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April 30, 2020

South Africa Ratings Lowered to 'BB-' from 'BB'

<strong>By: S&P Global</strong>

<h2>South Africa Ratings Lowered to 'BB-' from 'BB' As COVID-19 Further Impairs Fiscal and Growth Prospects; Outlook Stable</h2>

<strong>Overview</strong>

<ul>

<li>COVID-19-related pressures will have significant adverse implications for South Africa's already deficient growth and fiscal outcomes.</li><li>Its fiscal deficits will remain elevated, and the cost of servicing rising public debt will increase to about 6.5% of GDP by 2023.</li><li>In addition, contingent liabilities from state-owned enterprises constitute a significant additional risk to the public balance sheet.</li><li>We have lowered our long-term foreign-currency rating on South Africa to 'BB-' and our long-term local-currency rating to 'BB'.</li><li>The outlook on both the foreign- and local-currency ratings is stable, as South Africa's credit strengths--particularly a credible and consistent central bank, a flexible actively traded currency, and deep capital markets--should facilitate a gradual, albeit painful, external and fiscal adjustment.</li>

</ul>

<span style="font-weight: 400;">On April 29, 2020, S&P Global Ratings lowered its long-term foreign-currency sovereign credit </span><span style="font-weight: 400;">rating on the Republic of South Africa to 'BB-' from 'BB' and affirmed the 'B' short-term foreign-currency sovereign credit rating. The outlook is stable. </span>

<span style="font-weight: 400;">At the same time, the long-term local-currency sovereign credit rating was lowered to 'BB' from </span><span style="font-weight: 400;">'BB+', and the 'B' short-term local-currency sovereign credit rating was affirmed. The outlook is stable. </span>

<span style="font-weight: 400;">We maintained the long-term South Africa national-scale rating at 'zaAAA' and affirmed the 'zaA-1+' short-term national-scale rating alongside a re-calibration of the national-scale rating scale. </span>

<span style="font-weight: 400;">We revised our transfer and convertibility assessment for South Africa to 'BB+' from 'BBB-'. </span>

<span style="font-weight: 400;">As a "sovereign rating" (as defined in EU CRA Regulation 1060/2009 "EU CRA Regulation"), the ratings on South Africa 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 (see "Calendar Of 2020 EMEA Sovereign, Regional, And Local Government Rating Publication Dates," published Dec. 20, 2019, on RatingsDirect). 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 the rapidly worsening global and domestic economic conditions related to the evolving COVID-19 health crisis. The next scheduled publication on the sovereign rating on South Africa will be on May 22, 2020. </span>

<b>Outlook </b>

<span style="font-weight: 400;">The stable outlook reflects the balance between pressures related to very low GDP growth and high fiscal deficits, against the sovereign's deep financial markets and monetary flexibility. </span>

<b>Downside scenario </b>

<span style="font-weight: 400;">We could lower the ratings again if South Africa's economic prospects fail to recover during the forecast period and financing pressures mount. We could also consider another downgrade if the rule of law, property rights, or enforcement of contracts were to weaken significantly, undermining the investment and economic outlook. </span>

<b>Upside scenario </b>

<span style="font-weight: 400;">We could raise the ratings if the government's reform efforts were to credibly arrest the rise in the government debt-to-GDP ratio. An upgrade could also occur if there is a substantial improvement in job creation and productivity gains, leading to higher real per capita GDP growth. </span>

<b>Rationale </b>

<span style="font-weight: 400;">South Africa's already contracting economy will face a further sharp COVID-19-related downturn in 2020. In the second half of 2019, the economy shrank, due partly to a set of severe rolling power blackouts. The COVID-19 health crisis will create additional and even more substantial headwinds to GDP growth, owing to a strict five-week domestic lockdown, the markedly weaker external demand outlook, and tighter credit conditions. As a result, we now project the economy to shrink by 4.5% this year compared with our November 2019 estimate of growth of 1.6%. </span>

<span style="font-weight: 400;">A proactive policy response, including South Africa's decision to go into a strict lockdown relatively early, has so far limited the health impact of COVID-19. Early gains in tackling the virus will be built upon, with the gradual phased reopening of the economy next month. Nevertheless, the broader economic fallout will be very difficult to handle, and South Africa entered the crisis from a weak fiscal and economic position. </span>

<span style="font-weight: 400;">On April 21, President Ramaphosa unveiled a large COVID-19-related social-relief and economic-support package totaling about 500 billion South African rand (ZAR), which is about 10% of GDP. However, the additional direct financing impact of the new expenditure measures are closer to ZAR170 billion (3.4% of GDP), while ZAR130 billion constitute reallocations from existing, </span><span style="font-weight: 400;">already budgeted, expenditures. There is ZAR200 billion allocated via government guarantees for a loan scheme, which will require no immediate government spending, though it will add to the government's already material contingent liability risks. </span>

<span style="font-weight: 400;">The extraordinary package will be partially financed through the issuance of concessional debt from international financial institutions (IFIs). This includes about $4.2 billion (ZAR80 billion) that we believe South Africa can access under the IMF's emergency (COVID-19-related) Rapid Funding Facility. We expect further funds could be sourced from other IFIs, including the New Development Bank (the BRICS Development Bank), the AfDB, and the World Bank. In addition, authorities are planning to tap about ZAR40 billion from the Unemployment Insurance Fund (UIF), which had investments worth ZAR165 billion at the time of its last audited statements dated March 2019. We expect any residual funding gap will likely be financed through domestic rand-denominated debt issuance. Moreover, the Treasury has several deposits at the central bank that could be used if there are any issuance concerns, though any drawdown on an US$8 billion dollar-denominated deposit would lead to lower gross international reserves, negatively affecting external buffers. </span>

<span style="font-weight: 400;">Authorities are aiming to source much of the COVID-19-related health and social expenditures through re-prioritizations of expenditures from areas such as travel, training, and events. In our view, this could prove overly ambitious if the virus spread worsens or there is a second wave of infections. In addition, a significant planned saving in the 2020/2021 budget was a politically contentious reduction in public-sector wage hikes, which is estimated to save ZAR160 billion but is being challenged by powerful unions. </span>

<span style="font-weight: 400;">The appreciably weaker macroeconomic environment will also weigh heavily on South Africa's fiscal revenues. We expect its headline fiscal deficit will widen to 13.3% of GDP in 2020--the widest in the country's democratic history. We estimate this will lead to net debt levels rising to over 75% of GDP by the end of 2020. Our anticipation of an only tepid economic recovery means that public financing needs will likely remain elevated throughout the forecast period. As a result, the debt-to-GDP ratio is unlikely to stabilize within this timeframe, rising to 84.7% by 2023, raising questions around debt sustainability. Another legacy of the COVID-19 shock will likely be a far higher annual interest bill. By 2023, we project that interest expenditures consume an even larger share of public resources, increasing to 6.5% of GDP (22% of total government revenues) versus 4.1% of GDP (14% of total revenues) last year. </span>

<span style="font-weight: 400;">Year-to-date capital flight out of emerging market assets has been particularly acute in South Africa, which has been reliant on nonresident portfolio investors to fund its current account deficits. The outflows have led to the rand losing about a quarter of its value this year, one of the largest moves of any major emerging market currency. </span>

<span style="font-weight: 400;">As an energy importer, the drop in oil prices will ease some external pressure, but this will be roughly offset by the lockdown-induced closure of the export sector, including most mines. Overall, on the back of a timely depreciation in South Africa's real effective exchange rate as well as weak growth, we expect the current account will narrow sharply this year to negative 1% of GDP this year and average negative 2.2% in 2020-2023. However, interest paid to nonresident holders of domestic government debt are set to rise to about $10.2 billion (3.3% of GDP) by 2023 from $8.0 billion (2.3% of GDP) last year. </span>

<span style="font-weight: 400;">Nonresident participation in South African capital markets is foremost in local-currency government debt, and the limited foreign-currency public obligations remain a credit strength. This means the outflows will mechanically lower the stock of external debt owed by South African residents vis-à-vis nonresidents. However, because we measure external indebtedness by netting out liquid central bank reserves and scaling by current account receipts (CAR), the fall in both of these will more than offset the former effect. We project narrow net external debt will worsen to 75% of CAR by the end of 2020 before plateauing to an average of 71.5% over 2021-2023.</span>

<span style="font-weight: 400;">South Africa's external assets (stock of assets) are overwhelmingly denominated in foreign currencies, whereas its external liabilities are predominantly denominated in rand. Therefore, a weakening rand improves South Africa's net external creditor position relative to the rest of the world. South Africa's largest claim on nonresidents is its outbound direct investment, which is equivalent to 131% of GDP. The return on South Africa's investment in companies abroad largely offsets the foreign-currency payments the government makes to nonresident holders of its domestic debt, and on balance, South Africa is forecast to maintain a small net external asset position of 10% of current account receipts by 2023. </span>

<span style="font-weight: 400;">The recent portfolio outflows and other pressures have led to a pronounced steepening of the domestic yield curve, which threatens to tighten domestic credit conditions to the wider economy and further drag on growth. The scale of the selloff was large enough to prompt central bank intervention in late March, whereby the South African Reserve Bank (SARB) committed to an open-ended program of government bond buying in the secondary market to "provide liquidity and promote the smooth functioning of domestic financial markets." The program has been broadly successful and is modest in size compared to the deep domestic local-currency bond market. South Africa's creditworthiness continues to enjoy considerable support from its central bank, which we assess as highly credible and independent. </span>

<span style="font-weight: 400;">Dramatically lower oil prices in 2020 and lower inflationary pressures have also given the SARB room to make series of sizeable rate cuts, which have totaled 225 basis points so far this year. In combination with a set of temporary capital-relief measures implemented by the Prudential Authority, this will ease some of the credit pressures, at the margin. Flexibility to delay payroll taxes will also provide some near-term liquidity to struggling firms. Nonetheless, these will not be sufficient to offset the cumbersome demand and supply shock. </span>

<span style="font-weight: 400;">Contingent liabilities are more likely to require government financing in 2020, owing to the broad-based slowdown across most sectors of the economy, which could add pressure to the fiscal balances. Stress is most extreme at South African Airways (SAA), which was already restructuring and appears unlikely to survive without new cash injections, in our opinion. Nonetheless, we do not project any new government financing to the entity beyond servicing its relatively small government-guaranteed obligations, which we already include within general government debt. State-owned utility company ESKOM will likely face near-term liquidity challenges in light of lower energy demand throughout the lockdown. We continue to view the already sizable pre-existing support package for Eskom as insufficient to meet remaining fiscal-year funding requirements. </span>

<span style="font-weight: 400;">We estimate South Africa's GDP per capita at close to US$4,800 in 2020, a sharp fall from about US$6,000 in 2019. Real GDP per capita has been shrinking since 2014, exacerbated by the depreciation of the rand. Despite considerable progress on alleviating poverty since the end of apartheid, South Africa remains one of the most unequal societies in the world, with the poorest 60% of the population controlling less than 10% of wealth. Even though unemployment remains very high, the public sector received an above-inflation pay hike last year. Meanwhile, heavy unionization in key sectors such as mining creates an insider/outsider labor market that is inflexible and further constrains GDP growth, in our opinion. </span>

<h2><span style="font-weight: 400;"><strong>Download the Full Article Below</strong></span></h2>

<a href="https://www.cover.co.za/wp-content/uploads/2020/04/South-Africa-Ratings-Lowered-To-BB-From-BB_Apr29.pdf">South Africa Ratings Lowered To 'BB-' From 'BB'_Apr29</a>

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