The agency cited poor prospects for medium-term economic growth and rising public debt as the reasons for the downgrade.
Structural weaknesses, including ongoing energy shortages as well as rising interest rates, further deterioration in the investor climate and a less supportive capital market environment for countries such as South Africa that are highly dependent on external capital was also one of the key drivers of the downgrade.
The outlook on the rating changed to stable from negative.
Moody’s also downgraded the rating assigned to the debt issued by ZAR Sovereign Capital Fund Propriety Limited from Baa1 to Baa2.
A key driver of this downgrade was the prospect of further increases in the government’s debt-to-GDP ratio implied by the low-growth environment.
The agency added that even strict compliance with the government spending ceiling and somewhat smaller fiscal deficits are unlikely to arrest in the near term.
(READ MORE: Moody’s downgrades four S.African banks)
In response to the downgrade, South Africa’s government said it is committed to narrowing its budget deficit and recognised the need to implement measures to boost economic growth.
“Government will continue to make the tough decisions that are necessary to address our challenges so we can build on the gains we have made over the past 20 years to improve the lives of our people,” Treasury said.
Moody’s indicated that the assignment of a stable outlook reflects policymakers’ commitment to reining in government debt growth over the medium term and broad political support for a macroeconomic strategy.
This includes the National Development Plan (NDP) and tighter monetary policy and fiscal restraint, which should help stabilise the debt burden over the medium term.
The ratings agency also said the first driver for the downgrade of South Africa’s long-term debt rating to Baa2 is the weak outlook for real growth over the coming years, continuing the below-potential performance of 2012 to 2014.
“Moody’s has revised down its forecasts for real GDP growth to only 1.4 per cent in 2014, followed by a 2.5 per cent increase in 2015, and expects that the economy will not reach its long-run potential growth rate of roughly three per cent until 2018 because of ongoing energy shortages and other structural constraints,” it said.
Moody’s added that these low projections are also subject to material downside risks from both domestic sources – mainly new strike activity – and external sources, particularly a slowdown in demand from China, South Africa’s single largest export market, and weak growth in world trade generally.
“Even if such impediments are overcome, real growth is likely to come in below levels seen a few years ago,” the ratings agency said.
According to Moody’s, government effort to restrict current spending – including the wage bill – to protect its infrastructure expansion efforts are an important part of its broader efforts to enhance longer-term growth prospects by eliminating infrastructure bottlenecks without significantly loosening fiscal policy.
The recent Medium Term Budget Policy Statement provided further assurance of continuity in macroeconomic policy and showed that the South African Treasury is no longer counting on a recovery of growth to bring down deficits in the future.
(WATCH VIDEO: Fitch revises South Africa’s outlook to negative)
Aside from cuts in the existing spending ceilings for 2015/2016 and 2016/2017, the statement outlines newly-lowered fiscal deficits that are limits that cannot be exceeded, which Moody’s deemed as important given downside risks to growth on both the domestic and external fronts.
Moreover, Moody’s noted that South Africa’s Baa2 investment grade rating reflected its position as the most developed country in Africa, offering by far the deepest capital market and one of the most sophisticated financial systems among emerging markets.