Fitch release on Kingdom of Lesotho

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29 August 2007

(The following statement was released by the ratings agency)

Aug 29 - Fitch Ratings affirmed the Kingdom of Lesotho's Long-term foreign currency Issuer Default Rating ('IDR') at 'BB-' (BB minus) and local currency IDR at 'BB' with a Stable Outlook. The Short-term foreign currency IDR is affirmed at 'B'. The Country Ceiling for the Common Monetary Area is 'A', two notches above South Africa's sovereign rating

Lesotho's credit strengths continue to be its strengthened public finances, as a result of exceptional Southern African Customs Union ('SACU') revenues over the past four years, and external balance sheet as SACU revenues have facilitated a faster build-up of official reserves and enabled the government to prepay some of its commercial external debt. Diamond production starting in 2004 has helped diversify Lesotho's exports and brought increased growth. Political instability following the February elections has had no discernible impact on the economy and Lesotho received a grant from the US Millennium Challenge Corporation ('MCC') in July 2007. Unlike many countries in Sub-Saharan Africa, Lesotho has not sought debt relief under bilateral and multilateral initiatives, despite its low per capita income.

'Improved medium-term growth prospects mean that Lesotho is now more or less in line with its rated peers in terms of recent and prospective GDP growth,' says Veronica Kalema, Fitch's lead analyst on Lesotho. The big boost has come from diamond mining; GDP growth in 2004 and 2005 has been revised upwards to 4% (from 3.1%) and 3.1% (from 1.2%) respectively and in 2006 the doubling of diamond output resulted in 6.2% growth—the highest in many years. The textiles sector is also recovering and Lesotho is seeing a return of investment to, and expansion of, the sector, although activity has yet to reach 2004 levels. Due to the much more competitive operating environment, Fitch expects that the textiles industry will grow more gradually than it did between 2001-2004 when the sector was boosted by the introduction of the US Africa Growth and Opportunities Act ('AGOA') trade agreement. GDP growth is projected by the government to average 6.5% in 2007-2009 due to further expansion of diamonds output, continued recovery of the textile sector and rising public investment.

The ratings are supported by strong fiscal consolidation. Although the gross public debt ratio of 50.3% of GDP is above the 'BB' median, the net debt ratio of 28% of GDP in the fiscal year ended March 2007 was much lower and all of Lesotho's other public finance ratios were substantially stronger than the 'BB' median. SACU revenues have also supported the balance of payments and Lesotho achieved a current account surplus of around 4% of GDP in 2006 for the first time in over a decade; a further surplus is expected in 2007. As a result, its net external creditor position strengthened to 21% of GDP in 2006 and the country became a net public external creditor.

On the negative side, however, there has been political instability since the parliamentary elections in February 2007 due to the opposition parties' dissatisfaction with the way 40 proportional representation seats in the country's 120-member parliament were allocated after the elections. Even so, Fitch believes that the situation is unlikely to escalate to the levels seen in 1998, which almost led to a coup, as the Southern African Development Community ('SADC') leadership is mediating between the government and opposition parties. Nevertheless, the situation is a potential concern and could lead to negative rating action if political violence increased or reduced government effectiveness. The impasse has to be resolved for the government to attract much needed investment and to focus on more pressing development issues.

The prospective long-term decline in SACU revenues remains a threat, particularly as there has been only a very gradual improvement in expenditure management despite initiation of reforms since FY2002 (to end March 2003). Lesotho's SACU revenues are threatened by lower tariffs due to the EU and other trade agreements, the possible expansion of the SACU into the SADC customs union and by South Africa's desire to re-negotiate the current revenue-sharing agreement. In addition, although the textiles sector has been fairly resilient to the expiry of the Multi Fibre Agreement, the end of AGOA in 2015 will mean that there will have to be an improvement in productivity if the textiles sector is to be sustainable and remain competitive in the long term.

Lesotho's fundamental credit weaknesses—the low level of development compared with rated peers and the weak business environment—will take time to address. The government acknowledges all these challenges and is focusing on structural and institutional reforms, skills development and investment in infrastructure with the support of a large grant from the MCC and other donors such as the World Bank and the EU. Improvements in the country's creditworthiness will depend on the impact of reforms and enhanced infrastructure on increasing private sector activity, the diversification of the government's revenue base and its ability to foster development.

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