Fitch Ratings-Hong Kong-11 October 2018:
Fitch Ratings has downgraded Zambia’s Long-Term Foreign-Currency Issuer Default Rating (IDR) to ‘B-‘ from ‘B’, with a Negative Outlook.
A full list of rating actions is at the end of this rating action commentary.
KEY RATING DRIVERS
The downgrade and Negative Outlook on Zambia’s Long-Term IDRs reflects the substantial upward revision in the government budget deficit targets.
The Minister of Finance presented the 2019 Budget to the National Assembly on 28 September. This followed the release of the 2019-2021 Medium-Term Expenditure Framework (MTEF) earlier in September. Both documents lay out the government’s fiscal framework, which envisages a reduction in the fiscal deficit to 5.1 per cent of GDP by 2021, down from 7.9 per cent in 2017. The new fiscal framework represents a significantly less ambitious fiscal consolidation effort than the previous MTEF, which had set out the objective of reducing the fiscal deficit to no more than 3 per cent of GDP by 2020.
Upward revisions to fiscal deficits and government debt have weakened the credibility of the government’s fiscal targets. The government revised the 2018 fiscal deficit target to 7.4 per cent of GDP from the 6.1 per cent contained in the 2018 budget. Earlier in the year, the government revised its 2017 fiscal deficit to 7.9 per cent of GDP from the provisional figure of 7 per cent, and also revised its external debt stock up to USD8.7 billion from USD7.9 billion. The deficit revisions have been the result of the reconciliation of previous disbursements to externally financed projects and of higher debt-servicing costs, both of which reflect broad deficiencies in public financial management and a rapid accumulation of new external debt. The government has taken some steps to keep future disbursements in line with the budget, but this is likely to remain a problem over the medium term.
The 2019 Budget envisages an increase in revenue from a number of tax reform measures. These measures include reducing tax expenditures by updating the rules on tax deductions and transfer pricing, and increasing the withholding tax. The budget also proposes changes to the mining tax regime, which would increase royalty rates by 1.5pp across all brackets and add a new top bracket. These measures could help to marginally increase government revenue, but not by enough to counter the expected increase in capital expenditure. The government’s budget targets a reduction in the 2019 fiscal deficit to 6.5 per cent of GDP, from 7.4 per cent in 2018. Fitch believes that the budget targets are optimistic, and forecasts a deficit of 7.5 per cent of GDP in 2018 and 6.9 per cent in 2019. The agency also believes that the risks are tilted to the downside.
The Ministry of Finance released a statement in June, noting the need for fiscal consolidation and highlighting the high risk of debt distress. The statement indicated the government’s intention to curtail the contraction of new debt and to cancel some of the contracted but undisbursed loans. Despite the statement, the current MTEF contains a total of USD3.4 billion in new external financing in the years 2019 to 2021, which equates to approximately 4.3 per cent of GDP each year. The government has reduced some domestically financed project spending, but capital expenditure remains at around 7 per cent of GDP per year through 2021. Over the same period, debt servicing will consume approximately 24 per cent of government revenue.
Fitch now forecasts Zambia’s general government debt to reach 69 per cent of GDP by end-2018, up from 60 per cent at end-2017, and to rise again in 2019. This represents an increase from our previous forecast of a rise to 64 per cent of GDP in 2018 and for government debt to begin falling in 2019. The further expected increase in foreign-currency debt will make Zambia’s debt stock more vulnerable to FX volatility and to a rising global interest-rate environment.
Increased external borrowing will also weaken the external position. Reserves were USD 1.7 billion in August 2018, which is down from the USD2.1 billion (or 2.4 months of current external payments (CXP)) at end-2017, as the Bank of Zambia has sought to contain currency depreciation. Fitch forecasts reserves to remain below three months of CXP through 2018 and 2019.
Zambia’s ‘B-‘ IDRs also reflect the following key rating drivers:
Fitch forecasts GDP growth at 4.5 per cent in 2018 and 2019, but emphasises that risks are tilted to the downside. Copper output will increase to around 830,000 metric tonnes (mt) in 2018, and to grow at approximately 5 per cent per annum in the following years. However, Fitch expects that copper prices will plateau, which, along with increasing mining taxes and questions about the business environment, may reduce investment in the sector. Beyond the mining sector, increased government capital expenditure will support growth in the construction and services sector.
Delayed fiscal consolidation and high debt will weigh on macroeconomic stability. In a sign of stress, the Zambian kwacha depreciated by almost 20 per cent in September 2018, after a period of relative stability beginning in 2H16. The kwacha may recover some ground, but FX volatility raises risks to debt/GDP projections. CPI growth has increased to 8% yoy in August 2018, having fallen to 6.1% at end-2017. Inflation will accelerate further if the recent weakness of the kwacha is not reversed. The ability of the Bank of Zambia to tighten monetary policy in response will be constrained by the impact on the government’s interest expenditure which is already high, while currency depreciation will increase the government debt/GDP ratio.
Zambia’s sovereign ratings remain constrained by weak development indicators. Both GDP per capita and per capita income remain below half the historical ‘B’ median, and measures of human development compare weakly with rated peers. Furthermore, deterioration in performance on governance indicators has put downward pressure on the ratings.