In the agency’s opinion, Zambia has only limited fiscal financing options at its disposal, with external debt financing being prohibitively expensive and limited capacity in the domestic banking system available, against a backdrop of sizable redemptions in 2017.
The only hope for Zambia is to plead to the IMF for a loan, but the IMF has already given its conditions, which are that ZESCO, ZAMTEL and all remaining parastatals must be sold and subsidies must be removed, price of electricity must be increased etc..
“Government revenues have increased only incrementally and we have revised our economic growth expectations downward, while interest expenditures consume an increasing amount of total revenues–having nearly trebled since 2013 to an estimated 21 per cent of revenues in 2017. Domestic debt redemptions in 2017 are almost double that of 2016, at one per cent of GDP, and Eurobond coupon payments are also estimated at just over one per cent of GDP. Offsetting these strains, we expect an International Monetary Fund (IMF) program to be in place by the middle of the year, bringing with it financing support and a firm policy anchor. If needed, we expect the government will meet maturities by diverting revenues earmarked for other purposes or, in extremis, by asking the central bank for an interim loan, although we note bridge loans are already close to their permitted maximum.
“The new government has stated that the clearance of arrears is a priority action as part of its “Zambia Plus” strategy for economic recovery. We also expect that the IMF will require the estimated nine per cent of GDP of arrears accrued over 2015 and 2016 to be cleared over the course of the program, and this will keep headline fiscal deficits wide over the forecast horizon. Furthermore, we expect the underlying fiscal consolidation to act as a break on economic growth as public consumption reduces. In addition, we note that private sector credit growth contracted over 2016, indicating both the impact of local currency appreciation (because nearly 40 per cent of domestic assets are denominated in U.S. dollar), but also weak confidence and low levels of investment.
“Conversely, we expect that the recent climb in copper prices could be an impetus for growth, particularly after an IMF program is in place. We view both as important for investor confidence, as the earning potential in mining operations becomes more tangible, and government policy over public finances firmer. As to government policy, we expect an IMF program to help deliver a decision on the final mining tax regime, which has been a key source of uncertainty for a number of years and particularly since commodity prices started to fall. We also understand that rainfall has improved, which should help to alleviate electricity shortages and the related electricity import bill, even though reservoir levels remain very low. Agricultural production should also increase as the government takes substantive action against an army worm invasion, which otherwise could threaten overall agricultural production. Mining accounts for a relatively small proportion of GDP (estimated at 11 per cent) and on balance, we expect economic growth to be slightly lower than at our previous review in August 2016, averaging 3.8 per cent over 2016-2019 compared with 4.4 per cent previously. Our real GDP per capita trend growth metric for Zambia now falls below the average for peers with similar per capita wealth levels.
“The increase in copper prices could provide an important boost to government revenues and support foreign currency inflows into Zambia. However, the government’s fiscal position remains difficult, in our view. The average interest rate on domestic debt issuance remains above 20 per cent across all maturities. Interest expenditures now total over 14 per cent of all expenditures or 21 per cent of revenues in 2017, up from 11 per cent in 2015. Preliminary 2016 data indicate a deficit of 5.9 per cent of GDP and a substantial consolidation from 2015 performance.
“However, while tight liquidity in domestic banks and prohibitive rates on external markets effectively limited cash expenditures, the government continued to commit to expenditures, building up arrears estimated at four per cent of GDP. Arrears of nine per cent of GDP have accumulated over the past two years. Government auction data for 2017 indicate improving subscription rates as banking system liquidity improves, which, if continued, will limit the accumulation of payables. Still, we expect that the IMF may require these arrears to be cured as part of program conditionality, and we have therefore added their clearance to our fiscal expenditure estimates over the forecast. We expect that the change in debt will remain high. We expect debt repayments to remain the highest priority for the government. The central bank bridge loan facility has reached its maximum. However, in extreme need, we expect that reserves could be used to meet debt payments.
“In terms of the consolidation path, we expect that capital expenditures, transfers, and subsidies (including to the Food Reserve Agency, which purchases corn from farmers) will be targets for cuts, despite social sensitivities surrounding them. On the revenues side, we expect that changes to mining-related taxes are also likely to be finalized.
“Our headline debt assessment remains in line with our previous review, and we expect net debt to peak at 55 per cent of GDP, when including our assumption of financing from the IMF. Given that two-thirds of the government’s debt stock is in foreign currency, the impact of exchange rate fluctuations affects our metrics. The appreciation of the kwacha toward the end of 2016 has benefitted the debt-to-GDP ratio in that respect. A high 45 per cent of the banking system’s assets are to the government. We factor into our contingent liability analysis a stock of government guarantees estimated at $2.8 billion or 14 per cent of GDP, as the government has largely been paying interest on these loans on the entities’ behalf. We understand that the bulk of these relate to the support of the utility company, ZESCO, but also a recently signed loan guarantee of $1.5 billion for the construction of a hydroelectric power station.
“Our external analysis includes an improvement in current account expectations on the back of improving copper price assumptions and a substantial reduction in imports over 2016. Part of the latter is linked to lower consumption and part due to lower imports of capital investment-related machinery. Still, Zambia’s terms of trade are volatile and linked to changes in copper prices.
“Foreign direct investment levels over the first to the third quarters of 2016 (last actual data) show a very substantial decline in inflows (from $1.1 billion in the same period of 2015 to only $250 million over the same period in 2016), largely indicating a lack of appetite to commit funds during a period of heightened uncertainty. The majority of this investment is likely linked to copper mining activity, and we note that periods of underinvestment can reduce overall output as maintenance issues are more likely to hamper production. Foreign direct investment (FDI) has been an important source of external financing and its sharp reduction is a concern, given that reserve levels are less than three months’ worth of imports, even though imports have contracted. We expect that IMF program disbursements will support external finances over our forecast period through 2020.
“Although in a comparison of net international investment positions (IIP) Zambia remains in an asset position because of mining company profits invested abroad, we view Zambia’s external position as weak. And we note, particularly in light of lower FDI inflows, that external financing needs remain high. We therefore think that Zambia is highly vulnerable to any further shocks. We also note that Zambia’s external data contain numerous stock/flow discrepancies that limit our ability to analyse changes in its external stock position. Zambia has not produced a full IIP report since 2013.
“Tight liquidity conditions in the domestic banking system appear to be easing slowly, as indicators show a slight increase in liquid assets, Interbank rates are declining, and government T-Bill auction subscriptions are being met.
“Liquidity in the system tightened in part as a result of the central bank’s policy action designed to tame inflation, which spiked at over 22 per cent in March.
“In order to reduce what it viewed as excessive speculative behavior in the foreign exchange market that was adding to kwacha depreciation (thereby increasing inflation), the bank sought to reduce local currency liquidity by reducing access to its overnight lending window. This resulted in a prolonged period of high interbank rates, averaging approximately 27 per cent between November 2015 and April 2016. Inflation has also started to reduce as a result, and the kwacha has remained relatively stable, appreciating about 13 per cent from midyear 2016 through the year-end. Nevertheless, asset quality is declining, with nonperforming loans at just under nine per cent as of June 30, 2016, as borrowers of foreign currency (roughly 35 per cent of total loans) struggle to repay these obligations. Previous increases in capital requirements have helped banks’ overall capitalization levels remain adequate through this turbulent period. Deposit dollarization has fallen to 49 per cent, but we expect this will decline further as confidence returns after a period of exchange rate stability.
“In our opinion, uncertainty regarding the strength of Zambia’s institutions, particularly with respect to clearly identifying policy priorities, has increased over the past few years as numerous external shocks, in particular a sharp decline in copper prices, have brought with them substantial challenges.
“However, we continue to view Zambia’s institutional setting as relatively strong for the region and with a backdrop of social stability and calm. We also point to the assertive measures by the central bank in the face of very substantial pressure on Zambia’s currency in containing speculative behavior and limiting the overall impact on price inflation, which has started to normalize from a peak of 22 per cent in March 2016. Following the August 2016 elections, details on the government’s fiscal and economic plan have started to emerge, albeit more slowly than we expected. We expect an IMF program will act as an important policy anchor once it is in place.
“The outlook is negative, reflecting the downside risk that fiscal financing pressures could increase further in the face of high maturities over 2017, while economic growth momentum has weakened.
“We could lower the ratings over the next year if there are further material delays to plans to put public finances on a sustainable path, including securing debt financing. We could also lower the ratings if levels of investment, including FDI, remain low or worsen, increasing external financing needs and potentially compounding already weaker economic growth.
“We could affirm the ratings at their current levels if sustainable fiscal and economic policies are implemented efficiently, thereby leading to assured financing conditions and an acceleration of economic output.”