Moody’s changes outlook on Zambia’s B3 rating to stable from negative, affirms rating

London (Capital Markets in Africa) – Moody’s Investors Service, (“Moody’s”) has today changed the rating outlook for the Government of Zambia to stable from negative and affirmed its B3 long-term issuer rating.

The stable outlook reflects reduced government liquidity pressures and a slowdown in government debt accumulation which Moody’s expects to continue.

The B3 rating balances a strong growth potential boosted by ample natural resources and a young and growing population against continuing credit challenges which include a moderate debt burden, though with a significant share denominated in foreign currency, low debt affordability, and risks of delays in implementing further fiscal consolidation plans. Other challenges include sizeable funding requirements, a rising reliance on external debt including for local currency government securities and large Eurobond maturities due early in the next decade.

Zambia’s foreign- and local-currency bond ceilings remain unchanged, with the long-term foreign-currency bond ceiling at B1, its long-term foreign-currency deposit ceiling at Caa1, and its long-term local-currency bond and deposit ceilings at Ba2.

RATIONALE FOR CHANGING THE OUTLOOK TO STABLE
The government’s gradual progress with fiscal consolidation is helping to cap borrowing needs and gradually restore policy credibility. As a result, the pace of increase in government debt from 2014 to 2015 is not expected to repeat. Evidence of fiscal consolidation, together with a favourable commodity price environment, foster stability in the exchange rate allowing the central bank to ease monetary policy. In turn, this contributes to support liquidity in the banking sector.

Moody’s estimates that in 2017, Zambia’s fiscal deficit (on commitment basis) fell to 6.5% of GDP, down from an 8.6% deficit in 2016. With the total deficit (including interest payments) being the main source of funding pressures over the past few years, the gradual reduction in the fiscal deficit alleviates liquidity pressures and has supported an easing of monetary policy.

Moreover, elimination of the electricity supply gap (which the country’s energy minister estimated at around 1,000 MW, or about half of the country’s needs during its peak in early 2016) lowered costly electricity imports funded by the government while fuel subsidy reform and currency stability have reduced the government’s subsidy bill. The government has also reduced farmer subsidies, raised retail power tariffs by 75%, increased the tariff for mines, and is phasing out the fuel distribution business entirely. Overall, these amount to savings of around 2% of GDP relative to the 2016 outcome.

These measures contribute to reduced pressures for spending overruns and also help the government in reducing its expenditure arrears, accumulated mostly in the aftermath of the copper price shock in the period 2015 to 2016. In 2017, arrears worth 3% of GDP were settled.

Moody’s expects that fiscal revenues will gradually rise over the medium term, to around 18% of GDP in 2020, from around 16% in 2016, supported by higher copper prices, higher copper production and structural tax measures. Such measures are likely to include steps towards implementation of more effective tax regimes and tighter incentives for compliance. Combined with fiscal measures to rein in expenditures, the fiscal deficit will continue to fall and reach 5.7% of GDP in 2018 and 5.0% in 2019.

Moreover, the government has implemented a new public financial management act and established control over non-concessional borrowing, reducing the risk of liquidity pressures going forward. In particular, all new non-concessional borrowing has been suspended since November 2017 unless approved by Cabinet while the government has also embarked on preparing the Treasury Single Account to reduce future arrears occurrences. Moody’s expects the remainder of the government expenditure arrears to be cleared by 2020.

Overall, Moody’s expects that gross financing needs will be contained below 15% of GDP and gradually subside, facilitating further easing of liquidity pressures.

With ongoing, albeit gradual, fiscal consolidation, and robust nominal GDP growth, government debt will rise very gradually as a ratio to GDP, remaining around 60% of GDP over the medium term. Moody’s projects real GDP growth above 4% in both 2018 and 2019, and nominal GDP growth at around 13%, supported by a robust global growth environment and demand for copper and an easing of some domestic structural bottlenecks including in power.

RATIONALE FOR AFFIRMING THE B3 ISSUER RATING
The B3 issuer rating balances Zambia’s credit supports (including natural resource endowment and a young population pointing to robust medium-term growth prospects, and access to concessional external financing with the average maturity of external debt around 20 years) against continuing credit challenges and vulnerabilities (including a moderate debt burden, albeit with a significant share denominated in foreign currency, low debt affordability, risks of delays in implementing further fiscal consolidation plans, sizeable funding requirements and large external maturities due early in the next decade). Strong inflows of foreign investment, exceeding regional peers, also provide credit support.

Despite progress with fiscal consolidation, Zambia’s gross funding needs, which Moody’s estimates at almost 14% of GDP in 2018, present a risk for the government given the country’s narrow domestic capital market and potential sudden changes in appetite for risk by international investors. Interest payments consume almost a quarter of budgetary revenue, up from 5% in 2011. While increased participation of foreign investors in government local currency securities has eased the government’s financing constraint, it amplifies the sensitivity of financing conditions to fluctuations in foreign investors’ sentiment.

Moreover, unless the government refinances its external debt maturities ahead of schedule, its funding needs will rise again significantly in the early part of the next decade, with the first Eurobond maturity due in 2022, and two other Eurobonds maturing in 2024 and 2027, respectively. This concentration of Zambia’s maturities coincides with large maturities for a number of other Sub-Saharan African countries, amplifying roll-over risk.

Finally, given the high share of government debt denominated in foreign currency, the overall debt trajectory is particularly sensitive to a potential renewed depreciation of the exchange rate. A sudden and pronounced weakening of the kwacha would raise the debt burden significantly, as seen in recent years. Similarly, debt affordability and the debt burden are exposed to a potential reversal in recent increases in copper prices which would extend the erosion of revenues.

WHAT CAN CHANGE RATING UP/DOWN
A repeat of fiscal slippages or significant depreciation of the currency seen in recent years, leading to the re-emergence of government liquidity challenges and increased indebtedness, could drive a negative rating action. The absence of a clear and credible plan to manage refinancing risk as the Eurobond maturities in the early part of the next decade near would also put pressure on the rating. An absence of longer-term fiscal and other structural reforms, including narrowing the energy gap over the medium term, that would reduce potential growth and undermine fiscal strength would also put downward pressure on the rating.

Faster progress with fiscal consolidation than Moody’s currently expects that markedly reduces the likelihood of liquidity pressures returning and brings government debt on a distinct downward trajectory would be credit positive. Progress with economic diversification and structural reform that leads to higher and more stable growth would also support Zambia’s creditworthiness in the medium term.