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21 January 2024 – Fitch Ratings – Hong Kong – 19 Jan 2024: Fitch Ratings has affirmed South Africa’s Long-Term Foreign-Currency Issuer Default Rating (IDR) at ‘BB-‘ with a Stable Outlook.
KEY RATING DRIVERS
Credit Fundamentals: South Africa’s ‘BB-‘ IDR is constrained by low real GDP growth, a high level of inequality, a high and rising government debt-to-GDP ratio, and a modest path of fiscal consolidation. Growth is hampered by power shortages that are expected to continue in the near to medium term, although at a lower magnitude than in recent months, and by a struggling logistic sector. The ratings are supported by a favourable debt structure with long maturities and mostly local-currency-denominated, strong institutions, as well as a credible monetary policy framework.
Weak GDP Growth Outlook: We forecast real GDP growth will accelerate to 0.9% in 2024 and 1.3% in 2025, from an estimated 0.5% in 2023. The economy remains severely troubled by the impact of electricity capacity constraints, a struggling logistics sector and a high level of inequality. Further incremental progress on the 35 priority reforms identified by the government under Operation Vulindlela, launched in 2020, was recorded in 2H23, mainly in the energy and logistics sectors.
Although the reforms will contribute to a modest increase in real GDP growth in the near to medium term, they are limited in ambition and we do not think they will significantly enhance South Africa’s low growth potential, which we estimate at 1.2%.
Slowly Improving Power Generation Capacity: Fitch estimates that load-shedding will reduce in intensity in 2024 and 2025 compared with 2023, but not disappear. The peak of load shedding declined from 6.7 GW in May 2023 to 3.5 GW in December 2023. The return to the grid of three units of Kusile power station since September 2023, and the synchronisation of unit 5 in December 2023 add a total 3.2 GW to generation capacity. Further capacity is expected to come from private-sector investments, with a pipeline of confirmed projects representing 12GW of new capacity.
The legal separation of Eskom into three divisions, intended to further catalyse investment in generation and transmission, is moving slowly, and we do not expect full separation before 2025.
Struggling Logistics Sector; Likely Support: Financial, operational and governance weaknesses at Transnet, the logistics SOE, disrupted supply chains in 2023, with significant delays at ports and decreased rail freight volumes. To address its immediate liquidity constraints and support its recovery plan, the government granted a ZAR47 billion (0.7% of GDP) guarantee facility in December 2023. Transnet plans to announce a five-year strategic plan by March 2024, and we assess that fiscal support, through either capital injections or debt transfer, is likely given the importance of Transnet in the South African economy.
We have assumed ZAR50 billion below-the-line support in our debt projections, split between the fiscal year ending in March 2025 (Fitch-defined FY24) and FY25. The opening of Transnet’s infrastructure to third-party freight operators in 2Q24 would help improve the performance of the logistics sector.
Large, Persistent Fiscal Deficits: We forecast a widening of the consolidated fiscal deficit to 4.7% of GDP in FY23, from 3.7% in FY22. This will be driven by an erosion of revenue collection hampered by low real GDP growth and low corporate profitability, upward expenditure pressure stemming from the public-service agreement that was signed after the budget was released and interest payments with the interest-to-revenue ratio gradually increasing to 20.9% in FY25, from 16.7% in FY22.
The consolidated budget deficit will remain substantial at 4.8% of GDP in FY24 and 4.6% in FY25, reflecting further payroll increases and high social spending partially offset by higher revenue growth. Fiscal flexibility will reduce with a growing share of expenditure going to the wage bill and interest payments, from 46% in FY21 to an estimated 49% in FY25. The continuation of social spending beyond the end of the social relief of distress programme, which was due to expire in March 2024, was confirmed in November 2023. This is in line with Fitch’s previous assumptions.
Rising Government Debt, Favourable Structure: We expect general government debt to reach 83.2% of GDP in FY25, from an estimated 76% in FY23, well above the anticipated 2023 ‘BB median’ of 52.2% ‘BB’. Government debt will increase due to a primary surplus below its debt-stabilising level, weak growth and large stock-flow adjustments driven by the revaluation of inflation-linked bonds, foreign-currency denominated debt, discount on loan transactions, debt transfers from Eskom and the assumed debt transfer from Transnet. Total Transnet debt amounts to ZAR130 billion.
To contain debt accumulation, the government plans to present a new fiscal anchor in the FY24 fiscal bill to be presented in February 2024.
Inflation Tapering: We estimate CPI inflation declined to 5.5% at end-2023, down from 7.2% at end-2022. Inflationary pressure stemming from a weak rand, the cost of load-shedding for businesses, and from supply chain disruptions, will be cushioned by South Africa Reserve Bank (SARB)’s hawkish, higher-for-longer stance, enabling CPI inflation to decrease to 5% at end-2024, within SARB’s 4.5% (+-1.5%) target band. We believe the SARB has completed its tightening cycle and leave the policy rate at 8.25% until 1Q24.
Widening Current-Account Deficit: We estimate the current-account deficit widened to 2% of GDP in 2023, from 0.4% in 2022, amid a marked decline in export receipts due to lower volumes constrained by logistics sector difficulties and a deterioration in South Africa’s terms of trade. We anticipate the current account deficit to widen to 2.9% of GDP in 2024 and stabilise at 3% in 2025, fuelled by rising imports driven by a recovery in investment. However, the fully flexible exchange-rate regime, the rand’s high liquidity in international markets, the strong domestic fund-management industry and high share of local currency in government debt should help insulate the sovereign from external shocks.
Elevated Socio-Political Risks: South Africa’s unemployment moderately declined to 32.2% in 3Q23, from a record high of 35.4% in 4Q21, but remains much higher than pre-pandemic. The high unemployment rate, in conjunction with an exceptionally high level of income inequality will continue to constrain fiscal consolidation and pose a risk to socio-political stability, with frequent strikes and protests.
The African National Congress’s dominance over the political landscape has been challenged since the party’s poor performance in the November 2021 municipal elections. We believe the party could lose its majority in the May 2024 general election, but this would be unlikely to result in major changes in economic policy.
ESG – Governance: South Africa has an ESG Relevance Score (RS) of ‘5’ for both Political Stability and Rights and for the Rule of Law, Institutional and Regulatory Quality and Control of Corruption. Theses scores reflect the high weight that the World Bank Governance Indicators (WBGI) have in our proprietary Sovereign Rating Model. South Africa has a medium WBGI ranking at 46.7 reflecting a strong level of rights for participation in the political process, moderate institutional capacity, established rule of law and a moderate level of corruption.
RATING SENSITIVITIES
Factors that Could, Individually or Collectively, Lead to Negative Rating Action/Downgrade
-Public Finance: Further significant increase in government debt-to-GDP, for example, due to persistent large fiscal deficits or the materialisation of large-scale contingent liabilities
-Macroeconomic Performance, Policies and Prospects: A further weakening of trend growth or a sustained shock that further undermines fiscal consolidation efforts and raises socio-economic pressure in the face of exceptional inequality
Factors that Could, Individually or Collectively, Lead to Positive Rating Action/Upgrade
-Public Finances: Confidence that government debt-to-GDP will stabilise; for example, due to persistent higher tax collections combined with successful sustained expenditure control that could lead to the removal of the -1 qualitative overlay notch on public finance
-Macroeconomic Performance, Policies and Prospects: Greater confidence in stronger medium-term growth prospects, sufficient to support fiscal consolidation and address challenges from high inequality and unemployment
SOVEREIGN RATING MODEL (SRM) AND QUALITATIVE OVERLAY (QO)
Fitch’s proprietary SRM assigns South Africa a score equivalent to a rating of ‘BB+’ on the Long-Term Foreign-Currency (LT FC) IDR scale.
Fitch’s sovereign rating committee adjusted the output from the SRM to arrive at the final LT FC IDR by applying its QO, relative to SRM data and output, as follows:
– Macro: -1 notch, to reflect South Africa’s weak growth prospects relative to the ‘BB’ category median and to population growth, partly the result of deeply entrenched structural problems, with important implications for public finances.
– Public Finances: -1 notch, to reflect the continued uncertainty about the government’s ability to stabilise debt-to-GDP in the context of high unemployment and inequality. It also reflects the weak finances of state-owned enterprises that could lead to the materialisation of contingent liabilities beyond what is budgeted.
Fitch’s SRM is the agency’s proprietary multiple regression rating model that employs 18 variables based on three-year centred averages, including one year of forecasts, to produce a score equivalent to a LT FC IDR. Fitch’s QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.
COUNTRY CEILING
The Country Ceiling for South Africa is ‘BB’, 1 notch above the LT FC IDR. This reflects moderate constraints and incentives, relative to the IDR, against capital or exchange controls being imposed that would prevent or significantly impede the private sector from converting local currency into foreign currency and transferring the proceeds to non-resident creditors to service debt payments.
Fitch’s Country Ceiling Model produced a starting point uplift of +0 notch above the IDR. Fitch’s rating committee applied a +1 notch qualitative adjustment to this, under the Balance of Payments Restriction pillar reflecting South Africa’s relatively open capital account, and ongoing efforts to make the currency fully convertible, that are not reflected by the high number of capital-account restrictions recorded in the IMF’s AREAER report that feed into the model score.
REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING
The principal sources of information used in the analysis are described in the Applicable Criteria.
ESG CONSIDERATIONS
South Africa has an ESG Relevance Score of ‘5’ for Political Stability and Rights as World Bank Governance Indicators have the highest weight in Fitch’s SRM and are therefore highly relevant to the rating and a key rating driver with a high weight. As South Africa has a percentile rank below 50 for the respective Governance Indicator, this has a negative impact on the credit profile.
South Africa has an ESG Relevance Score of ‘5’ for Rule of Law, Institutional & Regulatory Quality and Control of Corruption as World Bank Governance Indicators have the highest weight in Fitch’s SRM and are therefore highly relevant to the rating and are a key rating driver with a high weight. As South Africa has a percentile rank below 50 for the respective Governance Indicators, this has a negative impact on the credit profile.
South Africa has an ESG Relevance Score of ‘4[+]’for Human Rights and Political Freedoms as the Voice and Accountability pillar of the World Bank Governance Indicators is relevant to the rating and a rating driver. As South Africa has a percentile rank above 50 for the respective Governance Indicator, this has a positive impact on the credit profile.
South Africa has an ESG Relevance Score of ‘4[+]’ for Creditor Rights as willingness to service and repay debt is relevant to the rating and is a rating driver for South Africa, as for all sovereigns. As South Africa has track record of 20+ years without a restructuring of public debt and captured in our SRM variable, this has a positive impact on the credit profile.
South Africa has an ESG Relevance Score of ‘4’ for Employment and Income Equality as exceptionally high inequality is one of the factors behind political and social risks, low trend growth and the difficulty in containing fiscal deficits. This has a negative impact on the credit profile, is relevant to the rating and a rating driver.
The highest level of ESG credit relevance is a score of ‘3’, unless otherwise disclosed in this section. A score of ‘3’ means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. Fitch’s ESG Relevance Scores are not inputs in the rating process; they are an observation on the relevance and materiality of ESG factors in the rating decision. Source: https://www.fitchratings.com/