Despite Eskom, S&P affirms SA’s rating – expects “slight improvement”

From S&P Ratings:

Overview

  • After expected poor GDP growth in South Africa in 2014, we forecast a slight improvement in 2015-2017. We also expect the Treasury to keep to its “hard expenditure ceiling” and thereby contain fiscal deficits and general government debt levels in the medium term.
  • Nevertheless, GDP growth remains low, current account deficits remain relatively high, general government debt sizable, and portfolio flows potentially volatile.
  • We are affirming our long- and short-term foreign currency sovereign credit ratings on South Africa at ‘BBB-/A-3’.
  • The outlook remains stable, reflecting our view that a slight rebound in GDP growth in 2015-2017 will help contain South Africa’s fiscal and external balances within our current expectations.

Rating Action

On Dec. 12, 2014, Standard & Poor’s Ratings Services affirmed its long- and short-term foreign currency sovereign credit ratings on the Republic of South Africa at ‘BBB-/A-3’. We also affirmed the ‘BBB+/A-2’ local currency ratings and the ‘zaAAA/zaA-1’ South Africa national scale ratings. The outlook remains stable.

Rationale

The ratings are supported by our view that President Jacob Zuma’s second term will continue to ensure political and institutional stability, and broad policy continuity, and that South Africa will maintain fairly strong and transparent institutions, and deep financial markets.

Nevertheless, GDP growth remains low, current account deficits remain relatively high, general government debt sizable, and external financing flows potentially volatile. We now expect full-year GDP (by expenditure) growth of 1.4% in 2014, rising to 2.5% in 2015 and 2.9% in 2016 and 2017, based on fewer and shorter strikes, and increases in electricity supply and consumer demand.

This follows relatively slow growth of 1.9% in 2013 and 2.5% in 2012, and continues to highlight prolonged subdued growth for a country with per capita GDP of about US$6,500. The improvement in growth in 2015-2017 will also depend on wage negotiations in the gold, and other, sectors and the electricity supply situation–continued shortages of electricity could jeopardize any possible recovery.

Although we expect the South African Treasury to abide by its hard expenditure ceiling, as highlighted in its October 2014 Medium Term Budget Policy Statement (MTBPS), slower-than-forecast growth and other factors may place overall fiscal targets beyond reach.

The fiscal stance over the next few years may become exposed to lower-than-expected economic growth, pressures from a forthcoming round of public-sector wage negotiations, and increased public spending needs. General government debt, net of liquid assets, increased to 39% of GDP in 2013, from 22% in 2008, and we expect it to reach 44% by 2017. Although little of the government’s debt stock is denominated in foreign currency, nonresidents hold about 37% of the government’s rand-denominated debt, which could make financing vulnerable to investor sentiment. The ratings are also constrained by sizable current account deficits.

Although the rand floats and is an actively traded currency (according to the BIS triennial survey of foreign exchange dealing, it is traded in 1.1% of global foreign-exchange contracts), the portfolio and other investment flows that finance these deficits can be volatile. Outflows could result from global changes in risk appetite or from foreign investors reappraising prospective returns in the event of growth or policy slippage in South Africa, or rising interest rates in advanced markets.

While capital inflows have largely resumed since February 2014–after a period of withdrawal–another reappraisal of risk is possible. Slow growth and strikes may heighten both fiscal and external pressures. While we think that President Jacob Zuma’s second administration will continue the policies of his first administration, which controlled fiscal expenditure and fostered broadly stable prices, it has so far not undertaken labor or other economic reforms aimed at significantly boosting GDP growth.

However, at the same time, we also do not believe the ANC-led government will entertain radical policies, such as the nationalization of mines. With 2014 per capita GDP estimated at about $6,500, South Africa is a middle-income country. We consider its economy to be diverse, yet with wide income disparities. Per capita GDP growth is forecast to average 1.5% in 2014-2017. We view South Africa’s contingent liabilities as currently “limited,” under our criteria.

Nevertheless, the government has South African rand (ZAR) 350 billion (about 9% of GDP) available in potential guarantees for the state-owned utility Eskom. Eskom currently uses about ZAR135 billion of these guarantees. Eskom’s operating margins have been hurt by the lack of tariff rises permitted by the regulator among other factors, and Eskom’s funding needs may require the government’s guarantee envelope to increase by 2017-2018, and may affect our contingent liability estimate.

Nevertheless, planned higher electricity prices may help Eskom’s finances and mitigate risks. The 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 South African Reserve Bank’s independent monetary policy and a large active local currency fixed-income market.

Outlook

The stable outlook reflects our view that a slight improvement in GDP growth in 2015-2017 will help contain South Africa’s fiscal and external balances within our expectations.

We could lower the ratings if external imbalances increase, or funding for South Africa’s current account or fiscal deficits becomes less readily available.

We could also lower the ratings if South Africa’s business and investment climate weakens, for instance if labor disputes escalate again or GDP growth weakens significantly; if large electricity shortages persist; or if political tensions increase.

We could lower the local currency ratings–potentially by more than one notch–if the government’s fiscal policy flexibility decreases, particularly if public sector wages or debt-service costs increase more than we currently expect.

We could revise the outlook to positive if an improvement in investment and economic growth prospects produces better government debt dynamics than we currently expect.

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