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Monday, 6 April 2015

Zambia Standard & Poor Rating (March 2015)

Editor's note: Standard and Poor a week ago affirmed Zambia's credit rating at 'B+', and kept its outlook on negative based on fiscal and external risks.
Overview
  • We continue to believe that Zambia’s institutional strengths and solid growth prospects remain sufficient to offset increasing short-term fiscal and external challenges.
  • However, we consider that policy-making could be constrained by political considerations, preventing the final resolution of key fiscal uncertainties, which could add to copper-price led currency depreciation and external pressure.
  • We are affirming our 'B+/B' sovereign credit ratings on Zambia.
  • The outlook remains negative, reflecting increasing uncertainty over Zambia's management of public finances and external accounts.

Rating Action 

On March 27, 2015, Standard & Poor's Ratings Services affirmed its 'B+/B' long- and short-term foreign and local currency sovereign credit ratings on the Republic of Zambia. The outlook is still negative.

Rationale

Since our last review in October 2014, Zambia’s fiscal challenges have increased and the external environment has deteriorated, partially due to a fall in copper prices. Despite these intensifying and increasingly interrelated challenges, we have affirmed our ratings on Zambia because we continue to believe that a relatively stable political environment and continued strong growth prospects act as a counterbalance.

However, we expect a shorter-term deterioration in both public finances and external accounts, and, together with the ongoing local currency weakness, these pose downside risks to the rating. Following the death of President Michael Sata and in the lead-up to 2016 elections, we are also concerned that the policy-making environment will be constrained and that fiscal uncertainties will remain, which in turn could hamper mining sector activity, undermine overall private sector confidence, and further pressurize the kwacha. We no longer include an International Monetary Fund program in our base-case assumptions and believe that fiscal financing gaps could appear over 2015.

The ratings on Zambia are constrained by its fairly low level of economic development (we estimate GDP per capita at US$1,466 in 2015), and vulnerability to copper prices, as copper accounts for almost 70% of goods exported. The ratings are supported by promising long-term investment prospects in the mining sector, positive economic growth trends, moderate general government debt, and a moderate, but increasingly indebted, external balance sheet.

At approximately 5.4% of GDP, Zambia’s 2014 fiscal deficit was narrower than we had expected, but underperformance on the expenditure side because of procurement delays on infrastructure projects, a buildup of arrears to construction companies that now total about 1.2% of GDP, and failure to resolve US$600 million (2.6% of GDP) in disputed refunds of value-added tax (VAT) all point to a weakening of public finances.

On the revenue side, income taxes and VAT receipts exceeded our expectation, reflecting continued strong economic growth, particularly in the manufacturing and agriculture sectors. However, corporate tax and grant revenues both underperformed. Grant revenues, expected at 1.6% of GDP, were almost entirely absent after international financial institutions suspended funds following an increase in fiscal imbalances that were in part caused by significant public sector salary increases.

We no longer include the repayment of the US$600 million in disputed VAT receipts to mining companies in our fiscal projections. A full settlement of the dispute between the government and mining companies over withheld VAT repayments appears unlikely before the September 2016 elections. We believe that this, alongside the introduction of a new mining royalty regime, may dent business confidence in the mining sector at a time when copper prices are expected to remain low. Given Zambia's significant infrastructure needs, the need to clear arrears, and continued subsidy provision (which increased by 25% against amounts budgeted in 2014, totaling 3.4% of GDP), financing gaps in the 2015 budget could well emerge.

Net general government debt increased significantly in 2014, to 33% of GDP, from 27% in 2013, following the issuance of Zambia’s US$1 billion Eurobond. We expect that fiscal deficits of about 6% of GDP in 2015-2018 will continue to add to the debt burden. In addition, the continued depreciation of the kwacha on this increased stock of external debt, which comprises 55% of total debt, is behind our projection for net debt to increase to over 40% of GDP over 2015-2018. We expect that multilateral foreign lending will be available, but that it and commercial borrowing will incur higher interest rates than in the past as Zambia approaches middle-income status.

On a positive note, Zambia’s growth performance has continued to be strong, despite a 6% reduction in copper production in 2014. A significant increase in the corn harvest fed through into increased food and beverage manufacture and electricity production increased over 2013 levels. The tourism and transportation sectors also posted healthy growth. We continue to view Zambia's growth prospects as strong, reflected in the potential of its agricultural, mining, electricity, and services sectors. An estimated 20% of potential agricultural land is currently under cultivation, the country's coal and gemstone resources remain substantial, as does its capacity to generate and export electricity, and demand from neighboring countries continues to grow.

We expect non-copper production growth to increase and to support an average real GDP growth of about 6.5% during 2015-2018, in line with average growth in 2007-2012. However, copper production fell by about 6% in 2014 because of technical difficulties of some older mining operations. We include a resumption of production in our 2015 growth expectations, and expect figures more in line with 2013 levels, which is notably lower than the goverment's official 11.7% growth estimates.

The impact of the 30% fall in copper prices from midyear 2013 to today’s prices has not been as evident as one might have expected on Zambia’s current account; copper export earnings actually increased by 10% in 2014 over 2013, totalling 69% of all exports. We understand this increase is likely to be related to production in the Democratic Republic of Congo, which is exported through Zambia. However, data does not appear to fully capture a related increase in copper imports, leaving the potential for downward revisions to the current account data. Following a data revision, Zambia’s current account turned to a deficit position averaging -1.5% of GDP over 2013 and 2014, from what we expected to be a marginal surplus. However, our future assumptions on copper production and price (US$2.7/pound) mean we expect the current account deficit to widen, adding to Zambia’s stock of moderate, but growing external liabilities.

On a net basis, we expect Zambia’s external position (debt and liability) to deteriorate as foreign asset accumulation slows, reflecting reduced corporate profitability, which in turn is linked to lower copper prices. When expressed as a ratio of current account receipts, we note a significant negative development, which again relates to the 26% depreciation of the kwacha in 2014 and continuing into March 2015. Zambia’s stock of external assets mainly relates to expatriated mining sector profitability.

Following the robust policy response to the kwacha's depreciation in the first half of 2014 (tightening the policy rate from 9.75% to 12% and increasing banks’ reserve requirements by 6% to 14%), downward momentum in copper prices (which are in part linked to oil prices) resumed in tandem with a strengthening U.S. dollar. Zambia’s reserve position stands at US$2.7 billion or 2.7 months of current account payments. We expect the national bank's policy responses to include further tightening action, such as the recently announced increase in capital requirements from 14% to 18%, which could reduce banking sector liquidity and the ability of the local banks to absorb government debt. In addition, the weaker kwacha has stoked inflationary pressures, although with a lower fuel bill, we expect inflation to remain under 10%.

Following the death of President Sata, President Edgar Lungu, also from the ruling Patriotic Front party, was elected in a relatively smooth transition, in line with Zambia's democratic traditions. Although we expect that policy-making will enter a holding pattern before the next full elections in late 2016, we expect Zambia’s political environment to remain stable relative to that of peers and do not anticipate radical changes in policy, either before or after the scheduled 2016 elections.

Outlook

The negative outlook reflects increasing uncertainty over Zambia’s public finances and external accounts.

We could lower the ratings if the government's policy stagnates and leads to a further deterioration in Zambia’s fiscal position. Similarly, we could lower the ratings if external pressures further strain Zambia's external accounts.

We could revise the outlook to stable if policy uncertainties are resolved constructively, leading to improved mining sector activity and structural improvement in public finances. We could also consider revising the outlook to stable if our assumptions concerning the weakening external metrics, in part because of a weaker kwacha, prove too conservative, and Zambia instead displays a stronger-than-anticipated external performance and reserve position.

More detail can be found on the Standard and Poor website here.

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