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Thursday, 2 July 2015

Zambia credit downgrade

Editor's note : The ratings agency Standard and Poor has downgraded Zambia's long term credit rating because of deteriorating fiscal situation. It has kept the short term rating the same. S&P has become the first of three agencies to downgrade Zambia. It notes that public sector debt is on course to be more 50% of GDP if Alexander Chikwanda's new Eurobond debt plans succeed.   Fitch recently signaled the possibility of a downgrade in August unless the economic situation improves. Worsening credit rating may impact on the cost of borrowing and compound the current depreciation of the Kwacha.

KEY POINTS

  • In our opinion, Zambia's fiscal position is markedly and negatively deviating from our previous expectations. We believe the government's policy response will be constrained in the run-up to September 2016 elections.
  • We are therefore lowering our long-term sovereign credit ratings on Zambia to 'B' from 'B+' and affirming our 'B' short-term ratings.
  • The outlook is stable, reflecting our expectation that the fiscal deficit will not weaken over 2015-2018 more than we currently anticipate.
RATING ACTION

On July 1, 2015, Standard & Poor's Ratings Services lowered its long-term foreign and local currency sovereign credit ratings on the Republic of Zambia  to 'B' from 'B+'. At the same time, we affirmed our 'B' short-term foreign and local currency ratings. The outlook is stable.

As a "sovereign rating" (as defined in EU CRA Regulation 1060/2009 "EU CRA  Regulation"), the ratings on the Republic of Zambia are subject to certain publication restrictions set out in Art 8a of the EU CRA Regulation, including publication in accordance with a pre-established calendar. Under the  EU CRA Regulation, deviations from the announced calendar are allowed only in  limited circumstances and must be accompanied by a detailed explanation of the reasons for the deviation. 

In this case, the reason for the deviation is a significant deterioration, beyond our expectations, in fiscal metrics and the consequent increase in government indebtedness. The next scheduled rating  publication on the sovereign rating of the Republic of Zambia will be on Sept. 25, 2015.

RATIONALE

In our March 27, 2015, review of Zambia, we indicated that we could lower our ratings on Zambia if its fiscal or external position deteriorated beyond our expectations. Since that time, and in line with the government's recent midyear economic and budget review, we think that pressures on Zambia's fiscal position have markedly increased. 

We now expect the 2015 fiscal deficit, on a  gross cash basis, will widen to approximately 10% of GDP, versus our previous estimate of 6%. Including arrears, we expect the 2015 deficit will be about 14% of GDP. We think that financing this deficit will lead to increased external indebtedness and higher related interest costs. With the next round of elections scheduled in September 2016, we view the likelihood of deep-rooted fiscal reform that could tackle weakening public finances as limited.

Zambia's fiscal position has become increasingly strained, with government expenditures increasing by some 4% of GDP between 2012 and 2014 (to 26% of  GDP), while revenues remained generally stable at 20% of GDP over the same  period. The government estimated, in its June midyear economic and budget review, that 2015 expenditures, including partial arrears payments, would increase by some 8% of GDP, while revenues, mainly related to the mining sector would decline. 

The government has indicated a consolidation package of  approximately 3% of GDP. However, the related measures remain uncertain, as  does the timing of their implementation. Furthermore, in addition to the extra cost likely to be incurred for the 2016 elections, we think the potential for  a deep-rooted rebalancing of public finances before this time is limited and  that fiscal deficits will remain elevated as a result. 

That said, on a cash basis, we expect the size of the deficit will be more limited, as deficits can only be incurred to the extent financing resources are available. These factors mark a pronounced deviation from our previous assumptions.

On the expenditure side, interest costs on debt have increased. On domestic debt, tighter liquidity in the banking sector has dampened appetite for government paper, as illustrated by 60% subscription rates on recent debt  auctions, forcing yields up--on a composite basis for treasury bills--to  nearly 20%. 

Furthermore, we expect a high rate of maize purchases from farmers (similar to 2014 levels), a budgeted 18% increase in goods and services, and  the planned clearance of a growing stock of arrears to keep expenditures high. In terms of arrears, at the end of 2014, 2.1% of GDP related to disputed  value-added tax payments and 2.5% related to payments to contractors.

The government has looked to the mining sector as a potential source of  income, which could help to fund increased expenditures. The World Bank  estimates that 16% of total Zambian government revenues derived from mining  activity over the past few years. 

From January 2015, the highly controversial  mineral royalty tax regime had been increased to 20% from 6% for the larger,  open-cast mines, and to 8% from 6% for underground mines, following a  government review. This was subsequently revised down to 9% for all mines, after a period of intense industry lobbying, because it became clear that such measures could have a significant impact on overall copper production as smaller, less efficient mines could be forced to close. 

This represents the fifth revision to Zambia's mining fiscal regime since 2008. Given the reduced production through the first quarter of 2015--8.5% lower than in first-quarter 2014--and continued subdued copper prices, we expect that revenues from mining operations (company tax and mineral royalties) will be up to 50% lower than originally budgeted for 2015. We anticipate that uncertainty over the final royalty rate will remain and potentially reduce production, until the next administration clarifies its policy toward the mining sector.

We understand the Zambian government plans to finance the 2015 fiscal deficit by issuing a Eurobond, which we expect will contribute to a net debt burden of about 50% of GDP, including the impact of the 16% depreciation of the Zambian kwacha so far in 2015. We also expect that as a proportion of lower government revenues, interest costs will become increasingly burdensome.

We think that the current fiscal uncertainty may be curbing foreign investment in Zambia, beyond just in the mining sector, and potentially detracting from otherwise positive longer-term growth prospects. Although we have not factored a potential investment slowdown into our growth forecasts through to 2019, because we think that mining production will increase as fiscal issues are fixed and that prices will increase, the current slowdown could well dampen future copper production growth.

On a positive note, Zambia's growth performance has continued to be strong, despite a 6% reduction in copper production in 2014. An increase in the maize harvest is likely in 2015, related to improved weather conditions, which should feed through into increased food and beverage manufacture and electricity production. The tourism and transportation sectors posted healthy growth in 2014, which we expect will continue, linked to solid regional 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 ability to generate and export electricity, and aggregate demand from neighbouring countries continues to grow.

The impact of the 30% fall in copper prices from midyear 2013 to today's prices has not been as strong as 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 neighbouring Democratic Republic of Congo, which is exported through Zambia. However, data do 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 averaging negative 1.5% of GDP over 2013 and 2014, versus the marginal surplus we previously expected. However, our future assumptions on copper production  and price (US$2.7/pound) underpin our expectation that the current account  deficit will 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. Zambia’s stock of external assets reflect mining sector profits from copper sales that have  been invested abroad.

Following the robust policy response to the kwacha's depreciation in the first half of 2014 (tightening the policy rate to 12.00% from 9.75% and increasing  banks' reserve requirements by 6% to 14%), downward momentum in copper prices  (in part linked to oil prices) resumed in tandem with a strengthening U.S.  dollar. Zambia's reserve position ststood at US$2.7 billion at the end of 2014, 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 to 18% from 14%, 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 will remain under 10% over the forecast.

OUTLOOK

The stable outlook on Zambia reflects our expectation that the fiscal deficit will not deteriorate further over 2015-2018 than our current base-case  projections.

We could raise the ratings if reform to public finances indicates a  sustainable consolidation path without deterring future investment in growth  producing activities.

We could lower the ratings if we observe that the government will struggle to finance emerging fiscal gaps. Moreover, we could lower the ratings if inflows  of external funds drop, causing a deterioration in external balances.

(Source : Standard & Poor)

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