South Africa Ratings Affirmed; Outlook Remains Negative On Weak Growth
03-Jun-2016 11:36 EDT
Low GDP growth is putting South Africa's economic metrics at risk and could eventually weaken the government's social contract with business and labor.
Rising political tensions are accentuating vulnerabilities in the country's sovereign credit profile.
Still, energy sector improvements will likely reduce some of the economic bottlenecks and pending finalization of labor and mining reforms could engender a positive confidence shock. On the fiscal side, the government is showing greater resolve to reduce fiscal deficits at a faster pace than we expected.
We are therefore affirming our 'BBB-/A-3' foreign currency and 'BBB+/A-2' local currency ratings on South Africa.
The outlook remains negative, reflecting the potential adverse consequences of low GDP growth and signaling that we could lower our ratings on South Africa this year or next if policy measures do not turn the economy around.
On June 3, 2016, S&P Global Ratings affirmed its long- and short-term 'BBB-/A-3' foreign currency and 'BBB+/A-2' local currency sovereign credit ratings on the Republic of South Africa. The outlook remains negative.
At the same time, we affirmed the 'zaAAA/zaA-1' South Africa national scale ratings.
South Africa's weak economic growth, relative to that of peers in similar wealth categories, continues to be hurt by a combination of factors, in our view. On the external side, adverse terms of trade and weak external demand have created headwinds. On the domestic side, drought and subdued mining and manufacturing output, coupled with structural constraints, remain key negative factors.
Largely due to some of these cyclical factors, we have revised down our real GDP growth assumptions for South Africa to 0.6% in 2016 from our 1.6% forecast published in December 2015. As weather patterns and terms of trade revert to mean levels, economic growth should improve.
However, to place South Africa's economy on firmer footing and to maintain our investment-grade rating, we see several structural measures as key. The first is the provision of a reliable source of energy, where we have observed progress. Eskom, the state-owned power utility, has improved the energy supply through a better maintenance program, managing demand in peak periods, and by additions from its new power plants and from independent power producers.
The combined measures have helped eliminate load shedding, which was prevalent in the last winter cycle and depressed overall 2015 economic growth. The second is labor reform. Prolonged strikes, mainly in mining and some manufacturing sectors, combined with less flexible labor laws and high youth unemployment, continue to pose structural weaknesses to South Africa's economy.
The third measure is the mining code, for which negotiations on Black Economic Empowerment are already sensitive. On these latter two points, we see risks that negotiations between the government, private sector, and unions could become protracted and, even if concluded, implementation could be nettlesome. Rules regarding labor relations and extractive industries are contentious in any country, but even more so in South Africa, given the historical legacy of apartheid.
However, these challenges are not new and we believe a successful conclusion could help improve confidence and investment. The fourth factor pertains to the cohesion of the executive branch. Political tensions have increased in South Africa since the removal of former Finance Minister, Nhlanhla Nene, on Dec. 9, 2015; the Constitutional Court ruling against President Jacob Zuma on March 31, 2016; and periodic disputes between key government institutions and within the ruling African National Congress (ANC).
We believe that these political factors--if they continue to fester--could weigh more on investor confidence than inconclusive labor or mining sector reform. We base our rating affirmation on the expectation that they will be held in check, albeit in the context of political jockeying in the run-up to local government elections in August of this year and the ANC's elective conference in December 2017.
Keeping in mind these structural issues and our expectation that future interest rate hikes by the U.S. Federal Reserve will not roil emerging markets and that China will remain moderately supportive of world growth, we forecast South Africa's economy will grow 1.5% in real terms in 2017 and rise above 2% only by 2019. We also estimate that real GDP per capita will stand at US$5,000 this year and rise commensurately with growth through our forecast horizon to 2019.
South Africa has strong democracy with independent media and reporting. We believe South Africa will continue to maintain strong institutions such as the Public Protector and the Judiciary, which provide checks and balances. However, the latter have been tested after the executive and ANC-dominated legislature attempted to set aside some of the recommendations of the Public Protector.
On a broader basis, South Africa has shown effective policy-making since 1994 that has produced sustainable public finances. That said, the socioeconomic dynamics of race and skewed income distribution have the potential, in our view, to shift policy toward intervention and income redistribution, at the cost of headline GDP growth.
On the fiscal side, the government is showing stronger resolve to reduce fiscal deficits, with targets of 3.2% of GDP this year, 2.8% in 2017, and 2.4% in 2018. This consolidation is being achieved through a combination of expenditure and revenue measures. On the expenditure side, the nominal expenditure ceiling, while tight, can accommodate unforeseen expenditure pressures within the existing framework--as was the case this year with extra outlays on university fees and higher-than-budgeted wage increases.
On the revenue side, the government has introduced some tax hikes in trade and excise duties, among other measures. On the broader taxes, treasury tax collection targets have often performed better than suggested by nominal GDP growth, pointing to tax buoyancy that is somewhat resilient to weaker economic growth trends.
However, the treasury's annual change in general government debt in the past has tended to be higher than the reported deficit by at least 1% of GDP in the past five years. Therefore, we project the annual change in general government debt will average 4% of GDP over 2016-2019.
General government debt, net of liquid assets, increased to around 45% of GDP in 2015 from about 30% in 2010, and we expect it will stabilize at around 48% of GDP only in 2018-2019. Although less than a tenth of the government's debt stock is denominated in foreign currency, nonresidents hold about 35% of the government's rand-denominated debt, which could make financing costs vulnerable to foreign investor sentiment, exchange rate fluctuations, and rises in developed market interest rates. We project interest expense will remain at about 11% of government revenues this year. Debt-servicing costs could be higher than we estimate if domestic interest rates continue to rise owing to a repricing of South Africa risk or changing inflation expectations.
We currently view South Africa's contingent liabilities as limited. Nevertheless, in our view, the government faces risks from nonfinancial public enterprises with weak balance sheets, which may require more government support than we currently assume.
Eskom benefits from a government guarantee framework of South African rand (ZAR) 350 billion (US$22 billion)--about 7% of 2015 GDP. Eskom has used approximately ZAR170 billion of this guarantee amount to date. The government has provided Eskom a support package in the form of a ZAR23 billion equity injection, and a conversion of a ZAR60 billion loan to equity in order to boost the firm's capital.
Other state-owned entities that we consider may pose a risk to the fiscal outlook include national road agency Sanral, which is reported to have revenue collection challenges with its Gauteng tolling system, and South African Airways, which may be unable to obtain financing without additional government support.
In 2016, net general government debt and used government guarantees combined (excluding the independent power producers' guarantees, which are more like completion guarantees than financial guarantees of operation), account for close to 55% of GDP. Broader state-owned enterprise reform is under discussion but we do not expect it to conclude this year or next.
The size of the current account deficit has narrowed in 2015 owing to the lower price of oil (which constitutes about one-fifth of South Africa's imports), weak domestic demand, and some export response from the mining and auto manufacturing sectors. We believe real exports' growth will be slow over 2016-2019 as supply side constraints to production remain, while import growth may be compressed, with currency weakness and the weak domestic economy.
Therefore, we estimate current account deficits will average 4% of GDP (or 12% of current account receipts) over 2016-2019. The rand floats and is an actively traded currency. According to the Bank of International Settlements' triennial survey of foreign exchange dealing, it is traded in 1.1% of global foreign-exchange contracts.
The country finances its current account deficits mostly with portfolio and other investment flows, which can be volatile. Such volatilities could result from global changes in risk appetite; foreign investors reappraising prospective returns in the event of growth or policy slippage in South Africa; or rising interest rates in developed markets. We expect external debt net of liquid assets will average below 50% of current account receipts over 2016-2019.
South Africa continues to pursue a floating exchange rate regime. The South African Reserve Bank (SARB, the central bank) does not have exchange rate targets and does not defend any particular exchange rate level. It consequently forgoes expending reserves to lean against market sentiment. We assess the SARB as being operationally independent and its policies as credible.
It uses an inflation-targeting framework for its monetary policy. The bank also uses open market operations to manage liquidity, including sterilizing its purchases of foreign exchange inflows. The repurchase (repo) rate is the bank's most important monetary policy instrument.
Despite lower oil prices, a weaker exchange rate and higher electricity prices have increased inflationary pressures.
The central bank expects inflation to remain outside its 3%-6% target range in 2016 and early 2017 while these transitory shocks dissipate. The bank is in a monetary tightening cycle, with 75 basis points (bps) of cumulative hikes in 2016 so far, or 200 bps since January 2014. Domestic capital markets are well developed, in our view, with depository corporation claims on residents' nongovernment sector accounting for about 80% of GDP. Local currency debt market capitalization (dominated by government bonds) accounts for 60% of GDP.
Our long-term local currency sovereign rating on South Africa is two notches above the long-term foreign currency sovereign rating. This is because we believe that the sovereign's flexibility in its own currency is supported by the SARB's independent monetary policy, a large and active local currency fixed-income market, and a prudent fiscal policy.
South Africa remains a middle-income country with a diversified economy and wide income disparities. The ratings are supported by our assumption that South Africa will experience continued broad political institutional stability and macroeconomic policy continuity.
We also take into account our view that South Africa will maintain fairly strong and transparent political institutions and deep financial markets. The ratings are constrained by the need for further reforms, low GDP growth, volatile sources of financing, structural current account deficits, and sizable general government debt.
The negative outlook reflects the potential adverse consequences of low growth and signals that we could lower our ratings on South Africa this year or next if policy measures do not turn the economy around.
We could lower the ratings if GDP growth does not improve in line with our current expectations, or wealth levels continue to decline in U.S. dollar terms. We could also lower the ratings if we believed that institutions became weaker due to political interference affecting the government's policy framework.
Downward rating pressure would also mount if net general government debt plus government guarantees to financially weak government-related entities together surpass 60% of GDP throughout our forecast period through 2019. A reduction in fiscal flexibility could also lead us to narrow the gap between the local and foreign currency ratings.
We could revise the outlook to stable if we observed policy implementation leading to improving business confidence and increasing private sector investment, and ultimately contributing to higher GDP growth.
Statement issued by S&P Global Ratings (Standard and Poor’s), 3 June 2016