Fitch Ratings has revised the Outlook on Lesotho’s Long-Term Foreign-Currency Issuer Default Rating (IDR) to Negative from Stable and affirmed the IDR at ‘B’.
KEY RATING DRIVERS
The revision of the Outlook to Negative reflects the significant impact of the coronavirus pandemic on Lesotho’s economy’s and public finances. The pandemic will lead to a sharp contraction in GDP in 2020, create risks to medium-term growth prospects, and result in a substantial rise in general government (GG) debt. These developments take place against a background of falling receipts from the Southern Africa Customs Union (SACU), an important source of fiscal and external financing, as well as a source of reserves that help support the currency peg to the South African rand.
Fitch forecasts a 5% contraction in GDP growth in 2020. The coronavirus shock exacerbates Lesotho’s already weak growth prospects, due to lockdown measures impacting the domestic economy and weaker global trade negatively affecting mining and textiles, two of the biggest sectors in the economy. In addition, the closure of Lesotho’s border with South Africa has meant a temporary halt to work on the second phase of the Lesotho Highlands Water Project (LHWPII), which will contribute to a sharp contraction in the construction sector.
Our forecasts see Lesotho returning to growth of between 4% and 5% in 2021 and 2022, as work on LHWPII resumes and the construction of the dam commences, as well improved external demand for Lesotho’s exports. The pre-coronavirus timeline of LHWPII called for preparatory work on roads in 2019 and 2020, leading to construction of the Polihali Dam and transfer tunnel, along with associated hydropower facilities, in 2021 and 2022. We note the downside risk of delays if the pandemic persists longer than we presently expect.
Fitch expects that the loti’s peg to the South African rand, a support for Lesotho’s macroeconomic and financial stability, will remain in place. The Central Bank of Lesotho supports the currency peg by maintaining its net international reserves (NIR) position at not less than 120% of M1 plus callable deposits (so the total NIR target is approximately 130% of M1). The NIR ratio increased to 220% in April 2020 after falling as low as 153% in February 2019. We expect the NIR ratio to fall again as an expected increase in government expenditure drives a rise in broad money while reserves fall on lower SACU revenue. Fitch considers that the authorities remain committed to the peg and will likely make policy adjustment to preserve a NIR ratio consistent with the peg.
The pandemic will also hit Lesotho’s already weakened public finances. The budget for the fiscal year ending March 2021 (FY20) was passed with an additional 5% of GDP in coronavirus-related expenditure and forecasts a fall in revenue of approximately 7% of GDP. We expect that the FY20 fiscal deficit to widen to 7.7% of GDP, from 4.9% in FY19, as some of the additional spending will be offset by lower capital expenditure and the running of domestic payment arrears. In the absence of additional financing, the government’s tight cash position means that some of the budgeted expenditure will simply be unexecuted.
Lesotho’s public finances are characterised by high levels of government expenditure that have been partly financed by volatile SACU receipts. The SACU revenue pool is calculated every December based on forecasts for the next fiscal year’s collections, with adjustments made for over-or-under estimation of the previous fiscal year. An increase in SACU receipts, to 26.8% of GDP in FY20 from 18.3% in FY19, will temporarily bolster government deposits and keep the fiscal deficit from widening further, but will likely be offset by a lower disbursement for FY22. As a result, we expect fiscal deficits to remain just below 8% of GDP in FY21 and FY22, despite a moderation in expenditure.
The decline in SACU revenue has required the drawing down of government deposits. Government expenditure is elevated and rigid due to a high wage bill and other personnel costs. Ongoing political infighting has delayed the implementation of planned fiscal adjustments and public financial management reforms. The resignation of former Prime Minister Tom Thabane in May 2020 could lead to renewed efforts to implement Lesotho’s promised fiscal and public financial management reforms.
We expect Lesotho’s GG debt to increase to 62.6% by the end of FY20, slightly below our current median forecast for ‘B’ rated sovereigns of 65.3%. Interest costs, forecast at 3.3% of revenue, are much lower than the current ‘B’ median of 13.2%, which reflects the high share of concessional debt.
Our base case scenario envisages a post-coronavirus stabilisation of the debt/GDP ratio at approximately 65% by 2022, which is in line with our forecast ‘B’ median. However, risks to the debt dynamics stem from both lower-than-expected growth or failure to narrow the fiscal deficit. The government has a stock of outstanding arrears, which represents an additional fiscal risk. There is no audited account of the arrears stock, but Fitch estimates it at between 3% and 4% of GDP. The authorities announced their intention to pay LSL800 million (2.4% of GDP) in domestic arrears as part of its stimulus measures, but this effort will likely result in the shifting in arrears rather than their clearance, in our view.
Lesotho’s ‘B’ rating is supported by the favourable profile of its external debt, the continued support from multilateral and bilateral lenders, and the general stability of the banking sector. This is balanced against rising external indebtedness and a history of political instability.
The sovereign’s higher debt levels and the fall in sovereign assets have both increased Lesotho’s net external debt (NXD). We forecast net external debt of 2.5% of GDP in 2020, following the steady deterioration since 2009 when Lesotho was a net external creditor of 101.9%. Lesotho’s external debt position still compares favourably with the ‘B’ median NXD of 36.5% of GDP.
Lesotho’s external debt stock is heavily weighted toward sovereign borrowing, but approximately 80% of external debt is on concessional or near-concessional terms and most debt is owed to multilateral and bilateral lenders. Lesotho currently has no outstanding Eurobonds. Lesotho has low external debt servicing costs compared with peers. We estimate 2020 external debt servicing at approximately USD60 million (3.1% of current external receipts). The current ‘B’ median forecast is 20.2%.
In July 2020, the IMF agreed USD49 million in support for Lesotho under the Rapid Credit Facility and Rapid Financing Instrument, which Fitch believes will likely act as a catalyst for additional official financing. A full IMF programme would provide additional external support, which would be a support for the current rating. However, Fitch assumes that such a programme is not likely to occur until the authorities can begin to implement reforms to Lesotho’s fiscal framework and public financial management.
The banking sector is dominated by local subsidiaries of South African banks, which benefit from strong South African supervision. Lesotho’s banks are well capitalised and have adequate liquidity. However, banks’ lending portfolios are highly concentrated in manufacturing, construction and retail lending, all areas likely to be negatively impacted by the COVID-19 recession. The size of the banking sector is relatively small, with assets at 47% of GDP; therefore, the banking sector is unlikely to become a significant liability to 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, as is the case for all sovereigns. Theses scores reflect the high weight that the World Bank Governance Indicators (WBGI) have in our proprietary Sovereign Rating Model. Lesotho has a medium WBGI ranking at 39.3, 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.