Zambia — S&P affirms rating, warns of thinning capital base

copper-mine1.jpg

An opencast copper mine in Zambia.

S&P Global Ratings affirmed Zambia’s sovereign credit rating in a February report, warning that the copper producer faces constrained fiscal financing options in the context of limited domestic capacity.

NKC Africa Economics.

An opencast copper mine in Zambia.

An opencast copper mine in Zambia.

The rapid deterioration in the public debt metrics and accumulation of arrears, combined with tight domestic liquidity conditions and a structural fiscal deficit, culminated in a surge in borrowing costs to “prohibitively expensive” levels.

Specifically, interest expenditure has nearly trebled since 2013 and will reach an estimated 21% of fiscal revenue during 2017 — from 11% in 2015 — and accounts for 14% of total expenditure. In turn, Eurobond coupon payments amount to just over 1% of GDP in S&P’s estimation.

The rating agency estimates that arrears accrued over the 2015-16 period amounted to 9% of GDP. The substantial debt burden contributes to a structural fiscal deficit and acts as a drag on the consolidation process.

In turn, the central bank bridge facility has reached its maximum. High recurrent expenditures will result in a reduction in capital spending due to consolidation goals, while government spending on transfers and subsidies will also be reduced to meet fiscal targets. As a result of these constraints, S&P maintained Zambia’s sovereign credit rating at “B” with a negative outlook.

S&P projects that real economic growth will average 3,8% over the 2016-19 period, lower than its previous projection of 4,4% over the same period and below the average for peers with comparable per capita wealth levels.

Whilst the rating agency views a recovery in the international copper price and successful negotiation with the International Monetary Fund (IMF) as drivers of growth — with both factors aiding investor confidence — fiscal consolidation efforts will constrain growth-supportive government expenditure.

On the other hand, S&P voiced optimism that the agricultural sector will benefit from improved rainfall and “substantive” government actions taken against the armyworm infestation. In turn, domestic power generation capacity is seen as improving on the back of more favourable rainfall, which S&P projects to alleviate some electricity shortages and reduce costs associated with the power import bill.

The external position remains weak, characterised by volatile terms of trade and high sensitivity to international copper price dynamics. External financing needs remain high, and cognisant of the decline in foreign direct investment (FDI) inflows, Zambia is considered “highly vulnerable” to additional shocks. This is despite Zambia’s favourable net international investment positions (IIP) — a position attributable to mining profits (private sector) invested abroad. That said, the absence of timely and reliable data constrained the rating agency’s ability to analyse changes in the external stock position as Zambia last published a full IIP report in 2013.

Foreign appetite for investment in Zambia has declined in line with an increase in policy uncertainty. This pertains in particular to incoherent mining tax policy amendments. S&P warned that the periods of underinvestment — as the extractive sector mothballed expansion projects in the wake of numerous punitive mining policies — not only reduced aggregate output but that the sharp decline in FDI inflows — a significant source of external funding — adversely impacted the foreign reserve position. In this regard, S&P expects that IMF programme disbursements will support external finances in the period through 2020.

Government debt is projected to peak at 55% of GDP, although S&P conceded that, due to balance sheet effects, this forecast is highly sensitive to the exchange rate assumption. Central bank actions taken to limit speculative behaviour against the local unit and to tame inflation have aided a recovery of the kwacha exchange rate in recent months.

With regard to rating sensitivities, S&P warned that the sovereign credit rating of “B” may be lowered over the coming year should “material delays” unravel fiscal consolidation, or in the event that levels of investment (including FDI) remain low or worsen — thereby increasing external financing needs and “potentially compounding already weaker economic growth.” In turn, the efficient implementation of “sustainable fiscal and economic policies” which will lead to “assured” funding conditions and accelerated economic growth may lead to an affirmation of ratings at current levels.

Why do we care?

The sovereign credit rating awarded by S&P is on par with our own assessment – which we most recently affirmed in December 2016 — as well as that of Fitch, which was confirmed on February 20.

This rating, which places Zambia firmly in the “highly speculative” risk category, captures Zambia’s recent track record of weak fiscal discipline, persistent underperformance of domestic revenues, poorly constructed and frequently-amended tax policies, and budgetary overruns ascribable to unforeseen expenses.

In our view, Zambia’s sovereign credit risk dynamics essentially hinge on three pillars: the fiscal account, sector concentration as relating to external fragility, and policy risk. Fiscal spendthrift and currency erosion culminated in a rapid increase in the real debt burden to the detriment of economic growth potential. While aggressive central bank actions arrested the depreciation in the local currency unit, this came at a cost to growth as tight liquidity conditions undermined private sector credit extension and real-side economic activity.

The negative outlook furthermore reflects our view that still-low commodity prices and ongoing power shortages will suppress economic growth, and by extension, fiscal revenue and FDI potential. Notwithstanding consolidation goals, the weaker growth environment — with our projection for this year at a meagre 3, 25% — may not be sufficient to offset growth in nominal debt in the event of volatile global risk sentiment (due to balance sheet effects and the increased risk premium demanded by investors) while domestic borrowing capacity remains constrained by high nominal interest rates and a narrow capital base.

Due to structural twin deficits and particularly high recurrent costs, a narrow export base and overreliance on the copper sector for export earnings, Zambia’s substantial external fragility leaves the sovereign exposed to both domestic and external shocks, especially in the context of a weakened external buffer.

On a positive note, the finance ministry envisions that an agreement with the IMF will be reached during H1, which will act as a policy anchor, reduce the risk of a balance of payments event, pave the way towards reducing high borrowing costs, and ultimately create the fiscal space needed for growth-supportive capital expenditure. Our expectation is for a funding package to range between US$1bn — US$1,5bn, cognisant of high external borrowing costs on commercial terms, and high financing needs.

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