockdown was gradually eased during the third quarter and we expect GDP will contract by 7.3% in 2020.

Due to base effects, growth will surge to 4.8% in 2021 but then slow to 2.5% in 2022. We believe that trend growth will remain around 1.5%, and there are risks that the lasting effects of the pandemic could further weigh on trend growth. Investment spending had already weakened in recent years, falling last year to the lowest level in real terms since 2012, reflecting challenges to the business environment such as the poor reliability of power supply, labour market inflexibility and subdued domestic demand prospects.

Economic Reconstruction and Recovery Plan

In October the government launched an Economic Reconstruction and Recovery Plan (ERRP), focusing on boosting infrastructure investment, increasing energy supply, job creation and re-industrialisation. However, the track record of implementation of earlier reform initiatives has been relatively weak and, even if implemented, the effect of the reforms would be limited and take time to accumulate. The challenging fiscal context will also complicate some of the initiatives and will weigh on growth over the medium term.

The pandemic shock has led to a sharp fall in government revenue and additional spending needs, worsening already weak public finances. While some of the additional expenditure was covered by reprioritisation, expenditure is still expected to be 0.8% of GDP higher than in the pre-pandemic February Budget. We expect the consolidated deficit to rise to 16.3% of GDP in the fiscal year ending March 2021 (FY20/21), up from 6.4% in FY19/20, overshooting the government’s latest projection of 15.7%. This largely reflects our assumption that the government will be forced to reverse a decision not to pay a wage increase agreed for the current fiscal year under the 2018 three-year public sector wage agreement.

Key rating drivers

The downgrade and Negative outlook reflect high and rising government debt, exacerbated by the economic shock triggered by the COVID-19 pandemic. The very low trend growth and exceptionally high inequality will continue to complicate fiscal consolidation efforts.

The pandemic has severely hit South Africa’s economic growth performance, and GDP is expected to remain below 2019 levels even in 2022. A particularly tight lockdown in the second quarter, combined with the broader global and domestic fall-out of the pandemic, led to a sharp fall in output, but GDP had already been contracting in quarter-on-quarter terms since 3Q19. A recovery is on the way as the lockdown was gradually eased during the third quarter and we expect GDP will contract by 7.3% in 2020.

Due to base effects, growth will surge to 4.8% in 2021 but then slow to 2.5% in 2022. We believe that trend growth will remain around 1.5%, and there are risks that lasting effects of the pandemic could further weigh on trend growth. Investment spending had already weakened in recent years, falling last year to the lowest level in real terms since 2012, reflecting challenges to the business environment such as the poor reliability of power supply, labour market inflexibility and subdued domestic demand prospects.

In October the government launched an Economic Reconstruction and Recovery Plan (ERRP), focusing on boosting infrastructure investment, increasing energy supply, job creation and re-industrialisation. However, the track record of implementation of earlier reform initiatives has been relatively weak and, even if implemented, the effect of the reforms would be limited and take time to accumulate. The challenging fiscal context will also complicate some of the initiatives and will weigh on growth over the medium term.

The pandemic shock has led to a sharp fall in government revenue and additional spending needs, worsening already weak public finances. While some of the additional expenditure was covered by reprioritisation, expenditure is still expected to be 0.8% of GDP higher than in the pre-pandemic February Budget. We expect the consolidated deficit to rise to 16.3% of GDP in the fiscal year ending March 2021 (FY20/21), up from 6.4% in FY19/20, overshooting the government’s latest projection of 15.7%. This largely reflects our assumption that the government will be forced to reverse a decision not to pay a wage increase agreed for the current fiscal year under the 2018 three-year public sector wage agreement.

A recovery in 2021 and an end to COVID-19 related support programmes will contribute to lower deficits in FY21/22 but the government’s target to bring the deficit to 7.3% in FY23/24 will be hard to achieve.

We expect general government debt (including gross loan debt and around 2% of GDP local government debt) to rise to 94.8% of GDP in FY22/23 from 64.9% in FY19/20. Given its lower deficit forecasts, the government expects gross loan debt to rise to 90.1% of GDP in FY22/23 and to peak at 95.3% in FY25/26. The government’s projection is subject to considerable risks from its reliance on wage bill savings, relatively optimistic revenue assumptions and contingent liabilities. Finding consolidation measures to compensate for these risks will be complicated, given in-fighting within the government, social pressures and the weak growth environment, which raises risks that consolidation measures are offset by the impact on economic growth.

The government assumes a freeze on wages will bring annual savings of 1.75% of GDP on average over the next two years relative to its October 2019 projections. This is unlikely to be achieved, as wage negotiations over the past decade inevitably led to above-budgeted settlements even as budget assumptions for wage bill driven consolidation were less ambitious than they are now. Upcoming local elections and an important conference of the governing African National Congress (ANC) party, which is in a close alliance with one of the leading trade union confederations, will further complicate wage negotiations.

Fiscal risks from the struggling state-owned enterprise sector and other contingent liabilities have been exacerbated by the pandemic shock. Liabilities of state-owned financial and non-financial enterprises and guarantees to independent power producers and for private-public partnerships amounted to 20.5% of GDP at end-March this year. While this is not exceptionally high relative to peers, the financial performance of many of the companies, including the largest, the electricity producer Eskom, is poor. The state has had to provide substantial support since last year, but the government factors in only limited further support for the coming three years although it acknowledges the risks.

We also see downside risks to government revenue projections, which assume a relatively rapid rebound in line with the pattern following the global financial crisis although GDP then returned to pre-crisis levels more quickly than is expected this time. The government plans some revenue measures, still to be specified, to raise 0.3% of GDP per year in FY22/23 and there is also the possibility of a better revenue performance, as the authorities are making progress in restoring capacity of the South African Revenue Service that was lost under the previous administration.

South Africa’s ‘BB-‘ IDRs also reflect the following key rating drivers:

South Africa’s financing conditions have recovered less from the initial pandemic shock than for many peers, although the impact on financing costs has so far been absorbed by a shift to shorter-term financing. Government debt markets experienced severe strains during the height of the pandemic shock, which led to large capital outflows and a fall in the share of non-resident holdings in local-currency government bonds from 37% at end-2019 to 29% in October, albeit still high by international standards.

Given the exceptionally long average maturity of local and international government marketable securities of 14 years at end-March, the rise of annual redemptions to around 3% of GDP in FY22/23 due to the shift to more short-term issuance is manageable. The easing in monetary policy will also support the government’s funding cost. The South African Reserve Bank (SARB) has been able to cut its rates to 3.5% from 6.5% at the end of last year, supported by falling inflation and a fall of medium-term inflation expectations to below the centre of the SARB’s inflation target range of 3%-6%. Its programme to buy government bonds in the secondary market was focused on restoring market stability, and assets bought under the programme have stabilised at around 0.8% of GDP.

The large foreign holdings of South Africa’s local-currency government bonds continue to pose a risk for fiscal financing and external stability. However, the fully flexible exchange rate regime combined with a low share of foreign-currency denominated debt in total government debt, at 11.8% in October, are important shock absorbers. The very large local non-bank financial sector, with around 160% of GDP of assets, provides significant buffers, and caps on foreign holdings of the sector also contain external financing risks.

The current-account deficit (CAD) is likely to narrow to just 0.3% of GDP in 2020 as a sharp fall in domestic demand, a rise in South Africa’s terms of trade helped by the surge in gold prices, and a faster recovery of exports has led to a sharp improvement in the trade balance over the first three quarters of the year. A normalisation of domestic demand should lead to a renewed widening of the CAD to on average 2% of GDP over the next two years. Net external debt is broadly in line with rating peers, but according to the IMF’s reserve adequacy metrics, international reserves are relatively low.

The banking sector is well regulated and is not expected to pose significant contingent liability risks to the sovereign, although profits in the sector are likely to slump as credit losses will soar as a result of the pandemic. The sector absorbed a large share of government issuance this year as higher risk aversion boosted deposit inflows to banks, but are unlikely to continue as large a role in funding the government.

ESG – Governance: South Africa has an ESG Relevance Score of 5 for both Political Stability and Rights and for the Rule of Law, Institutional and Regulatory Quality and Control of Corruption, as is the case for all sovereigns. Theses scores reflect the high weight that the World Bank Governance Indicators (WBGI) have in our proprietary Sovereign Rating Model. South Africa has a medium WBGI ranking at the 58th percentile, reflecting relatively institution and well-entrenched democratic processes. However, exceptionally high inequality could lead to long-term challenges to social stability and complicates the government’s efforts to accelerate economic growth and consolidate public finances in an environment of rising calls for improving public services. In-fighting with the ANC also continues to slow down government decision-making.

Leave a Reply

Your email address will not be published. Required fields are marked *