South Africa lifted on swift Covid recovery

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South Africa’s long-term foreign-currency issuer default rating’s (IDR) outlook has been lifted to stable from negative, by Fitch Ratings. This is on faster than expected economic recovery from the coronavirus disease 2019 (COVID-19) crisis.

The rating agency has also kept South Africa’s IDR at BB-  rating due to its favourable debt structure with long maturities and mostly local currency-denominated.

South Africa’s rating reflects faster than expected economic recovery, strong fiscal performance this year and significant improvements to key gross domestic product (GDP)-based credit metrics. This follows the re-basing of national accounts.

A recovery is under way and GDP now seems on track to return to pre-crisis levels during 2022, notwithstanding a 1.5% quarter-on-quarter contraction in the third quarter of 2021.

Fitch expects GDP to rise by 4.7% in 2021, boosted by base effects following the 6.4% contraction in 2020.

Growth will slow to 2% in 2022, held back by the low carry-over from a weak first half of 2021, continued effects of the crisis and electricity shortages.

This is with a moderate strengthening to 2.4% in 2023 as the negative output gap remains large. Fiscal indicators have also improved, supported by the economic recovery.

Fitch expects a consolidated fiscal deficit in the fiscal year ending March 2022, 7.7% of GDP, down from 10% in 2021.

These are both substantially better than previously expected, followed by further declines to 6.2% in 2023 and 2024.

The strong deficit reduction this year is due to a 4.1% of GDP rise in revenue according to forecasts, well above earlier expectations, driven in part by a surge in commodity prices this year.

Some of the higher revenue has been used for a fiscal support package of 0.6% of GDP announced in July to accommodate the economic impact of the riots in July and the continued effects of the crisis.

However, the upward adjustment to expenditure was substantially less than the over-performance in revenue, leading to lower deficits and a slower rise in government debt than expected.

The crisis continues to weigh on economic performance and remains a source of downside risk for public finances.

However, the likelihood of severe negative effects on creditworthiness has declined over the last year. This is despite the recent emergence of the Omicron variant of COVID-19 and the associated rapid surge in new cases in South Africa.

A tightening of containment measures is likely but Fitch assumes such measures would be short in duration and targeted, primarily hitting the hospitality sector rather than overall economic activity.

Major re-basing of national accounts has meant that 2020 nominal GDP was 11% higher than previously reported.

This has affected key credit metrics including GDP per capita and government debt to GDP, which for 2021 now stands at 72.2% rather than 81% based on the old national accounts data.

South Africa’s BB- IDRs are constrained by high and rising government debt, low trend growth and high inequality that will complicate consolidation efforts.

Weak trend growth remains a key credit weakness. Fitch estimates potential growth at just 1.1%, although the large negative output gap means actual growth will exceed that level for several years.

Low growth reflects deep-rooted labour market problems including skill mismatches and the fractious relationship between social partners but also very weak investment, exacerbated by electricity shortages.

While significant investment in power generation capacity are forthcoming in the form of independent power producer (IPP) contracts, it could take several years to stabilise electricity supply.

Reforms currently under way, including regulation of network industries and measures to boost investment, are moving only slowly and are insufficient to change the growth path significantly.

The announcement of a review of macroeconomic policies could lead to a lowering of the 3% to 6% inflation target.

Implications on monetary policy are likely to be moderate, given the strong credibility of the South African Reserve Bank (SARB), although it could initially lead to a slightly tighter monetary stance.

The SARB raised its policy rate by 25 basis points to 3.75% in November and in the context of global policy tightening, Fitch expects gradual further hikes to 5.5% in 2023.

This is despite a benign domestic inflation environment with inflation expectations firmly anchored close to all-time-lows.

Fitch expects government debt to GDP to remain on an upward trajectory, rising from 72.2% of GDP at end of 2021 to 76.1% of GDP in 2022 and 2023.

Fiscal deficits, while lower than previously expected and declining, will remain high, with significant upward risks.

Government’s consolidation strategy relies heavily on wage restraint in the public sector. This includes no nominal increase in compensation spending in 2022 and 2023, which Fitch believes will be hard to achieve.

While the government uses medium-term expenditure ceilings as an anchor it is unclear if it can stick to the ceilings.

The government had strictly adhered to the ceilings since their introduction in 2012 until a breach in 2020 due to bail-outs for state-owned enterprises and in 2021 and 2022 due to the crisis.

Pressure for a permanent social benefit programme for those not receiving unemployment, retirement or disability benefits is rising.

The government has committed to provide support for state-owned enterprises of around 0.4% of GDP per year over the next three years, after 1.5% in 2021 and 1.2% in 2022.

However, the risk that further spending will become necessary is high. While contingent liabilities from financial and non-financial state-owned companies and IPPs contracts are not unusually high, at 16% of GDP in 2021, the financial performance of the sector is particularly weak.

The government is still considering ways to lower the debt of the state-owned power company Eskom, currently at around 8% of GDP, to ensure its long-term viability.

Government plans to sell a majority stake in Southern African Airways to a local consortium, but it is not clear if this could open the way for partial privatisation of other SOEs with problems.

Contingent liabilities from the banking sector are contained, and a recent stress test suggested major banks could withstand a renewed substantial contraction.

South Africa last year recorded its first current account surplus since 2002, and Fitch expects the surplus to rise to 4.4% of GDP this year on the back of the strong commodity prices.

The current account will then gradually return to a small 0.2% of GDP deficit in 2023 as commodity prices become less supportive and import demand normalises.

The benign starting position of external accounts could still help South Africa weather less supportive international financing conditions in the context of global QE tapering and interest rate hikes.

While its foreign-currency debt is low, the high participation of non-residents in the local government debt market, holding a 30% share, is still a source of exposure.

Fitch would downgrade the rating if there was failure to implement fiscal consolidation measures that raise confidence in the ability of the government to stabilise fiscal debt to GDP.

A further weakening of trend growth or a sustained shock that further undermines fiscal consolidation efforts and raises socioeconomic pressures would also lead to a downgrade.

Fitch would also downgrade the rating if there were rising risk of a de-stabilising large net capital outflows that triggers sharp exchange rate depreciation, higher inflation and interest rates.

The rating agency would upgrade the rating if there was progress on fiscal consolidation that increases confidence that government debt to GDP will be reduced over the medium term.

Fitch would also upgrade the rating if there was greater confidence in stronger growth prospects, sufficient to support fiscal consolidation and address challenges from high inequality and unemployment.

This comes after South Africa’s long- and short-term foreign currency sovereign credit ratings were affirmed at BB-/B, with a stable outlook, by S&P Global Ratings, earlier in 2021.

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