Fitch Ratings has affirmed South Africa's Long-Term Foreign-Currency Issuer Default Rating (IDR) at 'BB+' with a Stable Outlook.
A full list of rating actions is at the end of this rating action commentary.
KEY RATING DRIVERS
South Africa's ratings are weighed down by low trend growth, sizeable government debt and contingent liabilities and the highest inequality in the world, which raises policy risks. These weaknesses are balanced by a favourable government debt structure, deep local capital markets, a healthy banking sector and strong institutions. The affirmation and Stable Outlook takes into consideration signs of recovering governance standards and the prospect of a mild cyclical recovery but also indications that financial challenges at key state-owned enterprises (SOEs) remain substantial and the fact that government debt has yet to stabilise.
Following his selection as ANC president in December, Cyril Ramaphosa quickly took office as president of South Africa, avoiding a period of competing power centres that could have hampered policy-making. The government has prioritised improving the governance of SOEs in the face of allegations of earlier high-level corruption. However, policy-making could still be hindered by significant tensions within the ANC, evidenced by legal challenges involving ANC provincial structures. Policy-makers over the next year will also be preoccupied with a parliamentary election due by August 2019. An earlier election remains possible.
The continued exceptionally high inequality and high unemployment (27.5% at end-2017) could raise long-term pressures for measures that might harm fiscal sustainability or growth prospects. However, despite serious challenges over the last years, South Africa's institutions, including the judiciary, SARB and the National Treasury, have shown significant resilience.
The change in political leadership following the ANC electoral conference in December has led to a significant improvement in economic confidence. Despite a sharp quarter-on-quarter contraction in 1Q, GDP growth will recover to 1.7% in 2018 and 2.4% in 2019 from 1.3% in 2017. This will reflect relatively steady private consumption growth combined with strengthening gross fixed investment. Trend growth, which Fitch estimates at just below 2.0%, is barely above population growth of around 1.5% and well below the five-year average growth rate of 3.4% for the 'BB' category median.
Current government initiatives are unlikely to improve trend growth significantly, as their implementation and timeline is uncertain and their impact on growth ambiguous. Measures undertaken include a high-profile campaign to attract USD100 billion of new investments over the next five years and a labour market reform introducing a national minimum wage and some measures to contain the risk of strikes. Land reform, including expropriation without compensation, will likely be handled so as to avoid significant economic damage, in our view. However, the policy will focus investors' minds on the more general risks to property rights resulting from high inequality.
The budget presented in February included a modest reduction of the planned deficit trajectory largely reflecting stronger growth prospects. It contained substantial new consolidation measures, including revenue measures worth 0.7% of GDP, notably a 1pp hike in the VAT rate and expenditure cuts by 0.5% of GDP per year relative to earlier targets. However, this was offset by higher expenditure, notably on an initiative to provide free tertiary education to students from a larger number of families, which will cost 0.2% of GDP in FY18/19 and 0.4% of GDP in FY19/20.
We expect the general government (GG) budget balance to fall to 3.5% of GDP in FY18/19 and further to 3.1% of GDP in FY20/21 from 4.2% of GDP in FY17/18. These forecasts are slightly more optimistic than the government's as our growth forecasts are higher than the budget assumptions. We expect GG debt (including local government debt of around 1.7% of GDP) to reach at 58% of GDP in FY19/20, compared with a 'BB' category median of 49%.
High debt and poor performance of SOEs remain a risk to the sovereign, and far-reaching restructuring measures could be politically difficult to implement. Eskom, the SOE with the highest debt, faced significant liquidity strains as lenders concerned about governance problems refused to roll over debt and to grant new financing in 2017. As a result of changes to Eskom's leadership earlier this year, the company has regained access to financing but returning it to viability will be challenging. Management is still preparing a turn-around strategy. While the authorities state further cash injections will not be needed, Fitch assumes some financial support from the government will be required. The government has already acknowledged that state airline SAA, which is also under pressure, will require further state support in addition to an injection received in 2017.
Total SOE debt securities and loans amounted to 13.4% of GDP in 3Q17. The government guarantees only 6.4% of GDP of public institutions (mainly SOE) debt, but the government would face significant pressure to stand behind non-guaranteed debt as well. Other sources of contingent liabilities, on which South Africa is particularly transparent, include contracts with independent power producers (2.6% of GDP) and unused guarantees to SOEs of 3.5% of GDP that may still be called on.
The current account deficit narrowed to 2.5% of GDP in 2017 but Fitch expects it to widen moderately, to 3.6% of GDP in 2019, on the back of stronger domestic demand. South Africa will be exposed to a tightening in global financing conditions given that more than 40% of domestic bonds are held by non-residents and that the current account deficit is mainly financed by portfolio inflows. However, the flexible exchange rate, the exceptional long average remaining maturity of 15 years of the government debt stock and the deep domestic capital market help to contain the sovereign's vulnerability. Net external debt is expected to rise to 23.8% of GDP in 2019, compared to a 'BB' category median of 9.5%.
SOVEREIGN RATING MODEL (SRM) and QUALITATIVE OVERLAY (QO)
Fitch's proprietary SRM assigns South Africa a score equivalent to a rating of 'BBB' on the Long-Term Foreign-Currency (LT FC) IDR scale.
Fitch's sovereign rating committee adjusted the output from the SRM to arrive at the final LT FC IDR by applying its QO, relative to rated peers, as follows:
- Macroeconomic Performance, Policies and Prospects: -1 notch, to reflect South Africa's weak growth prospects relative to the 'BB' and 'BBB' category medians, with important implications for public finances and long-term risks to social stability.
- Public Finances: -1 notch, to reflect substantial contingent liabilities mainly from SOEs, exacerbated by challenges to the liquidity and long-term viability of some of the SOEs.
Fitch's SRM is the agency's proprietary multiple regression rating model that employs 18 variables based on three-year centred averages, including one year of forecasts, to produce a score equivalent to a LT FC IDR. Fitch's QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.
RATING SENSITIVITIES
The following risk factors could, individually or collectively, result in negative rating action:
- A deteriorating debt/GDP trajectory resulting from a renewed widening of fiscal deficits or the migration of a large part of SOE debt to the sovereign balance sheet.
- A further deterioration in South Africa's trend GDP growth rate.
- Rising net external debt to levels that raise the potential for serious financing strains.
The following risk factors could, individually or collectively, result in positive rating action:
- Narrowing in the budget deficit sufficient to achieve a substantial reduction in the government debt/GDP ratio.
- A substantial strengthening in trend GDP growth.
- An improvement in governance standards and financial viability of SOEs.
KEY ASSUMPTIONS
Fitch expects global economic trends and commodity prices to develop as outlined in Fitch's Global Economic Outlook.
The full list of rating actions is as follows:
Long-Term Foreign-Currency IDR affirmed at 'BB+'; Outlook Stable
Long-Term Local-Currency IDR affirmed at 'BB+'; Outlook Stable
Short-Term Foreign-Currency IDR affirmed at 'B'
Short-Term Local-Currency IDR affirmed at 'B'
Country Ceiling affirmed at 'BBB-'
Issue ratings on long-term senior unsecured foreign-currency bonds affirmed at 'BB+'
Issue ratings on long-term senior unsecured local-currency bonds affirmed at 'BB+'
Issue ratings on short-term senior unsecured local-currency bonds affirmed at 'B'
Issue ratings on sukuk trust certificates issued by RSA Sukuk No. Trust affirmed at 'BB+'
