Moody’s: Economy will gradually improve from a weak 2018 level

Moody’s today issued a credit opinion on South Africa.

Rating outlook
While economic growth will remain slow and fiscal strength will continue eroding, we expect South Africa’s credit profile to remain
in line with those of Baa3-rated sovereigns. We expect that the government’s policies and the institutions will remain focused on
addressing this trend but any reversal will be gradual at best given that social, economic and fiscal policy objectives will remain difficult
to reconcile.
Factors that could lead to an upgrade
Successful implementation of structural reforms to raise potential growth and stabilize and eventually reduce the government’s debt
burden relative to Baa3-rated peers, including through SOE reforms that reduced contingent liabilities, would exert upward pressure on
South Africa’s ratings.
Factors that could lead to a downgrade
Conversely, South Africa’s ratings would likely be downgraded if we expect that government debt and contingent liabilities risk from
SOEs will continue rising to levels no longer consistent with a Baa3, or that medium-term growth will persist at very low levels as
recorded in 2018.

Detailed credit considerations

Moody’s says its assessment of South Africa’s economic strength as “moderate (+)” balances the economy’s relative size and diversification with
persistently slow growth. The ratings agency adds that the slow growth and productivity gains are mostly due to domestic constraints but external conditions have added headwinds, especially from global trade tensions. Key domestic constraints have included political tensions that have brought
about exceptionally low business confidence and heightened policy uncertainty in the past.

“A number of structural challenges hamper growth, such as the limited flexibility in the labor market as well as skills shortages that result in an increasingly high unemployment rate, at 27% at end of 2018, persisting regulatory uncertainty in the mining sector, the lack of competition in network sectors and the weak governance of state-owned enterprises. Inequality and poverty as well as health issues as highlighted by high HIV rates and child and maternal mortality rates also remain key challenges.

“We assess South Africa’s institutional strength as “moderate (+)”, below the indicative score of “high (-)”, because of the gradual deterioration in the country’s institutions in recent years, as exhibited by high-level corruption and ‘state capture’, that is not fully captured in scorecard metrics. While decisions taken by the government in relation to governance matters offer the prospect that institutional deterioration has halted, it will likely take time for the country to tackle those issues.”

Meanwhile, says Moody’s, institutions have maintained a track record of effective macroeconomic policy and adherence to the rule of law. “The government has a track record of sound fiscal management, especially on the spending side. We assess fiscal strength at “moderate (+)”. The National Treasury has largely adhered to expenditure ceilings which have helped contain spending net of interest. However, the collection of tax revenues has been constrained by low growth and the diminished effectiveness of the South African Revenue Service. Moreover ad-hoc support to SOEs has also weighed on government spending.”

The ratings agency adds that government debt and total contingent liabilities have doubled in terms of GDP since fiscal year 2008, reaching 53% and 15% of GDP in fiscal year 2017,1 respectively.

“Meanwhile debt affordability – as measured by interest payments as a share of government revenue – has deteriorated too. The structure of the government debt is, however, favorable, as it is mostly denominated in local currency and with long tenure (13 years). Moreover, the government actively manages debt and refinancing risk thanks to pre-funding. For these reasons, we adjust the score for fiscal strength to “moderate (+)” from an indicative score of “moderate”.

In Moody’s opinion, South Africa’s susceptibility to event risk is assessed to be “low (+)”, driven by domestic political risk.

“Our assessment of domestic political risk incorporates the recent changes in South Africa’s political landscape, which lower the risk of a further erosion of institutional strength and offer the prospect of renewed reform efforts, balanced against a history of political infighting that has
generated policy uncertainty in the past.

“Persistent current account deficits, which rely mostly on portfolio and other non-FDI flows for funding, represent a secondary vulnerability. However, while high non-FDI inflows make the country vulnerable to “sudden stops” (abrupt shift in investor’s appetite), the external balance has proven resilient to shocks. A flexible exchange rate, low external debt in foreign-currency and relatively large external assets (as reflected by the positive Net International Investment Position) serve as buffers. We adjust the score to a final “low” from an indicative of “low (+)” because a very large proportion of South Africa’s external debt is in rand, which lowers external vulnerability risks.

“We score government liquidity risk “low”, one notch below the indicative score of “low (+)”, given the inherent volatility in the market implied rating not accurately reflecting our assessment. While the government can access domestically a deep financial sector, it has relied on foreign investors with around 47% of government bonds being held by non-residents. In the current and next fiscal years, the government faces moderate funding needs of about 11% of GDP, including the roll-over of 6% of GDP in Treasury bills, in line with what the government funded in fiscal 2017.”

Moody’s assessment of the country’s banking sector risk as “low” differs from the scorecard’s indicative score of “low (+)”.

“The adjustment mainly reflects the higher-than-peer quality of South Africa’s macro-prudential framework. The tightening of credit standards that
began in 2015 has helped banks reduce their exposure to the household sector, which is the most vulnerable to interest rate shocks, and redirect it towards corporates that have a better debt-servicing capacity.”

Recent developments

Turning to recent developments, Moody’s believes that the country’s economy will gradually improve from a weak 2018 level.

“Economic growth came in at 0.8% in 2018, after experiencing a technical recession in the first half of the year. The agriculture, mining and construction sectors contracted throughout the year. On the expenditure side, gross capital formation declined by 2.8% in 2018, marking three consecutive years of anemic growth or contraction amid weak business sentiment. The reform agenda of the new administration, appointed in February 2018, has so far not translated in a material improvement in investor confidence.

“We expect growth to pick up modestly in 2019, at 1.3%, and converging to 1.5% the following years. The gradual implementation of the reform agenda of the new administration, combined with the reduction in political uncertainty following the May elections, will have a positive impact on confidence and lead to a gradual improvement in economic conditions. We caution, however, that the economy will likely continue to face significant supply-side constraints, including from unreliable electricity supply. Moreover, skills shortage and mismatch will continue to constrain job creation, meaning that a significant decline in South Africa’s unemployment rate, standing at 27.1% in the fourth quarter of 2018, is unlikely.”