Lesotho’s long-term foreign currency issuer default rating (IDR) has been downgraded from B+ to B with a stable outlook by Fitch, over political tensions.
The rating reflects on-going political disruptions, which have prevented authorities from implementing the adjustments necessary to counter the deterioration in public finance and lower external liquidity. These have resulted from the fall in customs receipts from the Southern African Customs Union (SACU).
Political tensions and uncertainty have re-emerged in recent months. This is after a deal brokered through the Southern African Development Community (SADC) in December 2017 helped to quell a previous bout of instability.
Lesotho Prime Minister, Tom Thabane came close to facing a no-confidence vote called from within his own party that was only averted through the suspension of parliament in April 2019. South African President, Cyril Ramaphosa helped to broker a deal that could re-open parliament and establish the National Reforms Authority. This an independent body with the power to over-see the as yet unimplemented political reforms recommended by the SADC in 2016.
In addition to delaying fiscal consolidation efforts, inability to pass reform measures has put on hold the authorities’ discussions with the International Monetary Fund (IMF) on a planned support programme.
Lesotho has historically relied on SACU receipts to finance high levels of government expenditure, according to Fitch. A sharp and likely persistent fall in SACU revenue has therefore led to higher fiscal deficits and a draw-down of fiscal buffers.
In the five years leading to the 2015 to 2016 fiscal year, SACU receipts averaged 20% of GDP, but fell to 13% in the year 2016 to 2017. Despite a modest recovery, the fiscal deficit in the year 2018 to 2019 was 4.3% of gross domestic product (GDP), above the current B median of 3.7%.
Government deposits, which help finance the deficit and contribute to official external reserves that provide a monetary anchor for the Lesotho loti (LSL) peg with the South African rand fell. These fell to 8.4% of GDP, at year ended 2018 to 2019 from 22.3% in the year 2015 to 2016.
The 2019 to 2020 fiscal year budget contains a number of measures to increase non-SACU revenue and contain the wage bill. The wage bill averaged 16% of GDP in the 10 years to the 2018 to 2019 fiscal year.
However, on-going political tensions have delayed the implementation of some reforms. As a result, Fitch expects the fiscal deficit to average 3.7% of GDP over the next three years. This will put government debt to GDP ratio on an upward trend and prevent the rebuilding of fiscal buffers.
Additionally, a combination of deficiencies in cash management, a shallow domestic debt market, and the maintenance of a floor on reserves has led to an increase in accounts payable. This has also led to an increase in unpaid bills to domestic goods and service providers.
At 40.5% of GDP at end of the 2018 to 2019 fiscal year, Lesotho’s public debt level remains below that of similarly rated peers, according to Fitch. The debt to revenue ratio, at 100% in 2018 to 2019, was well below the current B median of 276%. However, the rating agency expects government debt to rise as the floor on government deposits leads to more domestic issuance.
Fitch forecasts gross general government debt to increase to 44.5% of GDP in the 2019 to 2020 fiscal year and to continue rising in subsequent years.
On-going arrears accumulation is a downside risk to the rating agency’s fiscal forecasts. The IMF estimated the stock of arrears at 2% of GDP in April 2019 and this figure has likely continued to rise, according to Fitch.
External debt comprises 85% of the total debt stock, with approximately 40% of external debt on concessionary terms, defined as having a maturity of 25 years and a grace period of five years.
The rating also reflects the weak real GDP growth relative to peers. The economy is highly dependent on government spending, through both direct government consumption and high public sector employment that supports private consumption.
As such, constrained government expenditure has negatively impacted growth. Five-year growth to 2019 is projected at 1.6% compared with a B median of 4.6%. Growth is expected to rise to 2.7% in 2019, from 1.2% in 2018. This is due to the commencement of road construction in advance of phase 2 of the Lesotho Highlands Water Project (LHWPII). Fitch expects that growth will again slow in 2020, before accelerating in 2021 when the construction of dams, reservoirs and connecting tunnels is scheduled to begin.
The LHWPII is fully financed by capital grants from South Africa, but the associated increase in imports will widen the current account deficit. Fitch forecasts the current account deficit to widen to 9.3% of GDP in 2019 and to average 8.5% over 2019 to 2021. The current B median current account deficit is 4.0% of GDP. The combination of wider current account deficits and the drawdown of government deposits will lower official international reserves. Fitch forecasts the deficits at $718 million or 3.2 months of current external payments at end-2019.
Lesotho’s currency peg with the South African rand is backed by the maintenance of net international reserves above the targeted level of 120% of M1. The Central Bank of Lesotho lowered the target in May 2018 to allow the government to use more deposits to support the fiscal position.
According to Fitch, the authorities remain committed to the rand peg. However, Lesotho’s dependence on SACU receipts and official capital inflows leave it vulnerable to a shock that could cause official reserves to fall below a level where the rand peg is sustainable.
The rating is also constrained by weak structural indicators. GDP per capita, at $1,143, is a little more than a third of the current B category median. This is while the country’s small size constrains administrative capacity and contributes to volatility.
Lesotho’s governance indicators, as measured by the World Bank, have deteriorated since 2014, when a political crisis forced the sitting government out of power. The 2016 deal that allowed for new elections in 2017 saw governance metrics improve slightly, but metrics could worsen on recent instability.
On the upside, Lesotho’s domestic banking sector is stable and profitable and unlikely to present a significant liability to the sovereign. However, the small size of the sector has meant a limited impact on growth through the credit channel. Asset quality is good and non-performing loans (NPL) fell to 3.4% of total loans in the first quarter of 2019 from 4.4% in first quarter of 2018. The build-up in government arrears could cause the NPL ratio to rise. The deterioration in asset quality would likely cause a slowing in credit growth and have an overall detrimental impact on credit provision.
Fitch projects that implementation of fiscal adjustments that narrow the fiscal deficit, increase external buffers and decrease government debt to GDP ratio could improve the country’s rating.
Higher and sustainable GDP growth for example due an improvement in the business environment, political stability and diversification in the economy could lead to upgrading Lesotho’s rating according to Fitch.
Conversely failure to consolidate public finances leading to a further decline in reserves that increases liquidity pressures for the sovereign could lead to further downgrading of the country’s rating.
The rating agency forecast that political turmoil that leads to lower-than-expected GDP growth and negatively impacts potential external financial support could lead to a downgrade in Lesotho’s rating.