Moody's Downgrades Zambia's Ratings to Caa2, Outlook Changed to Negative


Friday, May 24, 2019  10:09AM / Moody’s Investors Service


Moody's Investors Service ("Moody's") has today downgraded the Government of Zambia's long-term issuer ratings to Caa2 from Caa1 and changed the outlook to negative from stable.

The downgrade reflects increasing external and liquidity pressures, which, by impairing the government's ability to service its debt over the medium term, raise the probability of default over the near term, including a distressed debt exchange, beyond what is captured in a Caa1 rating. The rising probability of default also reflects increasingly stark credit challenges stemming from rising debt levels, which further reduce the likelihood that the external and liquidity stress will be resolved rapidly.

The Caa2 rating balances those pressures against the possibility that Zambia could refinance the forthcoming maturities and continue to service its debt while preventing a depletion of foreign exchange reserves.

The negative outlook reflects the risk of material losses to investors in the event of a default by Zambia, beyond what would be consistent with a Caa2 rating.

Concurrently, Moody's has lowered Zambia's long-term foreign-currency bond ceiling to B3 from B2, its long-term foreign-currency deposit ceiling to Caa3 from Caa2, and its long-term local-currency bond and deposit ceilings to B2 from B1.

Ratings Rationale

Rationale for the Downgrade

Intensifying External Vulnerability and Liquidity Risks

External vulnerability and liquidity pressures have increased since Moody's last rating action in July 2018, as reflected in dwindling foreign exchange reserves and a sharply increasing cost of debt. With only very limited prospects that these pressures could ease, the probability of default has risen beyond what is captured in a Caa1 rating.

Despite mineral royalty receipts being now remitted in US dollar, the country's foreign exchange reserves have continued to decline gradually in recent months, drained by sizeable external government debt service and a current account deficit. As of the end of April, foreign exchange reserves had fallen to about US$1.1 billion (gross international reserves including gold and IMF SDR holdings stood at US$1.3 billion), or 1.3 months of imports, well below the three-month of imports threshold commonly considered a minimum level of reserve adequacy. Current reserve holdings have reached a record-low level in almost a decade and are very low compared to the external debt payments due in the remainder of 2019 and in 2020, let alone imports payments.

Moreover, while at the time of the last rating action, Moody's expected foreign exchange reserves to stabilize at around $1.7 billion, it now looks likely that, in the absence of an IMF financial support program, or of a debt reprofiling with some creditors including China, reserves will continue to decline given Zambia's external debt service and imports payments.

The narrow reserves buffer leaves Zambia's external position highly vulnerable to even small shocks, in particular to a fall in prices or production of copper or adverse business environment developments, that would significantly impair the government's ability to service its external debt obligations. Moody's projects its External Vulnerability Index (EVI) - the ratio of external debt payments (short-term and maturing long-term debt) due over the coming year and non-resident deposits over one year to foreign exchange reserves - to exceed 200% in 2019 and to rise further in the coming years as external debt payments coming due increase with the upcoming Eurobond maturities and reserves continue to decline.

External vulnerability is associated with heightened government liquidity risks. With falling reserves, very low fiscal policy credibility, and no tangible progress on talks with the IMF, spreads over U.S. Treasuries have widened to very high levels indicating impaired market access. Yields on domestic government securities have also continued to increase over the past year to very high levels. In addition, non-resident investor interest in Zambia's domestic securities has declined to about 15% as of March 2019 from 17% in June 2018 amid lower confidence. Overall, Zambia's access to market financing at manageable costs has become significantly impaired. In turn, the increasing cost of debt contributes to elevated borrowing requirements (likely to exceed 15% of GDP in the next few years), further constrains the government's financing options and raises liquidity risk.

Refinancing risks will intensify in the early part of the next decade as large Eurobond maturities fall due with early market-based refinancing prevented by unaffordable terms and no clear strategy to address the repayments. The government has for some time intended to reprofile bilateral loans owed to Chinese entities (that Moody's estimates to account for close to 30% of the total public external debt), but no progress that would ease liquidity pressures materially has been achieved so far. The government also created a sinking fund to save in advance for Eurobond maturity payments but little has been accumulated up to now. With Zambia running sizeable deficits, Moody's does not expect the fund to accumulate sufficient proceeds to reduce the Eurobond rollover risk meaningfully.

The Caa2 rating also captures the possibility that Zambia could refinance forthcoming maturities and continue to service its debt while preventing a depletion of its foreign exchange reserves.

Increasing Fiscal Challenges Amid Deteriorating Growth Outlook

The rising probability of default in Moody's assessment also reflects increasing credit challenges stemming from rising debt levels, currently exacerbated by weakening growth, which further reduce the likelihood that the external and liquidity stress will be resolved rapidly.

External and liquidity risks have put pressure on the exchange rate, raising Zambia's foreign-currency debt burden. As a result, Moody's now projects Zambia's government debt burden (including arrears) to exceed 76% of GDP in 2019, significantly higher than earlier expected, and to increase further approaching 80% early in the next decade.

The depreciation of the exchange rate in recent months has increased the debt burden. Consistent with very low foreign exchange reserves, depreciation pressures on the exchange rate have recently resumed. In the absence of credible policies to rebuild a foreign exchange reserves buffer, Zambia will remain exposed to bouts of depreciating pressure which would negatively affect the debt dynamics, given the significant proportion of debt denominated in foreign currency (at about 60% of the total).

The fiscal target was missed in 2018 and the fiscal deficit on a cash basis amounted to 7.6% of GDP in 2018 which was higher than the budget target of 6.1% - albeit in line with Moody's expectations - mainly as a result of higher than planned interest and capital spending. The stock of arrears also increased during the year, at 5.6% of GDP at end-2018. Moody's projects the fiscal deficit to average 7% of GDP in 2019-20 as spending pressures in particular from interest payments persist given the very high and rising cost of debt, resulting in a slower pace of fiscal consolidation than expected by the government.

The subdued growth outlook exacerbates the heightened fiscal challenges. Real GDP expanded by 3.7% in 2018 and Moody's projects it to remain below 3% in 2019 as a weather-related shock to agriculture undermines growth further. At these rates, GDP growth barely matches population growth. Furthermore, risks are tilted to the downside. A lack of decisive and credible measures to address fiscal and external challenges could weigh on growth to a greater extent than Moody's currently assumes, particularly if the accumulation of domestic arrears continues, negatively affecting the banking sector's asset quality and private sector credit growth. It could also erode investor confidence further and exacerbate already intense pressure on the exchange rate, forcing the central bank to tighten monetary policy significantly.

Rationale For The Negative Outlook

The negative outlook reflects the risk of material losses to investors in the event of a default by Zambia, beyond what would be consistent with a Caa2 rating.

Heightened and persistent fiscal, liquidity and external risks, and high and rising debt burden point to the possibility of significant losses in the event of a possible debt restructuring, including a distressed exchange.

What Could Change The Rating Up

Given the negative outlook, an upgrade is highly unlikely in the near term. Moody's would consider changing the outlook to stable in the presence of sustained improvements in Zambia's external liquidity position with a significant increase in foreign exchange reserves, and, probably at the same time, a lasting easing of liquidity pressures, in particular related to effective fiscal consolidation and a credible strategy to address the Eurobond repayments.

What Could Change The Rating Down

Moody's would downgrade the rating in the event of a larger or more rapid fall in foreign exchange reserves and/or further increase in liquidity stress that would make a default by the government on its debt payments increasingly likely, and under which Moody's would expect losses to investors to be larger than consistent with a Caa2 rating. A default could occur from a liability management exercise that would be considered a distressed exchange by Moody's and therefore a default under its definitions.

Developments in financial market indicators and liquidity and external vulnerability metrics required the publication of this credit action on a date that deviates from the previously scheduled release date in the sovereign release calendar published.

GDP per capita (PPP basis, US$): 3,999 (2017 Actual) (also known as Per Capita Income)

Real GDP growth (% change): 3.4% (2017 Actual) (also known as GDP Growth)

Inflation Rate (CPI, % change Dec/Dec): 6.1% (2017 Actual)

Gen. Gov. Financial Balance/GDP: -7.7% (2017 Actual) (also known as Fiscal Balance)

Current Account Balance/GDP: -3.9% (2017 Actual) (also known as External Balance)

External debt/GDP: 70.5%

Level of economic development: Low level of economic resilience

Default history: No default events (on bonds or loans) have been recorded since 1983.

On 20 May 2019, a rating committee was called to discuss the rating of the Government of Zambia. The main points raised during the discussion were: The issuer has become increasingly susceptible to event risks. Other views raised included: The issuer's fiscal or financial strength, including its debt profile, has decreased.

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