South Africa bolstered by favourable debt

South Africa’s long-term foreign-currency issuer default rating (IDR) has been affirmed at BB-, by Fitch Ratings. This is due to its favourable debt structure with long maturities, which are mostly denominated in local currency.

Fitch has however kept South Africa’s outlook at negative. This is on continued substantial risks to debt stabilisation despite the better than expected fiscal outturns in the fiscal year ending March 2021.

South Africa’s rating is further constrained by high and rising government debt, low trend growth and exceptionally high inequality that will complicate fiscal consolidation efforts.

A low share of foreign-currency debt, long-maturities, financing challenges are contained, according to the rating agency.

The country is also supported by investors now having returned to the local governmental market, following large outflows of non-resident investments during the initial phase of the coronavirus disease 2019 (COVID-19) crisis,

Local bond markets also stabilised in the second half of 2020.

As a result, the South African Reserve Bank has been able to start reducing its holdings of government bonds, which peaked in January at 0.8% of GDP.

This is a relatively low level compared with other emerging markets that supported bond markets during the crisis.

The government received official funding from the IMF, the World Bank and the New Development Bank.

The banking sector is well-managed and has withstood the crisis relatively well, reflecting a high degree of risk aversion.

South Africa’s economy is in the process of recovering from the sharp contraction of 7% last year and Fitch expects growth of 4.3% in 2021 and 2.5% in 2022.

Growth will be supported by the base effect and the rise in commodity prices. However, tight public finances, and in the near term, electricity shortages will hold back growth.

The rating agency expects medium-term growth to remain low at less than 2%, a key rating constraint, complicating fiscal consolidation.

Public finances have improved substantially relative to the last review but remain a rating weakness. The main, central government (CG) budget deficit came in at 11.1% of GDP in fiscal year 2020-2021, compared with Fitch’s November forecast of 15.5%.

This was partly because a court upheld the government’s decision not to pay out a wage increase due from April 2020 under the 2018 three-year agreement.

However, an appeal by trade unions against the ruling at the constitutional court could still require the payment, worth around 0.7% of gross domestic product (GDP).

However, the more important factor behind the out-performance was strong fiscal revenue. This stood at 2.8% of GDP above the government’s October medium-term budget policy statement forecast and 0.7% of GDP above the February budget projection.

Fitch assumes some of the revenue outperformance will carry over to subsequent years. The rating agency expects the general, consolidated government deficit to decline from its estimate of 13% of GDP between 2020 and 2021 to 8.8% between 2020 and 2021.

The rating agency also expects the general, consolidated government deficit to decline from 8.8% between 2020 and 2021, to 6.8% between 2021 and 2022.

However, the government’s fiscal consolidation plan relies heavily on containing public sector wages.

The government has incorporated an effective nominal wage freeze in its projections but trade unions are unlikely to accept that and Fitch assumes a wage increase in line with inflation.

A higher increase is possible given the trade unions demand a rise by inflation plus 4%. Wage growth in line with inflation raises spending by around 0.5% of GDP, which Fitch believes will be only partly absorbed by lower spending on other items.

Consolidation also relies on tight control of spending more generally in the context of exceptionally high inequality and demands for better public services.

While the government built a strong record before the crisis of sticking to expenditure ceilings, it no longer emphasised these ceilings in the 2021 budget. Building political support for fiscal consolidation remains challenging.

As a result, Fitch does not believe the government will achieve its target of a primary surplus in fiscal year, between 2024 and 2025, and a stabilisation of CG debt at 88.9% of GDP in the following year.

Fitch expects general government debt, CG debt plus around 1.7% of GDP local government debt, to rise from 82.5% of GDP between 2020 and 2021 to 87.1% between 2022 and 2023.

However, this is significantly lower its previous forecast of 94.8% between 2022 and 2023.

South Africa’s contingent liabilities at 20.1%, including financial and non-financial state-owned enterprises (SOEs), IPPs and public private partnerships, are not unusually high. However, the financial situation of SOEs is weak, exacerbated by COVID-19.

Significant government support is already incorporated in fiscal plans, but the government acknowledges the risk that further support is needed.

Notably, the largest SOE, the electricity provider Eskom, remains in a difficult financial situation, with wage negotiations also adding to risks. Discussions about easing Eskom’s debt burden have not made further progress in recent months.

Given South Africa’s favourable debt structure, with a low share of foreign-currency debt and long-maturities, financing challenges are contained.

While there were large outflows of non-resident investments in the local government market during the initial phase COVID-19, investors have returned and bond markets stabilised in the first half of 2020.

As a result, the South African Reserve Bank has been able to start reducing its holdings of government bonds, which peaked in January at 0.8% of GDP.

This a relatively low level compared with other emerging markets that supported bond markets during the crisis.

South Africa’s external finances have weathered the crisis well. The strengthening in gold prices and an import compression brought a current-account surplus of 2.2% of GDP, the first surplus since 2002.

Import demand will recover with domestic demand and domestic savings will remain structurally low, but prices for many of South Africa’s export commodities have risen further.

As a result, Fitch expects the current account to record a small surplus, of 0.4% of GDP in 2021 and return to a slight deficit in 2022.

The second wave of COVID-19 infections triggered a new lockdown in the first quarter of 2021. However, containment measures remained much less restrictive than during the first wave around mid-2020.

After stabilisation, infection numbers have started rising again and the crisis will continue to pose risks well into 2022, as vaccine roll-out is proceeding slowly.

The government has secured enough doses to inoculate the adult population, but most will arrive only in the second half of 2021.

Fitch expects that the economic fall-out of any new waves will be more limited than last year. This is as policy-makers have more targeted containment measures. The economy has adapted, but it could still weigh on public finances.

Fitch may downgrade the rating if there is failure to implement consolidation measures that raise confidence in the ability of the government to stabilise fiscal debt-GDP over the medium term.

Persistent weak trend GDP growth rate that further undermines fiscal consolidation efforts and raises socioeconomic pressures in the face of exceptional inequality, may also lead to a downgrade.

The rating agency may also downgrade the rating if there is rising risk of a de-stabilising large net capital outflow that triggers sharp exchange rate depreciation, higher inflation and – interest rates.

Fitch may consider upgrading the rating if there is progress on fiscal consolidation that increases confidence that government debt-GDP stabilisation will be achieved over the medium term.

Greater confidence in stronger growth prospects, sufficient to support fiscal consolidation and address challenges from high inequality and unemployment may also lead to an upgrade.

This comes after Moody’s downgraded South Africa’s issuer ratings to Ba2 from Ba1, in 2020. This was on concerns that its fiscal strength would weaken over the medium term – a mixture of rising debt, and a shrinking gross domestic product (GDP).

Moody’s also kept the country’s outlook at negative on the expectation that the country’s debt burden and affordability could deteriorate significantly more than projections.

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