OREANDA-NEWS.  Fitch Ratings has downgraded Lesotho's Long-term foreign currency Issuer Default Rating (IDR) to 'B+' from 'BB-' and the Long-term local currency IDR to 'BB- 'from 'BB'. The Outlooks on the Long-term IDRs are Stable. The Country Ceiling is affirmed at 'BBB' and the Short-Term Foreign-Currency IDR at 'B'.

KEY RATING DRIVERS
The downgrade of the IDRs reflects the following key rating drivers:

Medium

Fitch forecasts a continued deterioration in public finances, with projected deficits of 3.4% of GDP in fiscal year-ending March 2016 (FY16), 6.8% of GDP in FY17 and 6.5% of GDP in FY18. The widening deficit is due to the fall in South African Customs Union (SACU) revenues linked to the weakening in South Africa's economic performance. SACU receipts are forecast to drop to 16.6% of GDP in FY17 from 25.8% of GDP in FY16, and remain at around 18% of GDP in FY18. The authorities have not adjusted fiscal policy in response. Expenditure on wages is expected to remain very high at 23.7% of GDP in FY16 and FY17. The deficit will be funded from government deposits, which are forecast to fall to 19% of GDP in FY18 from 26% of GDP in FY16, and new government debt issuance.

Fitch forecasts gross general government debt (GGGD) to increase to 56% of GDP by FY18 from 52.5% of GDP in FY16 as a result of new debt issuance and Loti depreciation, as around 85% of GGGD debt is in foreign currency. In FY17 Lesotho's GGGD is forecast to exceed the peer 'B' median of 54.4% of GDP. GGGD is mostly concessional with long maturities.

Political tensions are complicating any policy response to the growing fiscal deficit. The governance and institutional environment have weakened significantly following an alleged coup attempt in 2014, as evidenced by the deterioration in Word Bank governance indicators. The recent South African Development Community (SADC) commission of enquiry report on its investigation into the death of a former army general highlights the institutional weaknesses. Fitch does not expect meaningful improvement in the political environment in the short-term.

Fitch estimates continued weak real GDP growth in 2015 and 2016 due to ongoing political tensions, a drop in SACU revenues and a recent drought. The political tension has hit investment, consumption and confidence, affecting the implementation of the National Strategic Development Plan (NSDP). Fitch forecasts GDP growth of 2.8% in 2016 up slightly from 2.7% in 2015, before increasing to 4% by 2017 as new mining production comes on stream and initial work on phase II of the Lesotho Highlands Water Project (LHWP) boosts the construction industry.

Donor relations are becoming increasingly strained. Disquiet regarding the political situation led to a loss of EU budget support in 2016 and has generated uncertainty regarding re-certification for the African Growth and Opportunity Act (AGOA). AGOA is very important to the textiles sector, a key component of Lesotho's economy, as it provides preferential access to the US market.

Lesotho's 'B+' IDRs also reflect the following key rating drivers:-

Lesotho's 'B+' rating is supported by the currency peg to the South African rand, which has contributed to macroeconomic stability. With large government deposits, forecast at 22% of GDP in FY17, and mostly held at the central bank, this will continue to support Lesotho's official foreign reserves.

Fitch forecasts the current account deficit (CAD) to widen to 14% of GDP in 2016 from 8% of GDP in 2015 due to the drop in SACU revenues in 2016 before returning to around 8% of GDP in 2017. The CAD is due to ongoing construction of projects in the country. A combination of grants and FDI will fund the CAD. The first part of phase II of LHWP will be funded by South Africa. Fitch forecasts international reserves to fall to around 4 months of current external payments in 2017 from 4.7 months in 2015, although remaining adequate to support the exchange rate peg.

RATING SENSITIVITIES
The Stable Outlook reflects Fitch's assessment that upside and downside risks to the rating are currently well-balanced. The main factors that could, individually or collectively lead to a negative rating action are:

- A further material weakening of debt ratios and an erosion of government deposits.
- Political turmoil that affects macro stability, GDP growth and potentially external financial support from the international community.
- A faster-than-projected deterioration in the current account balance due to a fall in SACU revenues leading to a significant decline in foreign reserves.

The main factors that could, individually or collectively lead to a positive rating action are:

- Higher real GDP growth, supported by an improvement in the business environment and political stability and diversification in the economy.
- Further progress in diversifying the revenue base and growing tax receipts that lessen the dependence on SACU revenues.
- A sustained reduction in GGGD/GDP.

KEY ASSUMPTIONS
Fitch assumes that economic growth in Lesotho will be supported by a gradual recovery in its key economic partners, namely the US, Europe and South Africa.

Fitch assumes there will be no major revision to the SACU revenue-sharing formula that could negatively affect SACU revenues to Lesotho. Fitch also assumes AGOA will be recertified in 2017.