Fitch Affirms Lesotho at ‘B’; Outlook Negative

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Photo by Markus Spiske on Unsplash

Fitch Ratings has affirmed Lesotho’s Long-Term Foreign-Currency (LTFC) Issuer Default Rating (IDR) at ‘B’ with a Negative Outlook.

KEY RATING DRIVERS

Lesotho’s ‘B’ rating balances high external indebtedness, deteriorating public finances and a history of political instability weighing on policy making against the favourable profile of the country’s external debt and continued support from multilateral and bilateral lenders. The Negative Outlook reflects risks to medium-term growth prospects and increased pressures on public finances aggravated by the prolonged pandemic and structurally lower receipts from the Southern African Customs Union (SACU).

Lesotho’s economy contracted 9.5% in 2020, as infrastructure projects such as the second phase of the Lesotho Highlands Water Project (LHWPII) were disrupted as a result of two lockdowns in March 2020 and January 2021. Two of the biggest sectors in the economy, mining and textiles, also suffered from weaker global demand and containment measures affecting the domestic economy.

We forecast a weak recovery in 2021 at 3.5% amid improved global demand and some normalisation of economic activities. While building of advance infrastructure for LHWPII started as early as 2019, construction of the main components (the Polihali Dam and the transfer tunnel) has been delayed repeatedly and we now expect it to start in 2022. Lesotho’s economy relies heavily on public spending funded by volatile SACU receipts and was in recession since 2017, previous to the pandemic. Hence, tight fiscal scope limits the government’s capacity to spend and boost growth in 2021. Our baseline forecast is also susceptible to a more severe resurgence of Covid-19 infections and new tighter containment measures given the country’s slow vaccine rollout. As of 26 July 2021, less than 2% of the population received at least one dose.

We expect economic growth to accelerate to 4.2% in 2022 and about 4% in 2023 as major projects such as the LHWPII and the Lowlands Water Project in Zone 2 & 3 are expected to scale up in 2022. While these investments bolster the medium-term growth outlook, growth potential is constrained by structural factors including high inequality and poverty, political instability, lack of skilled labour and weak infrastructure.

Recurring bouts of political volatility and infighting within the government amid an overall weak institutional capacity constrain the government’s ability to adjust fiscal policy and push forward reforms, and exacerbate problems with public-finance management. Political instability is underscored by Lesotho having experienced three early elections following no-confidence motions over the past decade and several cabinet reshuffles, reflecting partly intra-party conflicts. The risk of another successful no-confidence motion after two cabinet reshuffles in 2021 has subsided, as the ruling coalition still maintains a thin majority in the lower house of parliament. The next national elections are in 2022.

Lesotho registered a small fiscal surplus of 0.5% of GDP on a cash basis amid the Covid-19 pandemic in the fiscal year to March 2021 (FY20), partly due to limited policy scope, financing constraints and a build-up of arrears. Although Covid-19 related priority spending amounted to about 2.6% of GDP, authorities curtailed or delayed spending by tightly controlling the issuance of monthly spending orders (warrants) for budgeted non-priority spending. About 84% of the budgeted expenditure was executed in FY20 and it represented a saving of 10% of GDP compared with the budget. In addition, a temporary boost to SACU receipts (rising to 28.4% of GDP in FY20 from 18.7% in FY19) also offset the impact from the pandemic on revenue.

A sharp decline in SACU revenue expected in FY21 and FY22, the impact of the third wave of the pandemic and associated containment measures on revenues and the resumption of capital projects will outweigh continued tight expenditure control using warrants and expenditure cuts backed by a mid-term budget review in October, and some progress on improving revenue collection and broadening the tax base. As a result, we expect fiscal deficits to reach 7% and 5.4%of GDP in FY21 and FY22. Seizure under legal proceedings in South Africa by the German company Frazer Solar of Lesotho’s foreign receipts including water royalties that South Africa pays to Lesotho, if successful, would lead to a potential 2% of GDP revenue loss.

Lesotho’s general government (GG) debt reached 58.9% of GDP at FYE20, increasing from 44.7% at FYE18. Foreign-currency denominated debt accounts for 85% of total GG debt but around 80% of external debt is contracted on concessional or near-concessional terms with multilateral and bilateral lenders. Lesotho has no outstanding Eurobonds. The external debt servicing burden in 2021 is 4.7% of current external receipts, which is low compared the ‘B’ median forecast of 18.4%.

We forecast that debt/GDP will rise to 64% before stabilising in 2025. Debt dynamics are subject to downside risks stemming from failure of fiscal adjustment or lower-than-expected GDP growth. The government has a stock of outstanding arrears, which represents an additional fiscal risk. Lesotho has no audited account of the arrears stock, but Fitch estimates it at between 3% and 4% of GDP.

Lesotho continues to have access to external financing from multilateral and bilateral lenders. It received USD49 million under the IMF Rapid Credit Facility and Rapid Financing Instrument in 2020. In FY21, Lesotho also secured USD30 million through the World Bank Development Policy Operation in addition to about USD51.9 million through the World Bank nutrition and health projects. The G20 Debt Service Suspension Initiative until end-2021 helps provide small additional fiscal scope (about 0.2% of GDP each in 2020 and 2021).

Negotiations with the IMF have reportedly taken place since 2019 but were never concluded, possibly as ongoing political infighting has increased the challenges to the implementation of reform of the fiscal framework and to public financial management. A full IMF programme could provide additional external support and catalyse other external financing. However, in the absence of a programme and without a significant consolidation effort, Fitch expects a substantial drawdown of government deposits given Lesotho’s fairly shallow domestic debt market.

Lesotho runs a structural current account deficit. Exports declined significantly in 2020, but this was partly offset by a SACU windfall and weak import demand, resulting in a smaller current account deficit of 2.8% of GDP in 2020. Fitch forecasts widening current account deficits in the coming years as imports related to LHWPII increase. The stock of international reserves fell to USD812 million at the end of March 2021, from USD864 million at end-2020.

External liquidity risks are limited in the near term but reserve buffers are declining. The Central Bank of Lesotho (CBL) maintains a floor on net international reserves of 120% of M1 plus callable deposits (so the total net international reserve target is about 130% of M1) to support the loti’s peg at parity to the South African rand. The authorities remain committed to the currency peg and view it vital to macroeconomic and financial stability. However, long-standing current account deficits and continued drawdown of government deposits for fiscal financing have led to a fall in Lesotho’s official international reserves since early 2020, a further deterioration of which would undermine the ability to defend the currency peg.

Lesotho’s domestic banking sector is dominated by local subsidiaries of South African banks and they entered the pandemic with adequate liquidity and high profitability. The banking sector’s non-performing loan (NPL) ratio rose to 4.2% at end-2020 from 3.3% at end-2019 and is expected to remain around 4.9% in 2021. The size of the banking sector is fairly small (with assets at about 57% of 2020 GDP) and thus unlikely to impose a significant liability on the sovereign.

ESG – Governance: Lesotho has an ESG Relevance Score (RS) of 5 for both Political Stability and Rights and for the Rule of Law, Institutional and Regulatory Quality and Control of Corruption. Theses scores reflect the high weight that the World Bank Governance Indicators (WBGI) have in our proprietary Sovereign Rating Mode (SRM)l. Lesotho has a medium WBGI ranking at 38, reflecting a moderate level of rights for participation in the political process, established rule of law and a moderate level of corruption, but also reflecting a recent history of political instability and low levels of government effectiveness.

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