Overview

South Africa continues to depend on resident and nonresident purchases of rand denominated local currency debt to finance its fiscal and external deficits. Its financing needs have risen beyond our previous expectations, with general government debt set to increase by an average of 4.9% of GDP over 2016-2018, to reach gross debt of 54% of GDP in 2019. The proportion of rand in global foreign exchange turnover has also declined to just below 1% on average over the past three years.

We also believe political events have distracted from growth-enhancing reforms, while low GDP growth continues to affect South Africa’s economic and fiscal performance and overall debt stock.

We are therefore lowering our long-term local currency rating on South Africa to ‘BBB’. We are affirming all other ratings.

The negative outlook reflects the potentially adverse consequences of persistently low GDP growth for the public balance sheet.

Rating Action

On Dec. 2, 2016, S&P Global Ratings lowered the long-term local currency rating on the Republic of South Africa to ‘BBB’ from ‘BBB+’ and affirmed the ‘A-2’ short-term local currency ratings. We affirmed the long-and short-term foreign currency ratings at ‘BBB-/A-3’. The outlook on the long-term ratings remains negative.

At the same time, we affirmed the ‘zaAAA/zaA-1’ South Africa national scale ratings.

Rationale

We have lowered the long-term local currency ratings on South Africa because its fiscal financing needs are increasing beyond our previous base-case expectations, while the proportion of rand turnover in the global foreign exchange market has declined over the last three years.

South Africa continues to depend on resident and non-resident purchases of rand denominated local currency debt to finance its fiscal and external deficits. Its financing needs have increased beyond our previous base case, with general government debt set to increase by an average of 4.9% of GDP over 2016-2018, compared to our previous estimate of 4.1% for the same period.

The proportion of rand in global foreign exchange turnover has also declined to just below 1% on average over the past three years. More broadly, we believe political events have distracted from growth-enhancing reforms and persistently low GDP growth continues to dampen per capital wealth levels and the country’s fiscal performance.

Nevertheless, the ratings on South Africa reflect our view of the country’s large and active local currency fixed-income market, as well as the authorities’ commitment to gradual fiscal consolidation. We also note that South Africa’s institutions, such as the judiciary, remain strong while the South Africa Reserve Bank (SARB) maintains an independent monetary policy.

South Africa’s pace of economic growth remains a ratings weakness. It continues to be negative on a per capita GDP basis. While the government has identified important reforms and supply bottlenecks in South Africa’s highly concentrated economy, delivery has been piecemeal, in our opinion.

The country’s longstanding skills shortage and adverse terms of trade also explain poor growth outcomes, as does the corporate sector’s current preference to delay private investment, despite high margins and large cash positions.

We have marginally revised down our real GDP growth assumptions for South Africa to 0.5% for 2016 and 1.4% for 2017 (last June we forecast 0.6% for 2016 and 1.5% for 2017). Our revised projections are contingent on global growth, and, in particular, South Africa’s terms of trade. The economy remains directly and indirectly linked to demand for commodities, especially from China. We estimate that real GDP per capita will stand at US$5,300 in 2017.

While we believe the electricity sector has improved–with no load shedding since winter 2015 reflecting new capacity and lower demand–delivery on labor and mining sector reforms and other planned growth-enhancing measures continues to be slow. We think the government will soon enact the Mining and Petroleum Resources and Development Amendment Bill (MPRDA), which parliament recently passed into law. However, the mining charter is still under discussion and may drag over the next year.

The government has set up a commission into minimum wages, which has provided a starting point for negotiations with business and labor unions. Other implemented labor measures have given more power to labor tribunals to resolve disputes. Other matters, such as secret balloting, have been cascaded to labor unions to amend their individual constitutions. Nevertheless, prolonged and damaging strikes are likely to be curtailed over the next two to three years because the gold and platinum sectors signed multiyear wage agreements, which are likely to keep strikes to a minimum.

South Africa has a strong democracy with independent media and reporting. We also believe it will maintain institutional strength, particularly regarding the judiciary, which provides checks and balances and accountability where the executive and legislature has appeared less willing to do so.

That said, political tensions are still high. The former finance minister, Nhlanhla Nene, was removed from office on Dec. 9, 2015; the Constitutional Court ruled against President Jacob Zuma on March 31, 2016; and the ANC lost some of the key cities (Johannesburg, and Tshwane [Pretoria]) in the Aug. 3 municipal elections.

Furthermore, the National Prosecuting Authority pursued fraud charges against the current finance minister, Pravin Gordhan, and other former SARS employees in October 2016, before dropping them in the same month, and a North Gauteng High Court ruling led to the publication of the “State of Capture” report, which sheds light on alleged corruption between private individuals and public office bearers.

We believe that against this backdrop, tensions and contestations are increasing in the run up to the ANC’s December 2017 elective conference. We think that ongoing continued tensions and the potential for event risk could weigh on investor confidence and exchange rates, and potentially affect government policy direction.

South Africa’s gross external financing needs are large, averaging over 100% of current account receipts (CARs) plus useable reserves. However, they are declining because the current account deficit is narrowing. The trade deficit is declining on the lower price of oil (which constitutes about one-fifth of South Africa’s imports); weak domestic demand; and a notable increase in exports from the mining and manufacturing sectors and a slower pace of increase in imports.

We believe sustained real exports growth is likely to be slow over 2016-2019 on persistent supply side constraints to production. Import growth will be compressed, amid currency weakness and the subdued domestic economy. Therefore, we estimate current account deficits will average below 4% of GDP (or 11% of CARs) over 2016-2019. However, South Africa funds part of its current account deficits with portfolio and other investment flows, which can be volatile.

Such volatilities could result from global changes in risk appetite; foreign investors reappraising prospective returns in the event of growth or policy slippage in South Africa; or rising interest rates in developed markets. We also observe that the proportion of rand in global foreign exchange transactions has fallen below 1% over the past few years. A few anticipated large FDI transactions should help reduce the share of debt financing as a percentage of South Africa’s net external deficit over the next few years.

Since 2015, South Africa’s net external asset position has been benefiting from a weaker currency (valuation effects) given that some external liabilities to nonresidents are denominated in local currency. We expect external debt net of liquid assets will average below 50% of CARs over 2016-2019, and the banking sector will remain in a net asset position.

Despite the weak economic environment constraining tax revenue collections, we believe the government remains committed to a fiscal consolidation path over the medium term through expenditure and revenue adjustments. On the expenditure side, the nominal expenditure ceiling provides an anchor and limit to overall government spending. While tight, it can accommodate unforeseen expenditure pressures within the existing framework. On the revenue side, treasury tax collection targets have often performed better than suggested by nominal GDP growth, pointing to tax buoyancy that is somewhat resilient to weaker economic growth trends.

Nevertheless, the treasury’s annual change in general government debt in the past has tended to be higher than the reported deficit by at least 1% of GDP in the past five years.

Therefore, we project the annual change in general government debt will average at 4.9% of GDP over 2016-2018. The government has delayed for two decades plans to finance and build nuclear power plants, which could have negatively impacted the fiscal metrics.

General government debt, net of liquid assets, increased to around 45% of GDP in 2015 from about 30% in 2010, and we expect it will stabilize at around 49% of GDP only in 2018-2019. Although less than one-tenth of the government’s debt stock is denominated in foreign currency, nonresidents hold about 35% of the government’s rand-denominated debt, which could make financing costs vulnerable to foreign investor sentiment, exchange rate fluctuations, and rises in developed market interest rates. We project interest expense will remain at about 11% of government revenues this year.

We currently view South Africa’s contingent liabilities as limited. Nevertheless, in our view, the government faces risks from non-financial public enterprises with weak balance sheets, which may require more government support than we currently assume.

ESKOM (BB/Negative/–) benefits from a government guarantee framework of South African rand (ZAR) 350 billion (US$25 billion)–about 9% of 2016 GDP. ESKOM has used approximately ZAR190 billion of this guarantee amount to date.

Over the last year, the government has given ESKOM support in the form of a ZAR23 billion equity injection, and converting a ZAR60 billion loan to equity to boost the firm’s capital.

Other state-owned entities that we think could pose a risk to the fiscal outlook include national road agency Sanral (not rated), which is reported to have revenue collection challenges with its Gauteng tolling system, and South African Airways (not rated), which may be unable to obtain financing without additional government support.

As part of governance reforms, a new board was established to help turn the airline around. However, broader reforms to state owned enterprises are still under discussion and we do not expect implementation in the near term.

South Africa continues to pursue a floating exchange rate regime. The SARB (the central bank) does not have exchange rate targets and does not defend any particular exchange rate level. We assess the SARB as being operationally independent and its policies as credible. It uses an inflation-targeting framework for its monetary policy. The bank also uses open market operations to manage liquidity, including sterilizing its purchases of foreign exchange inflows. The repurchase (repo) rate is the bank’s most important monetary policy instrument.

Despite lower oil prices, a weaker exchange rate and higher electricity prices have increased inflationary pressures. The central bank expects inflation to remain higher than its 3%-6% target range in 2016 and early 2017 while these transitory shocks dissipate. The SARB has tightened by 75 basis points (bps) of cumulative hikes in 2016. Domestic capital markets are well developed, in our view, with depository corporation claims on residents’ nongovernment sector accounting for about 80% of GDP. Local currency debt market capitalization (dominated by government bonds) accounts for 60% of GDP.

The South African banking sector’s performance has remained reasonably strong. Key financial metrics improved across the board domestically, returns on equity improved to 17.1% in August 2016 from 16.5% one year earlier, and over the same period capital adequacy improved to 12.2% from 11.0%. This can be partly attributed to the positive endowment effect from higher interest rates but also improving cost controls and lower risk costs.

South Africa remains a middle-income country with a diversified economy and wide income disparities. The ratings are supported by our assumption that South Africa will experience continued broad political institutional stability and macroeconomic policy continuity. We also take into account our view that South Africa will maintain fairly strong and transparent political institutions and deep financial markets.

The ratings are constrained by the need for further reforms, low GDP growth, volatile sources of financing, structural current account deficits, and sizable general government debt.

Outlook

The negative outlook reflects the potential adverse consequences of persistently low GDP growth on the public balance sheet, in the next one to two years.

We could lower the ratings if GDP growth or the fiscal trajectory does not improve in line with our current expectations, for example if South Africa enters a recession in 2017 or wealth levels continue to decline in U.S. dollar terms. We could also lower the ratings if we believed that institutions had become weaker due to political interference affecting the government’s policy framework.

Downward rating pressure would also mount if net general government debt and contingent liabilities related to financially weak government-related entities exceeded our current expectations. A reduction in fiscal flexibility may also lead us to further narrow the gap between the local and foreign currency ratings.

We could revise our outlook to stable if we observed policy implementation leading to improving business confidence and increasing private sector investment, and ultimately contributing to higher GDP growth and improving fiscal dynamics.