Moody’s downgrades Zambia’s issuer rating to B3 with negative outlook

Lusaka, Zambia, Capital Markets in Africa — Moody’s Investors Service (Moody’s) has today downgraded Zambia’s long-term issuer rating to B3 from B2 and changed the outlook to negative from stable. The downgrade on the issuer rating was driven by:

•  Greater-than-anticipated fiscal slippages in 2016 leading to material liquidity pressures and significant challenges to finance the budget deficit;
• The prospects of further deterioration in Zambia’s debt matrix in a lower growth environment, with the government debt likely to exceed 60% of GDP by 2018

The negative outlook reflects the view that risks are skewed toward even greater fiscal slippages and slower fiscal consolidation, which creates uncertainty over the magnitude of the funding challenges and deterioration of Zambia’s debt profile over the rating horizon.

Concurrently, Moody’s has lowered Zambia’s long-term foreign-currency bond ceiling to B1 from Ba3, its long-term foreign-currency deposit ceiling to Caa1 from B3, and its long-term local-currency bond and deposit ceilings to Ba2 from Ba1.

Rationale for the downgrade 
Zambia’s credit metrics have deteriorated beyond Moody’s expectations since the agency downgraded the rating to B2 in September 2015. The negative trend in the credit metrics is expected to continue for at least two years, given the combination of shocks to the economy, the track record of missed fiscal targets and the absence of efforts to achieving sustainable fiscal consolidation. The downgrade to B3 is intended to capture this ongoing weakening of the government’s balance sheet and related liquidity risks.

FIRST DRIVER: GREATER-THAN-ANTICIPATED FISCAL SLIPPAGES LEADING TO LIQUIDITY PRESSURES 
In 2015, Zambia’s fiscal deficit reached 8.1% of GDP, up from 5.6% deficit in 2014. Moody’s expects that without measures to rein in expenditures, the fiscal deficit will remain elevated and reach 7% or more of GDP this year. The notably higher-than-projected power deficit (1,000 MW vs. 560 MW estimated in September 2015) has already necessitated costly electricity imports while sharp depreciation of currency increased the need for fuel subsidies. These factors have contributed to large spending overruns, which, if continued, are estimated to amount to 3% of GDP for the year. Lower for much longer copper prices, together with rain shortfalls and electricity shortages, have led to subdued growth and put additional pressure on the budget through weaker revenue.

Zambia’s high funding needs in the coming months and years present a significant challenge for the government given the country’s relatively underdeveloped domestic capital market and reduced risk tolerance of international investors. Domestic borrowing costs have risen sharply over the past year with yields on 1-year treasury bills reaching 28% in March. These high domestic borrowing costs and the impact of a weaker currency on cross-border borrowings have given rise to interest payments consuming an ever larger portion of budgetary revenue. Interest payment-to-government revenue ratio will likely near 20% this year, up from 8% in 2013. The general increase in yield rates on Government securities was largely attributed to the higher than projected fiscal deficit and the tightened monetary conditions.

Zambia’s financing options in the international capital market are limited given the investors’ reduced risk appetite and the yield on Zambia’s ten-year government bond at 12%. While still above three months of imports, foreign exchange reserves declined to US$ 3 billion in 2015 despite the sovereign bond issuance that year. Moody’s projects that in 2016 forex reserves will fall to $2- 2.3 billion, below three months of imports.

SECOND DRIVER: RAPID DEBT ACCUMULATION AND THE PROSPECT OF FURTHER DETERIORATION IN DEBT METRICS
The second driver for changing Zambia’s rating is the expectation that public debt will reach 56% of GDP in 2016, notably above Moody’s expectation of 45-50% a year ago, and will rise above 60% by 2018. The government domestic arrears accumulated in 2016 point further to emerging debt sustainability challenges. While in 2015 kwacha’s rapid depreciation was a key driver of the rapid public debt accumulation, Moody’s expects the elevated fiscal deficits in 2016 and 2017, in combination with lower growth, to drive future debt-to-GDP accumulation, which is now close to median of B3-rated peers.

Although the government plans to reduce the fiscal deficit to 4% of GDP this year, in part by cutting capital expenditures, and adopt further consolidation measures in 2017, Moody’s believes that given the track record of missed fiscal targets, deficits are likely to remain higher than targetted.

Sustainable fiscal consolidation will be challenging against the background of persistent structural weaknesses, particularly electricity shortages, and low copper prices. Moody’s latest growth projections assume just 3-3.5% growth in 2016, compared to our forecast of 5.2% in September 2015. This puts additional pressure on the debt-to-GDP ratio. Moody’s projects a return to +5% growth after 2018, as it expects the electricity shortages to be much less pronounced, while mining is projected to rebound due to current investments and cost reducing measures.

The government has recently announced its plans to negotiate an IMF program, which would help not only with the liquidity challenges but also with putting public finance on a sustainable path. However, a formal agreement has not been reached so far. In Moody’s view, the process is likely to be prolonged and only take –off after the presidential elections scheduled for August this year.

Rationale for the Negative Outlook
The negative outlook reflects heightened uncertainty about spending in the run up to the August elections and uncertainty about the liquidity and funding position of the government over the next 12-18 months.

What could change the rating up/down 
Downward pressure on Zambia’s rating could develop due to: 1) a further increase in electricity shortages or drop in domestic copper production that would cause a material impact on the government’s fiscal position or the country’s external position; or 2) larger-than-expected twin deficits and a strong upward trend in the overall debt burden; 3) a continuation, if not worsening, of liquidity pressure causing a further abrupt reduction of growth-supporting capital expenditures; and 4) a sustained decline in foreign currency reserves to below 2 months of import cover that amplifies the country’s external vulnerability to shock.

While an upgrade is unlikely in the near term, should the trends motivating the negative outlook dissipate or reverse in the next 12-18 months (for example, the fiscal deficit contracts to less than projected and in a sustainable way, uncertainty regarding government funding is reduced, and/or the current account returns to surplus), outlook could be stabilized. Zambia’s credit profile would likely remain in line with peers at the B3 level, including other commodity exporters, justifying a return to stable outlook.