Fitch Downgrades South Africa to 'BBB-'; Outlook Stable

04 DEC 2015 4:05 PM EST

Fitch Ratings-London-04 December 2015: Fitch Ratings has downgraded South Africa's Long-term foreign and local currency Issuer Default Rating to 'BBB-' from 'BBB' and to 'BBB' from 'BBB+', respectively. The Outlooks are Stable. The issue ratings on South Africa's senior unsecured foreign and local currency bonds have also been downgraded to 'BBB-' from 'BBB' and 'BBB' from 'BBB+', respectively. 

The Country Ceiling for South Africa and the common Country Ceiling of the Common Monetary Area of South Africa, Lesotho (BB-), Namibia (BBB-) and Swaziland has been lowered by two notches to 'BBB' from 'A-'. The Short-term foreign currency IDR has been affirmed at 'F3'. 

The rating of the RSA Sukuk No. 1 Trust has been downgraded to 'BBB-' from 'BBB', in line with the Long-term foreign currency IDR.

KEY RATING DRIVERS 

The downgrade of South Africa's IDRs reflects the following key rating drivers and their relative weights:

HIGH

GDP growth performance and estimates of growth potential have weakened further. There have been additional delays to the availability of new electricity generation capacity, which will likely constrain growth for another two years. Despite the ambitious structural reforms in the National Development Plan (NDP), various policies have weakened business confidence and South Africa's position in the World Bank's Doing Business rankings has fallen to 73rd from 69th.

This deterioration is reflected in the lowering of Fitch's GDP growth forecast to 1.4% for 2015 (from 2.1% in the previous review in June 2015) and to 1.7% for 2016 (from 2.3%). While growth is expected to accelerate to 2.4% in 2017, it will remain well below the country's growth trend before 2008 of around 4% and the NDP target of 5%. 

MEDIUM

Fitch forecasts gross general government debt (which includes local government) to increase to 51% of GDP at end 2015/16. This is up from 26% of GDP in 2008/09 and above the 'BBB' range median of 43%. The government revised up its forecast for the consolidated budget deficit in October's Medium-Term Budget Policy Statement to 3.3% of GDP in 2016/17 (from 2.6% in February's budget) and 3.2% in 2017/18 (from 2.5%).

It chose not to tighten fiscal policy in response to weaker revenues, highlighting the challenge of reducing the budget deficit and stabilising the ratio of government debt/GDP against a backdrop of weak economic growth. We project government debt/GDP to rise to 52.4% in 2017. The government also has contingent liabilities equivalent to 11.5% of GDP, mainly in the form of potential guarantees to state-owned enterprises including Eskom, the state electricity utility which it had to recapitalise this year, although issued guarantees are only 5.6% of GDP.

South Africa has a persistent current account deficit (CAD), which Fitch forecasts at 4.3% of GDP in 2015, despite weak domestic demand and the sharp depreciation of the rand. The CAD has contributed to deterioration in the country's net external debt/GDP ratio to an estimated 16.1% at end-2015 and exposes it to shifts in global liquidity and risk appetite. 

The 'BBB-' rating also reflects the following factors: 

The NDP has not delivered a rapid or material improvement in the business environment and medium-term growth prospects in Fitch's view. Unemployment remains stubbornly high, at 25.5%, and the share of the working age population in employment is only 43.8%. 

Electricity constraints have eased somewhat, with virtually no load shedding reported for recent months and the prospect of no load shedding until May 2016 according to Eskom. However, the timeframe for new power capacity has suffered further setbacks. A first generating unit at the Medupi plant came online in August 2015, but additional units at Medupi and Kusile will only gradually be completed from 2018 onwards. 

Government policies such as visa restrictions (since abolished), delays to the mineral resource law and prospective plans for land reform and a national minimum wage are not always conducive to economic growth. The government is considering requiring secret ballots for votes on strike action, which may reduce the propensity for violence and strikes. Major industrial action has been avoided so far in 2015, but this has been achieved in part through accommodative wage agreements. 

The banking system is strong, with a standalone Fitch banking system indicator of 'bbb'. South Africa also has deep and partially captive local capital markets with assets under management around twice GDP, which increases the government and economy's financing flexibility. Moderate credit growth in recent years suggests that macro-prudential risks are limited. 

South Africa scores better than the 'BBB' range median on the World Bank's governance indicators. The quality of monetary and fiscal institutions is a strength. Although inflation is relatively high, and will again breach the top of the 3%-6% inflation target in 2016, the South African Reserve Bank retains credibility and demonstrated its independence by raising interest rates again in July and November, despite subdued economic growth. The floating exchange rate provides a buffer against shocks. 

The Treasury has stuck to its nominal non-interest expenditure ceiling since 2012, providing a fiscal anchor. Both the headline and primary budget deficits are forecast to decline. Nevertheless, the above-planned public wage settlement has used up most of the contingency reserve, reducing the capacity of the budget to absorb further shocks. The government has several ambitious policy programmes, including the construction of nuclear power plants with a capacity of 9.6GW. However, this has yet to be agreed and the cost and financing remains uncertain. 

The structure of government debt is highly favourable, with only 8.5% denominated in foreign-currency debt and an average maturity of marketable bonds at 13.8 years. This provides the public finances some insulation against exchange rate shocks and rollover risk.

The CAD narrowed to USD6bn (3.9% of GDP) in 1H15, from USD9.5bn in 1H14, helped by weak domestic demand and the rising prices of imports related to the sharp currency depreciation. Fitch forecasts the CAD at 4.3% of GDP in 2015, 4.1% in 2016 and 3.9% in 2017, below its average of 5.4% from 2012-14. However, subdued commodity prices, a lack of capacity to produce goods currently imported and the tendency for gains in competitiveness to be absorbed by higher wage growth will limit the structural improvement. 

RATING SENSITIVITIES

The following risk factors, individually or collectively, could trigger negative rating action: 

- A loosening of fiscal policy, such as upward revisions to expenditure ceilings, leading to a failure to stabilise the ratio of government debt/GDP.
- Further marked weakening in trend GDP growth, for example due to a lack of policy changes to improve the investment climate.
- Rising net external debt to levels that raise the potential for serious financing strains. 

The following risk factors, individually or collectively, could trigger positive rating action: 

- A track record of improved growth performance, for example bolstered by the successful implementation of growth-enhancing structural reforms. 
- A marked narrowing in the budget deficit and a reduction in the ratio of government debt/GDP.
- A narrowing in the current account deficit and improvement in the country's net external debt/GDP ratio. 

KEY ASSUMPTIONS

Fitch assumes that the government will stick to its expenditure ceilings set out in the October 2015 Medium-Term Budget Policy Statement.

The agency assumes that the South African Reserve Bank remains committed to maintaining inflation within its 3%-6% inflation target.

Statement issued by Fitch Ratings, 4 December 2015