Moody’s downgrades Zambia’s ratings from B3 to Caa1, maintains stable outlook
London, 27 July 2018 — Moody’s Investors Service, (“Moody’s”) has on Friday downgraded the Government of Zambia’s long-term issuer ratings to Caa1 from B3 though maintaining a stable outlook.
The downgrade reflects ongoing fiscal consolidation challenges, pointing to an increasing government debt burden.
These developments are contrary to Moody’s previous expectations that the debt burden would stabilize.
Relatedly, and despite higher copper prices until recently, liquidity and external vulnerability risks are rising,
1. reflecting larger
gross funding needs than Moody’s previously estimated,
2. higher public external debt and
3. lower foreign exchange reserves buffers, trends which Moody’s does not expect to reverse.
The outlook is stable, reflecting balanced risks at the Caa1 rating level.
The outlook captures:
1. downside risks related to persistent fiscal and liquidity challenges,
2. a high and rising debt burden,
3. low foreign exchange reserves buffers and
4. moderate domestic political risk.
These challenges are balanced by strong growth potential derived from ample natural resources and a young population which point to potential upside risks in the medium term.
Concurrently, Moody’s has lowered Zambia’s long-term foreign-currency bond ceiling to B2 from B1, its long-term foreign-currency deposit ceiling to Caa2 from Caa1, and its long-term local-currency bond and deposit ceilings to B1 from Ba2.
RATIONALE FOR THE DOWNGRADE
ENDURING FISCAL CONSOLIDATION CHALLENGES AND INCREASING DEBT BURDEN
While the government made gradual progress with fiscal consolidation in 2017 and cleared a portion of its arrears, challenges to fiscal consolidation are rising again. Moody’s expects these challenges to persist.
As a result, according to Moody’s, Zambia’s government debt burden is likely to rise towards 70% of GDP at the turn of the decade, from around 60% currently. This contradicts Moody’s prior expectations that the debt burden would stabilize.
Moody’s estimates that the fiscal deficit amounted to 7.6% of GDP in 2017 on a cash basis, which was higher than the budget target of 7%, although in line with Moody’s previous projections.
Based on Moody’s estimates on budget implementation so far this year, the fiscal deficit for 2018 is expected to be around 7.8% of GDP, well above the government’s 6.1% target.
Spending pressures have risen, in particular from capital expenditure and interest payments, indicating increasing challenges for the government in meeting its fiscal consolidation objective.
With interest payments absorbing almost a quarter of revenue, and debt costs unlikely to decline, Moody’s now expects much slower fiscal consolidation in the next few years.
The budget deficit is not projected to narrow below 7% of GDP until the next decade.
In addition, the stock of arrears, which declined by one-third to around 5.2% of GDP at end-2017, remains relatively high by international standards. This poses difficult choices for the government between reducing arrears and controlling current expenditure.
There are multiple signs that point to a rising government debt burden.
These include a wider budget deficit over the next few years, official revisions to the level of external debt as of end-2017 and evidence of a further recent increase in external debt this year (from US$8.7 billion at end-December 2017 to US$9.3 billion at end-March 2018), as well as potential downward pressure on the currency. Moody’s expects the debt burden to approach 70% of GDP in 2020 from about 60% in 2017, despite sustained nominal GDP growth.
In efforts to reopen discussions with the IMF on a potential program, the authorities concluded a debt sustainability analysis exercise in June and announced a number of measures aimed at containing the pace of debt accumulation.
These measures include the intention to postpone all non-concessional borrowings planned but not yet contracted, to cancel some of the current contracted debt that is not yet disbursed, and to renegotiate some bilateral loans.
However, these measures lack implementation details. At this stage, the extent to which they will prove effective in bringing the debt to GDP ratio on a falling trajectory and preventing an increase in liquidity pressures, in particular when the Eurobond repayments start from 2022, remains unclear.
INCREASED LIQUIDITY AND EXTERNAL VULNERABILITY RISKS
Despite higher copper prices until recently, government liquidity and external vulnerability risks are rising, as a consequence of higher financing needs and falling foreign exchange reserves.
Consistent with the fiscal outlook presented above, and in the context of tightening financing conditions globally, Moody’s does not expect Zambia’s liquidity and external pressure to abate.
Fiscal slippage in 2018 will intensify the government’s liquidity challenges in financing persistently wider deficits, particularly given the high share of short-term domestic debt.
Moody’s expects gross financing needs to exceed 17% of GDP in 2018-19, and to rise further in the early part of the next decade as large Eurobond maturities fall due.
At that time, roll-over risk is amplified by the proximity of Zambia’s Eurobond maturities to international capital market instruments issued by a number of other Sub-Saharan African countries and other frontier markets sovereigns in the early part of this decade under favorable global financing conditions.
In general, refinancing risk is exacerbated by the country’s narrow domestic capital market and exposure to changes in risk appetite by international investors.
While the increasing share of non-resident investors’ holdings of government securities has somewhat eased the government’s financing constraint, it amplifies the sensitivity of financing conditions to fluctuations in foreign investors’ sentiment.
As of 2017, about 60% of Zambia’s government debt was contracted externally.
Moreover, the significant proportion of debt denominated in foreign currency (also estimated at about 60% of the total) heightens Zambia’s exposure to a depreciation of the exchange rate, which would raise the debt burden significantly and rapidly as seen in the recent past.
While the currency has been stable so far this year, downward pressure may intensify given Zambia’s fragile external position.
The country’s foreign exchange reserves have fallen, contrary to Moody’s previous expectations, and despite a large increase in copper prices until recently and a narrower current account deficit to 3.9% of GDP in 2017 from 4.6% of GDP in 2016.
Foreign exchange reserves reached US$1.8 billion as of April-2018, equivalent to about two months of imports, down from about three months at end 2017, commonly considered a minimum level of reserves adequacy.
Moody’s expects foreign exchange reserves adequacy to remain very low. In particular, largely as a result of the fall in reserves, Moody’s External Vulnerability Index (EVI), which measures the ratio of the sum of external debt due over the next year and non-resident deposits to foreign exchange reserves is expected to increase, to around 150% in 2019. The EVI will likely rise further in the coming years as external debt payments becoming due increase without reserves accretion.
RATIONALE FOR THE STABLE OUTLOOK
The outlook is stable, reflecting balanced risks at the Caa1 rating level.
The outlook captures downside risks related to persistent fiscal and liquidity challenges, a high and rising debt burden, low foreign exchange reserves buffers and moderate domestic political risk.
These challenges are balanced by strong growth potential, derived from ample natural resources and a young population which point to possible upside risks in the medium term.
WHAT COULD CHANGE THE RATING UP
Evidence that fiscal consolidation will probably be effective and sustained, reducing refinancing risks and reversing the upward debt trajectory would likely prompt Moody’s to upgrade the rating.
The probability of an upgrade would rise materially if an improvement in the fiscal metrics would be accompanied by diminished external vulnerability risks due to a significant increase in foreign exchange reserves.
WHAT COULD CHANGE THE RATING DOWN
A rating at this levels signals that default risk is rising materially, even if default is not yet the base case. Moody’s would downgrade the rating were it to conclude that the pressures set out above were rising further and that the likelihood of the government undergoing some form of default event had risen.
Such an outcome would most likely be driven by a further increase in liquidity pressures due for example to larger than currently anticipated fiscal slippages creating higher than expected annual refinancing needs; or to a shift in external investor sentiment which threatened the government’s access to finance at affordable rates; or by other factors that led to a further erosion of the foreign exchange buffer that would also jeopardize external financing.
GDP per capita (PPP basis, US$): 3,996 (2017 Actual) (also known as Per Capita Income)
Real GDP growth (% change): 4.1% (2017 Actual) (also known as GDP Growth)
Inflation Rate (CPI, % change Dec/Dec): 6.1% (2017 Actual)
Gen. Gov. Financial Balance/GDP: -7.6% (2017 Estimate) (also known as Fiscal Balance)
Current Account Balance/GDP: -3.9% (2017 Actual) (also known as External Balance)
External debt/GDP: 70.9% (2017 Estimate)
Level of economic development: Low level of economic resilience
Default history: No default events (on bonds or loans) have been recorded since 1983.
On 24 July 2018, a rating committee was called to discuss the rating of the Government of Zambia.
The main points raised during the discussion were:
The issuer’s fiscal or financial strength, including its debt profile, has materially decreased.
The issuer has become increasingly susceptible to event risks.
Other views raised included: The issuer’s economic fundamentals, including its economic strength, have not materially changed.
The issuer’s institutional strength/framework, have materially decreased.