Fitch: Fiscal Deterioration Will Raise Zambia's Debt Burden

The increasingly large budget gap in Zambia may prove costly to finance, Fitch Ratings says. Domestic financing conditions are constrained, and new external financing could push government debt toward 40% of GDP by end-2015.

The fiscal deficit could now jump to 7.7% (on a cash basis), according to IMF projections released earlier this month. The government expects the outturn to be lower, but has indicated that it expects the fiscal deficit to come in significantly above the 4.6% target announced in the 2015 budget. Mining revenue has come under pressure from lower copper prices and changes to the mining tax regime. The government has proposed trimming expenditure to offset the impact of lower revenue, although a rising interest burden and the re-emergence of fuel subsidies, among other factors, may make spending control challenging. The full budgetary impact of the government's commitment to pay VAT refunds built up between 2013 and 2014, which totalled 3% of GDP at end-2014, is not yet clear.

Increased domestic borrowing in the 2015 budget and a shortage of liquidity have pushed up financing costs, while demand for domestic government securities has fallen short of supply so far this year. The National Assembly on Thursday approved a Treasury request to raise the external debt limit to ZMW60bn (USD8bn), from ZMW35bn.

Tapping external sources of financing can expand an emerging market sovereign's investor base. But we have previously highlighted the risks of greater reliance on more expensive non-concessionary external financing to fund large budget deficits, particularly current expenditure. These include refinancing risk (although the Zambian authorities' announcement of a sinking fund to repay the sovereign's two outstanding Eurobonds may mitigate this), and the risk that debt servicing costs rise due to currency depreciation (the kwacha has fallen by 14% since January 2015).

Zambia has a historical track record of fiscal prudence, and government debt is well below the 'B' category median (30.5% of GDP, versus 49.1%). Nevertheless, the build-up in arrears as well as higher-than-budgeted fiscal deficits will push government debt-to-GDP higher, beyond Fitch's previous forecast peak of 34.2% of GDP in 2017. A rising debt burden will see interest costs rise sharply (these are expected to take up 17% of government revenue in 2015, up from 8% in 2012). This reduces fiscal flexibility and will complicate consolidation efforts.

Zambia's external position has worsened since the start of the year. Falls in reserves have been more pronounced this year than in early 2014, reflecting falling export revenues due to lower copper prices. Reserves have fallen by USD400m since December to USD2.6bn, from a peak of USD3.7bn in April 2014, following the last Eurobond issue.

A sustained deterioration in fiscal discipline would be negative for Zambia's sovereign credit profile. Concerns about policy coherence and credibility, highlighted by ongoing challenges for the mining tax regime, contributed towards Fitch's decision to revise the Outlook on the rating to Stable from Positive in March. The next scheduled rating review is on 21 August.