Tuesday 29, August 2017 by Matthew Amlôt

S&P: Republic of Zambia outlook revised to stable

On Aug. 25, 2017, S&P Global Ratings revised its outlook on the 'B' long-term foreign and local currency sovereign ratings on the Republic of Zambia to stable from negative. At the same time, the 'B' long-term and 'B' short-term sovereign ratings were affirmed. The transfer and convertibility (T&C) assessment remains at 'B'.

The stable outlook balances an improving macroeconomic picture against a number of negative rating pressures, including a wide fiscal imbalance and substantial debt stock.

We could lower the ratings over the next year if the government materially deviates from its fiscal consolidation target. We could also lower the ratings if previously destabilizing factors re-emerge, for example, if copper prices were to materially fall, or if rainfalls disappointed, or if improvements in the liquidity of the domestic banking system reversed. These factors have a substantial bearing on macroeconomic stability, growth, and the government's financing position.

We do not expect to raise the ratings over the next year. However, should

Zambia's external imbalances reduce materially faster than we expect in tandem with faster growth than we currently expect--which could raise our GDP per capita trend growth forecast--upward momentum on the ratings could emerge.

We have assigned a stable outlook to reflect a number of more positive developments that we expect will continue to reduce pressure on Zambia's fiscal, economic, and external assessments. That said, we still assess Zambia as being highly vulnerable to a reversal of these trends, despite the authorities implementing policies that aim to reduce macroeconomic susceptibility to such events.

We have improved our economic growth forecasts and expect increased economic output will be supportive of corrective fiscal measures. We view reducing fiscal deficits and the stock of debt as core to Zambia's rating trajectory, particularly as larger external debt maturities enter the forecast horizon through 2020. We expect an agreement with the International Monetary Fund (IMF) to be in place by year end (after repeated delays) and that this will act as a policy anchor. We note that, particularly between now and an IMF disbursement, higher copper prices--and an expected increase in copper output--are both supportive of not only higher growth but also of banking system liquidity, which in turn is a key source of government financing. Copper prices have risen by about 18 per cent in 2017 and core liquid assets in Zambia's banks by some 44 per cent over the same period. The central bank has continued to ease its policy rate and Zambia's currency, the kwacha, has remained on a slight appreciation path for some time now. As a result of these factors, the cost of debt for the government has also reduced. A related factor, given that inflation has fallen, is that foreign participation in the local bond market has increased by around 2.5 per cent of GDP over 2017, which is a helpful current account deficit financing item.

On the downside, the factors leading to anticipated higher growth are largely outside of the government's immediate control, leaving them vulnerable to calming demand for copper or unfavorable weather patterns. That said, the government has made efforts that are gradually diversifying the country's energy mix. We also note that discussions with the IMF have been ongoing for well over a year. A derailment of an expected agreement could dent confidence, reduce investment, and offset the positive factors. It could also risk the benefit to external finances of increased foreign participation in the government's local currency debt market.

Institutional and Economic Profile: Institutional setting still strong for the region

More recently, Zambia's institutional setting has been less supportive of the ratings, particularly with regard to controlling public finances.

We continue to assume that an IMF program will be agreed, but a derailment of these plans could disrupt what we view as a slowly improving macroeconomic story.

Many of the core factors of growth appear to be more supportive; however, their control is mostly out of the authorities' hands and the economy therefore remains vulnerable to their reversal.

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 the kwacha 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 plans have started to emerge, albeit much more slowly than we expected. Continued delays to an IMF program likely indicate substantial political sensitivity around expenditure controls, but we view the establishment of a firm consolidation path as core to the ratings trajectory.

We believe an IMF program would act as an important policy anchor, especially when viewed against the government's slow policy response since 2015, when commodity prices began their fall.

However, we view the main drivers of growth as relatively immune to political changes, aside from copper production and related investment. We believe that copper prices are the main determinant of mining company investment, despite often-voiced complaints that policy uncertainty has damaged business relations; copper prices have increased by 18 per cent over 2017 and in April we raised our copper price projections by an average of eight per cent per year through 2018.

Rainfall has improved, which brings with it two main benefits: a larger maize harvest and increased electricity production. Officials are expecting a bumper harvest this year and have already noted a 25 per cent increase in electricity production, which should support manufacturing activity as well as providing more fiscal space thanks to the reduced need for expensive fuel imports. Still, both of these factors could reverse, and while reforms are underway to install new irrigation systems and diversify the economic base, these core vulnerabilities are likely to remain in place over the rating horizon. Nevertheless, our real GDP per capita trend growth ratio has improved in this review, which is supportive of the ratings.

Flexibility and Performance Profile: Fiscal conditions are easing; pressures could arise if macroeconomic trends revert

We expect the government to establish a firm fiscal consolidation path, which includes the clearance of arrears (7 per cent of GDP), and should be supported by higher growth.

Upside pressure to our external forecasts could emerge if copper prices continue to climb, which could boost current account receipts and foreign exchange reserves.

The Bank of Zambia's monetary easing is also supportive of growth and helpful to government financing as the cost of debt falls.

The financing pressures faced by the government since copper prices started to fall in 2015 have started to ease, in our view. Persistently wide fiscal deficits and very limited domestic banking sector liquidity placed substantial strain on the government's financing options and has ultimately resulted in the accumulation of arrears to the tune of seven per cent of GDP. We include this stock of arrears in our debt ratios, which we expect will be 57 per cent of GDP on a net basis this year. This scenario highlights the risk that if fiscal imbalances remain wide, the government could yet again face similar pressures if macroeconomic trends explained above turn against them.

However, we expect that the government will progress with its own consolidation strategy, which we understand includes the repayment of arrears.

These relate to ZESCO, the state electricity company, which required transfers from the government to purchase fuel that was needed to replace a shortfall of hydro generated power and arrears to contractors involved in the construction of new roads. Furthermore, higher growth should lead to a revenue boost and better rainfalls to fewer electricity-related transfers by the government to ZESCO. Both of these factors are behind an underlying consolidation trend in our forecast. The presence of an IMF program could also act as an important policy anchor, in our view, and be supportive of more politically sensitive measures that include the reduction of excess maize purchases through the food reserve agency and the reduction of subsidies, which is already underway with electricity prices (we understand that power tariffs will be raised by a total of 75 per cent this year).

The cost of debt accounts for a large share of government expenditure and accounted for 24 per cent of government revenue between January and May of 2017. The government's net debt ratio increased from 23 per cent of GDP in 2013 to an estimated 57 per cent in 2017. Therefore the factors that affect the price of debt have a substantial influence on our rating on Zambia. The domestic banking system's liquidity is central to this dynamic, and, as such, a 44 per cent increase in core liquid assets over 2017 has played a part in reducing the cost of domestic issuance--the average rate on government T-Bills has fallen from 23 per cent at the beginning of the year to 14 per cent in June. Longer maturities remain more expensive but are also on a downward trend, in line with further reductions to the central bank's policy rate. Banking sector liquidity is a product both of growth (particularly of copper prices) and also of the central bank's policy.

The central bank has been very restrictive during the past few years in order to control both the impact of substantial exchange rate depreciation on prices and also speculative behavior. While these measures reduced the liquidity available to the government, they are important in illustrating the institution's operational independence. We expect inflation to remain in high single digits for 2017, down from the highs of nearly 20 per cent in early 2016.

Against this background of relative stability, high real returns for investors in local currency debt have prompted an increase in foreign participation in the government's local debt market of about 2.5 per cent of GDP over 2017. This takes foreign participation to over 60 per cent of total commercial debt. We expect this participation to reduce as returns fall, but expect this to play out slowly, in line with gradually improving growth. In the interim, these foreign inflows are acting as an important current account deficit financing item (making up 2.5 per cent of GDP, which is roughly half of the expected 2017 current account deficit).

Despite higher copper prices, which are boosting current account receipts, we expect that external imbalances will close more slowly, with recent updates showing weaker 2016 performance than expected and income deficits hampered by high interest payments. Still, there is upside scope for these forecasts to improve, particularly if copper prices continue to rise and extra maize production can be exported. In any case, we continue to project improving external flows in line with our copper price assumptions. Also positively, Zambia has revised its data on foreign direct investment (FDI), and this shows a more buoyant picture than we expected; at our last review, FDI data pointed to a very substantial decline over the first three quarters of 2016, which appears to have reversed in the fourth quarter, in part reflecting a pickup in mining-related investment. Together, these factors could lead to an improvement in the ratios for both narrow net external debt and also gross external financing needs. We note, however, that a full international investment position has not been published since 2013, which hampers our analysis of Zambia's external accounts. Our assessment includes a substantial stock of external assets belonging to the corporate sector (some 90 per cent of GDP), which we believe reflects the profitability of the mining sector.

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