Fitch Affirms South Africa at 'BBB'; Outlook Negative

5 June 2015

Fitch Ratings - London-05 June 2015: Fitch Ratings has affirmed South Africa's Long-term foreign and local currency Issuer Default Ratings (IDR) at 'BBB' and 'BBB+', respectively. The Outlooks are Negative. The issue ratings on the senior unsecured foreign and local currency bonds have also been affirmed at 'BBB' and 'BBB+', respectively. The Country Ceiling has been affirmed at 'A-' and the Short-term foreign currency IDR at 'F3'.

Fitch has also affirmed the common Country Ceiling of the Common Monetary Area of South Africa, Lesotho (BB-), Namibia (BBB-) and Swaziland at 'A-', in line with South Africa's Country Ceiling.

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

KEY RATING DRIVERS 

South Africa's 'BBB' IDRs reflect the following key rating drivers:

Economic growth potential is weak. GDP growth averaged just 2.4% in the five years to 2014 (1.2% in per capita terms) well below rates in other emerging markets and its earlier record. Inadequate and unstable electricity supply, stemming from high maintenance needs at ageing power plants and delays in building new capacity, has forced energy utility Eskom to implement rolling power cuts. This supply constraint has led Fitch to revise down its GDP growth forecasts to 2.1% in 2015, 2.3% in 2016, well below estimates of growth potential of 3.5% - 4% pre-global financial crisis. However, we forecast growth to pick up to 3% in 2017 as energy constraints start to ease somewhat.

The current account deficit (CAD) has started to narrow, although is still large. Fitch forecasts it will decline to 4.5% of GDP in 2015 and 4.3% in 2016, from 5.4% in 2014, helped by lower oil prices and weak domestic demand. The CAD is financed predominantly by portfolio and debt inflows. Large external financing needs expose the country to shifts in global liquidity at a time when interest rate rises by the US Federal Reserve may trigger market volatility. The stock of non-resident holdings of domestic government debt was USD38.8bn at end-2014, compared with foreign exchange reserves of USD49.2bn. The floating exchange rate, moderate foreign currency debts and overseas assets provide buffers against a 'sudden stop' of capital inflows or its effects. 

Net external debt is a little higher than rating peers and rising. We estimate it at 13.5% of GDP at end-2014, up from 0% in 2009, and above the 'BBB' range median of 7%. However, around 55% of external debt is denominated in rand and the international investment position is close to balance, helped by equity investments abroad and valuation changes.

The government has started to tighten fiscal policy, which is leading to a reduction in the budget deficit, despite weak growth. The preliminary outturn for the consolidated budget deficit was 3.5% of GDP in 2014/15 (fiscal year ending March 2015, Fitch FY14), below the 3.9% projection in February's 2015 budget. Fitch estimates it at 3.6% in FY15 (3.9% in the budget) after the government halted the ZAR15bn (0.4% of GDP) reduction in Unemployment Insurance Fund contributions. Fitch's baseline is for further reductions in the deficit to 2.9% of GDP in FY16 and 2.5% in FY17.

New measures raise taxes by a net 0.2% of GDP in FY15, although the results of the Davis Tax Committee were postponed. The nominal non-interest expenditure ceiling (which the government has a track record of meeting since 2012) was lowered again but may be difficult to deliver. The public wage settlement of 7% in FY15 and CPI+1 in FY16 and FY17 is above the target for the wage bill in the budget, but not critically, and it has avoided a strike.

Public debt is somewhat higher than rating peers, but should stabilise as a ratio of GDP, if the government meets its fiscal targets. Fitch estimates general government (national plus local government) debt at 48.4% of GDP in FY14, up from 26% at end-2008, compared with the 'BBB' median of 42%. We project the ratio to peak at around 50% in FY17. The central government has cash deposits of 4.7% of GDP. 

The sovereign faces significant contingent liabilities. Non-financial state-owned enterprises have outstanding bonds and loans equivalent of ZAR494bn (14% of GDP) and the government has committed to providing guarantees of ZAR461bn by FY16 GDP. The bulk of these are to Eskom, which Fitch views as having a standalone profile of 'B-'. The government will recapitalise Eskom with ZAR23bn of equity funded by asset sales and ZAR60bn from the conversion of a government loan, as part of a turnaround strategy. 

Inflation has been higher than in many emerging market peers, and Fitch forecasts it to average 5.0% in 2015 and 6.2% in 2016. However, the South African Reserve Bank retains credibility in the markets and its 3%-6% inflation target forms an effective nominal anchor.

Standards of governance and the business climate are stronger than the 'BBB' median according to World Bank indicators. The banking system is well capitalised and has a standalone investment grade rating. Deep local capital markets enhance fiscal financing flexibility. The structure of government debt is favourable, with 91% denominated in local currency and an average maturity of 12 years (excluding Treasury bills), although 21% of domestic debt is inflation indexed and 35% is held by non-residents. 

In Fitch's view, structural reforms such as those identified in the National Development Plan (NDP) are necessary to raise GDP growth. However, implementation has been gradual and the goal of raising growth to 5% looks distant. Forthcoming wage negotiations in the gold and coal sectors could lead to further debilitating strikes or a sharp increase in wage costs. Other policy proposals under discussion such as parts of the mineral resources law, visa regulations, a minimum wage, amendments to the labour law and land reform could have an adverse impact on growth, if implemented.

RATING SENSITIVITIES

The Negative Outlook reflects the following risk factors that may, individually or collectively, result in a downgrade:

- Weak GDP growth and a failure to boost growth potential, for example if there are only modest structural reforms or are policy measures that damage the investment climate.

- Failure to reduce the budget deficit and stabilise the government debt/GDP ratio.

- Failure to materially narrow the CAD.

The rating Outlook is Negative. Consequently, Fitch's sensitivity analysis does not currently anticipate developments with a material likelihood of leading to an upgrade. However, future developments that may, individually or collectively, lead to a stabilisation of the Outlook include:

- An improvement in growth prospects, for example bolstered by the successful implementation of structural reforms in the NDP.

- A reduction in the budget and current account deficits.

KEY ASSUMPTIONS

Fitch assumes that the South African Reserve Bank is committed to maintaining inflation within or close to its 3%-6% inflation target and would act as required to fulfil its mandate.

The agency's fiscal projections are based on the assumption that the government will broadly stick to its budget deficit plans set out in the February 2015 budget.

Fitch assumes there is no severe and sustained fall in South Africa's terms of trade.

Statement issued by Fitch Ratings, June 5 2015