A possible sharp rise in public debt and lower revenue due to a prolonged slump in diamond demand could put Botswana credit ratings at risk for downgrade, Moody's said on Wednesday.

The agency, which earlier this month joined Standard & Poor's in cutting the country's foreign currency rating outlook, forecast that the economy will contract in the 2008/09 and 2009/10 financial years.

A global economic slowdown has slashed demand for diamonds, leading to output cuts in the world's biggest producer of the precious stones, and a shift to a large budget deficit as revenue dries up.

Moody's said the heavy dependence on diamonds for fiscal and foreign exchange revenue was a key challenge, as were persistent income inequality and high unemployment, and a chronic HIV/Aids epidemic.

A lack of fiscal restraint leading to serious erosion in public asset holdings and/or a substantial rise in public debt ... could lead to a downgrade of the government's ratings and country ceilings, it said in a statement.

A prolonged downturn in diamond demand leading to a durable erosion of economic strength could also lead to a downgrade.

Increased diversification of the economy and a return to strong external and fiscal surpluses would lead to an upgrade, Moody's said.

The ratings agency cut the foreign currency rating outlook for Botswana -- Africa's highest rated sovereign -- to stable from positive on March 12, and downgraded the local currency rating to A2 to move in line with the foreign rating.

It said on Wednesday a potentially steep and relatively long global recession will hit Botswana's economy hard, resulting in it shrinking an estimated 5.2 percent and 6.2 percent for the current and next financial years -- which end in June -- respectively.

In the upcoming 2009/10 budget year, the budget deficit is expected to widen significantly, although probably not as much as predicted in the February budget speech, Moody's said.

The size of the revenue shortfall depended on how long cutbacks in diamond production lasted and how many jobs were lost in mining and other sectors, it said.

A boost for the economy from looser monetary policy and a stepping up in currency depreciation may alleviate some fiscal pressure.

Moody's predicted a budget deficit of 5.3 percent of GDP in 2008/09, widening to 8.4 percent in 2009/10.

Debswana, a 50/50 joint venture between the government and De Beers, in February decided to shut diamond operations until April 14 and has suspended production at two mines for the rest of the year. This was seen knocking growth and leading to job cuts. (Reporting by Gordon Bell; editing by Stephen Nisbet)

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