S&P Global Ratings

Overview

• South Africa's near-term economic performance and current account are experiencing a cyclical uplift as a result of a combination of base effects following a large economic contraction in 2020, and improving terms of trade from higher commodity prices.
• Never the less, structural constraints, a weak pace of economic reforms, and low vaccination rates will continue to constrain medium-term economic growth, and limit the government's ability to contain the debt-to-GDP ratio.
• We affirmed our long-and short-term foreign currency ratings at 'BB-/B' and our long and short-term local currency ratings at 'BB/B'.
• The outlook is stable.

Rating Action

S&P Global Ratings affirmed its 'BB-/B' long- and short-term foreign currency sovereign credit ratings and its 'BB/B' long- and short-term local currency sovereign credit ratings on South Africa. The outlook is stable.

The transfer and convertibility (T&C) assessment remains 'BB+'.

We also affirmed our 'zaAAA/zaA-1+' long- and short-term South Africa national scale ratings.

Outlook

The outlook on both the foreign and local currency ratings is stable, since South Africa's credit strengths--particularly a credible central bank, a flexible exchange rate, an actively traded currency, and deep capital markets--should help counterbalance relatively low economic growth and fiscal pressures.

Downside scenario

We could lower the ratings if South Africa's economy fails to recover during the forecast period and fiscal financing or external pressures mount. This could, for example, arise from further financing risks emanating from contingent liabilities, including public electricity utility Eskom, or tightening financing conditions increasing the government's interest burden as a proportion of revenue.

Upside scenario

We could raise the ratings if economic growth is sustainably higher than we currently expect over multiple years, leading to higher wealth levels and real per capita GDP growth, as well as a significant improvement in the government's debt-to-GDP ratio.

Rationale

South Africa is experiencing a cyclical upturn in its near-term economic performance and current account position. Following a contraction of 7% in 2020, the economy is set to rebound this year, following the relaxation of lockdown restrictions, re-opening of the economy, and an upturn in global commodity prices, which is helping to improve terms of trade. We also expect South Africa to post a second successive annual current account surplus this year, as commodity prices are relatively high and imports are recovering moderately. Over the medium term, we expect commodity prices to soften, while slow progress on economic reforms could result in the economy reverting to low economic growth and moderate current account deficits.

Our ratings are constrained by weak economic growth performance since well before the COVID-19 pandemic, particularly on a per capita basis; high economic inequality; as well as weak public finances, including high fiscal deficits, a high debt burden, and sizable contingent liabilities from weak state-owned enterprises (SOEs). Our ratings are supported by the country's monetary and exchange rate flexibility and credible monetary policy, a well-capitalized and regulated financial sector, and deep capital markets, alongside moderate external debt--in particular low levels of external debt denominated in foreign currency.

Institutional and economic profile: A cyclical upturn in terms of trade is boosting short-term economic performance, but structural constraints remain

• South Africa's long-term economic growth remains negative on a per capita basis.
• The implementation of planned economic reforms remains slow, along side reform of governance frame works to reduce misuse and leakage of public funds.

South Africa's economy contracted by 7% in 2020, the sharpest drop since the 2009 recession, partially due to lockdown restrictions on movement of people and goods to combat the first wave of the COVID-19 pandemic and many sectors were slow to recover from this shock. In early 2021, restrictions on movement were eased and the economy is again open and the focus moved to vaccinating the population and expanding the economy. International commodity prices have rebounded with greater global demand, helping an improvement in South Africa's terms of trade. Owing to base effects from the 2020 contraction and terms of trade improvements, we forecast economic growth in South Africa to rebound to 3.6% this year, before moderating to 2.5% in 2022 and below 2% in2023-2024. Structural impediments are likely to continue to weigh on medium-term growth, particularly the unreliable electricity supply, weak investment expenditure, and an inflexible labor market with heavy unionization across public and private sectors.

We estimate South Africa's GDP per capita at about $5,700 in 2021, an improvement from about $5,000 in 2020 but still lower than the $8,000 recorded in 2011. We see per capita GDP remaining close to $6,000 over the medium term. Despite considerable progress in alleviating poverty since the end of apartheid, South Africa remains one of the most unequal societies in the world, with the poorest 60% of the population controlling less than 10% of the wealth and facing high unemployment. At above 30% in 2021, the official unemployment rate is among the highest of all rated sovereigns.

South Africa's vaccine rollout program has been slow, primarily reaching health sector workers so far. The rollout has been complicated by negotiations with manufacturers and questions about the efficacy of some vaccines for the predominant variant of COVID-19 in South Africa. Agreements have now been reached with Johnson & Johnson and Pfizer that will aim to inoculate at least 40 million people (about two-thirds of total population) by early 2022. Phase 1, which focused on inoculating health sector workers is near completion while phase 2 began roll out from May 17, targeting people above 60 and those with comorbidities. Vaccinations are then planned to be expanded to the rest of the population.

Following past years of weakening state institutions and misuse of public funds, the current administration is trying to slowly strengthen various institutions such as the tax revenue authority (South African Revenue Service), SOEs, and the national prosecutions authority. Some of these processes have led to the establishment of commissions, such as the Zondo commission, to pursue accountability. The Secretary General of the African National Congress (ANC), Ace Magashule, was asked to step aside in early May, while corruption charges against him are pursued via the court. He is the party's most senior sitting official to be charged since the Ramaphosa administration took over in 2018.

Our institutional assessment reflects the strong checks and balances embedded within South Africa's institutional framework, which includes a constitutionally independent judiciary, an independent central bank, and largely free media. However, we see South Africa as still facing significant unaddressed challenges related to high levels of poverty, unemployment, and economic inequality, which still often run along racial lines.

Flexibility and performance profile: The general government debt burden is high and contingent liabilities are sizable, but monetary flexibility remains a strength

• South Africa's public finances remain structurally weak, with high fiscal deficits, a large debt burden, and sizable contingent liabilities. Nevertheless, near-term fiscal deficits are declining slightly faster than previously forecast, owing to recent higher-than-expected revenue.
• We consider South Africa's monetary flexibility, the freely floating exchange rate, and the country's deep financial markets to be significant credit strengths; the financial sector is very deep relative to many emerging market peers.
• The South African rand(ZAR) is anactively traded currency, and South Africa currently has low levels of external leverage and more recently, current account surpluses.

We classify the rand as an actively traded currency, based on the 2019 Bank for InternationalSettlement's triennial survey, which showed that it contributes at least 1% of global foreign exchange market turnover. For the first time since 2002, South Africa posted a full-year current account surplus in 2020, at 2.2%. This was driven by a combination of import contraction and higher commodity prices improving the terms of trade. Weak economic activity resulted in lower imports than in previous years. On the other hand, commodity prices began picking up in the second half of 2020, supporting South Africa's commodity exports of metals and mining--gold, iron ore, platinum group of metals, and coal--which contribute almost half of total merchandise exports.

In 2021, we expect that with increased economic activity, imports will recover, while mineral exports will continue to increase, supported by strong external demand, led by China. We estimate the current account surplus will narrow to about 1.2% of GDP in 2021, before reverting to structural current account deficits. In our view, the rise in commodity prices is cyclical and will moderate over the medium term (see "Metal Price Assumptions: Demand Surges But COVID-19, Trade, And ESG Concerns Flatten Output," published March 30, 2021, on RatingsDirect). Therefore, we forecast the current account deficit will average 1.1% in 2021-2024.

With average current account deficits at low levels over the medium term, current low levels of foreign direct investment or potential outflows of portfolio investors are unlikely to present near-term external financing risks to South Africa. In recent months, foreign investors have, once again, become net buyers of South African government bonds. Nevertheless, the risk of another sudden stop or reversal remains dependent on global developments, inflation, interest rates, and risk aversion.

South Africa's external debt, net of liquid assets, is relatively low, averaging less than 50% of current account receipts. And in contrast to most emerging markets, the country's overall net external position (taking into account all the country's external assets and liabilities) is forecast to be in an average net asset position of 34% of current account receipts in 2021-2024.

South Africa's public finances are structurally weak, with high fiscal deficits averaging at least 7% over 2021-2024, interest payments close to 20% of fiscal revenue, and debt to GDP averaging 85% over 2021-2024. Nevertheless, current recent fiscal performance is ahead of initial targets set in the February 2021 budget, and performing better than in October's medium term budget policy statement. In the fiscal year ended March 31, 2021 (FY2020/2021), we estimate the final deficit at just over 11% of GDP relative to our previous forecast of over 15% of GDP. The improvements were helped by increased tax revenue from improved economic activity, including in the mineral sectors. With a near-term rebound in economic activity (leading to higher tax revenue), we also estimate that the fiscal deficit is likely to be less than 9% of GDP, within the 9.3% deficit target for FY2021/2022 set in February 2021. Over the medium term, we forecast that fiscal deficits will reduce to about 6% by 2023/2024.

Fiscal consolidation efforts (and our medium-term forecasts) are centered on containing the growth in public-sector wages via a planned freeze of public-sector pay, something that has remained hard to achieve in the past despite concerted efforts, owing to strong union presence in the country. Risks to the fiscal outlook are mainly on two fronts--settling at higher wages than currently provisioned, and increased support to weak SOEs. Wage negotiations are still ongoing, and we assume that an eventual compromise between government and union demands is likely. Risks emanating from Eskom could include higher financing needs than currently provisioned for, or the government directly assuming Eskom's debt on its balance sheet.

Nevertheless, the fiscal performance trends are not strong enough to stabilize the debt-to-GDP trajectory over the forecast horizon. We forecast that general government debt as a percentage of GDP will remain on an upward trend from 65% in 2019, reaching just below 90% in 2024. At the same time, debt servicing costs will rise to over 20% of fiscal revenue by 2024. One of the key fiscal challenges for the National Treasury is that interest expenditure is structurally high, limiting fiscal flexibility, while also cementing large interest payment outflows to nonresidents abroad. A particular concern is that even if, on the back of tough political decisions, personnel expenditure can be reduced from current levels, the increase in interest payments over the same period implies there will be little progress in narrowing the large fiscal deficit or debt to GDP--except under scenarios of significantly higher GDP growth than we currently project.

However, the recent improvements in fiscal deficits and increased cash balances have helped the Treasury somewhat reduce its local currency issuances in the domestic market. With the majority of domestic debt stock having a long tenor, the government has now taken the opportunity to increase its issuances of short- to medium-term securities as a way to reduce borrowing costs, given an upward sloping yield curve. The Treasury has also continued to secure loans from multilateral institutions, including a recent external funding facility from the New Development Bank.

We view South Africa's contingent liabilities as moderate--on our scale of limited, moderate, high, or very high--posing a drag on the country's weak public finances. Our view reflects the substantial support government provides to SOEs with weak balance sheets. Eskom, the troubled state-owned electricity utility, receives sizable annual fiscal transfers via a multiyear support framework. Despite this significant ongoing support provided to Eskom, the amounts currently provided are likely to be insufficient to meet its funding requirements over the near term, and further transfers are likely.

The government's guarantee framework as regards Eskom amounts to ZAR350 billion, or around 7% of 2021 GDP. If government were to assume Eskom's guaranteed debt directly, this would increase general government debt to almost 90% of GDP in 2021. Beyond Eskom, the government has been supporting other SOEs including South African Airlines (SAA) and Land Bank. SAA will receive ZAR10.5 billion (0.2% of GDP) to enact restructuring plans, which comes on top of the ZAR6.5 billion in support announced in the 2020 budget to settle guaranteed debt obligations. Land Bank received a smaller package of ZAR7 billion in 2020.

Inflation was benign in 2020, averaging just over 3%, in light of sluggish aggregate demand, low oil prices, and a good agricultural harvest that lowered local food prices. The low levels of inflation allowed the South African Reserve Bank (SARB) to cut the policy rate cumulatively by 275 basis points in 2020. The policy rate currently stands at 3.5%.

In 2021, we expect inflation to rise above 4%, closer to the middle of the SARB's 3%-6% range, driven by higher prices of food, electricity, oil, and transport components. At the same, the growth of credit to the private sector will be subdued in 2021, due both to risk aversion by banks, and to consumers' still weak demand for credit.

The banking sector remains strong and well regulated. Earnings proved resilient in the face of higher credit losses in 2020. Credit losses rose to 2.1% in 2020 and will moderate to about 1.6% in 2021 by our estimate. Nonperforming loans will likely increase to 5% over the same period, reflecting the end of the regulatory forbearance. Commercial real estate has shown growing signs of stress since 2018; structural shifts have caused an increase in office vacancies which, combined with an extension of the current lockdown measures, could weigh on performance beyond 2021. Household debt remains high and poses the largest source of risks for banks, primarily via vehicle, asset financing, and personal loans.

Download the S&P Global Ratings latest research update on South Africa’s sovereign rating here