South Africa deficits discolour ratings

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South Africa’s long-term foreign-currency issuer default rating (IDR) has been pulled down from stable to negative, by Fitch, which is concerned about the country’s widening budget deficit. The rating agency has however affirmed the sovereign’s BB+ standing.

The deficit has suffered a double-edged sword of lower gross domestic product (GDP) growth and increased spending including state-owned enterprise (SOE) support. The country’s GDP growth projection for the year 2019 is now at 0.5%, from the 0.8% in 2018.

This has increased Fitch’s projections for government debt to GDP ratio and heightened the difficulty of stabilising the ratio over the medium term. Renewed downward revisions to GDP growth in 2019 also raise new questions about South Africa’s GDP growth potential, according to the rating agency. The social context of exceptionally high inequality will constrain the government’s policy response to these challenges.

Fiscal metrics have deteriorated significantly due to under-performance of revenue, which is expected to worsen in the current fiscal year (FY) as growth has turned out weaker than expected.  Low trend GDP growth means that economic recovery is not expected to drive a major fiscal improvement in later years.

Fitch also forecast expenditure to increase by approximately 2% of GDP between the year 2019 to 2020 and 2021 to 2022. The government’s deficit is set to further widen because of the sovereign’s pledged support to Eskom, the South Africa-based energy provider it owns.

The South African government in July 2019 tabled a special appropriations bill that provides for government support to Eskom, the troubled national electricity company. The bill was approximately $1.8 billion (R26 billion), representing 0.5% of GDP in the fiscal year ending March 2020.

The proposed legislation also constituted R33 billion in the year 2020 to 2021 in addition to R23 billion per year approved in the budget.

As a result, Fitch expects the consolidated general government (GG) deficit to widen to 6.3% of GDP in the year 2019 to 2020. This is significantly higher than the outcome of 4.2% for the year 2018 to 2019 and the government’s forecast of 4.5% for the year 2019 to 2020 from the February 2019 budget.

The rating agency forecasts the GG deficit to decline to 5.2% of GDP in the year 2021 to 2022, which Fitch considers to be still quite high. This is as it is still more than double the current ‘BB’ median deficit forecast of 2.3%.  Initial guidelines issued to government departments in preparation for the October medium-term budget policy statement suggest that the government will seek to implement significant consolidation measures. However, the already high tax burden and social pressures on spending limits the government’s room for manoeuvre.

Fitch forecasts GG debt to increase further to 68% of GDP in the year 2021 to 2022, and debt may continue rising after that. General government debt was 57.3% in the year 2018 to 2019, including central government gross loan debt of 55.6% of GDP and 1.6% of GDP of local government debt. This is compared with a current ‘BB’ category median of 44.6%. The debt structure helps to reduce refinancing and foreign-exchange risks, with a particularly long average maturity of central government debt of 13.2 years and foreign-currency debt accounting for just 8.2% of GG debt.

Upside risks to debt projections arise from 14.3% of GDP debt of non-financial SOEs, several of which, including Eskom, experience acute financial stress. Other contingent liabilities include debt of financial SOEs accounting for 2% of GDP, guarantees to independent power producers taking up 3% of GDP and actuarial liabilities of the Road Accident Fund. The actuarial liabilities of the Road Accident Fund is expected to rise to 5.6% of GDP in the year 2021 to 2022. However, these are less likely to materialise on the GG balance sheet in the medium term, according to Fitch.

The government is investigating options to secure the longer-term viability of Eskom, including potentially relieving the company of some or all of its debt of 9.1% of GDP. To fix the underlying on-going losses, support from the government is intended to be combined with consolidation and re-structuring measures. This includes a separation of electricity generation, transmission and distribution into different business units. However, trade unions, fearing privatisation and job losses, are strongly opposed to these measures and Fitch believes significant progress will be challenging.

Low GDP growth is increasingly weighing on South Africa’s credit profile.

Fitch estimates potential GDP growth at just 1.7%, compared with a current ‘BB’ category median of 2019 GDP growth of 3.4%. The rating agency expects growth of just 0.5% in 2019 after 0.8% in 2018, reflecting continued weak gross fixed investment and subdued private consumption.

The government is making efforts to boost growth, including an investment initiative, measures to accelerate infrastructure investment, reduce costs in logistics and telecommunications. The government is also taking measures to improve immigration rules to strengthen tourism. However, the scale of the measures and the slow pace of implementation suggest that the impact on growth is likely to remain muted.

South Africa’s BB+ IDR rating also reflects the fact that South Africa continues to depend on potentially volatile portfolio inflows for financing its current-account deficit (CAD). Fitch expects the CAD to decline only moderately to 3.1% in 2021 from 3.6% of GDP in 2018, partly reflecting a decline in the price of oil imports.

Fitch also projects that net external debt will rise to 27.3% of GDP in 2021, compared with a BB category median of 17.6% in the same year.

Significant participation of foreign portfolio investors in South Africa’s local currency central government debt market, holding 38.7% of outstanding debt in May, could lead to sudden outflows. This is in the case of increased global risk aversion.

South Africa is however bolstered, flexibility of the rand exchange rate and high liquidity of the R/$ foreign exchange market, which serve as shock absorbers.  This is despite international liquidity being low relative to short-term financial obligations.

The credibility of the South African Reserve Bank (SARB) and its inflation targeting regime are an important credit strength, according to Fitch.

Inflation has recently undershot expectations, allowing SARB to cut its interest rates in July 2019. The banking sector is well-regulated and healthy, according to Fitch. The non-bank financial sector, including pension funds and long-term insurance is large, with assets of 184% of GDP at 2018 year-end. Given the sector’s exposure to government debt is relatively low and caps on foreign investment, it could help absorb a potential outflow of foreign investors.

Fitch is also concerned about the country’s mounting political tensions. South Africa’s governing party, the African National Congress (ANC), won the national election in May 2019, with 230 out of 400 seats. However, the continued in-fighting within the ANC is likely to draw attention away from policymaking.

Fitch also expects the government to also continue to struggle to manage competing objectives of reducing exceptionally high inequality, boosting GDP growth and containing populist pressures, while maintaining macroeconomic stability.

The rating agency expects that the government will handle land reform, including measures to allow for expropriation without compensation. This in a way that will not damage growth or public finances, but the discussion could raise international investors’ concerns about property rights in the long term.

Failure to stabilise the debt to GDP ratio over the medium term will lead to a downgrade in the country’s IDR rating, according to Fitch.

The rating agency also projects that further deterioration in South Africa’s trend GDP growth rate would also worsen the country’s rating.

Increased vulnerability resulting from the current account deficit and external financing needs could also lead to a downgrade in the rating, according to Fitch.

On the upside, narrowing in the budget deficit sufficient to stabilise the government debt/GDP ratio could lead to improvement in the country’s rating, according to Fitch.

The rating agency also projects that strengthening in trend GDP growth would also lead to an upgrade in the rating.

Fitch also forecasts that an improvement in financial viability of SOEs would also lead to an improvement in South Africa’s rating.