The Rating Game
Ouch! Moody’s Investor Service, a ratings agency, announced yesterday that weak economic growth and lower tax revenues could lead to a downgrade of South Africa’s credit rating. That’s bad news because so far Moody’s has been more optimistic about South Africa than its competitors Standard and Poors [“S&P] and Fitch.
Rating Agency Primer
A credit ratings agency supplies a score that investors use to determine how likely they are to get their money back. The worse the score, the higher the interest investors demand. For the purposes of governments and corporate bonds the only agencies that really count are Moody’s, S&P and Fitch (of these Moody’s and S&P are generally more highly regarded). The critical difference in scoring comes between “Investment Grade” and “Non- Investment Grade” ratings. Many large investors such as pension funds are only allowed to own investment grade debt. If an entity loses an investment grade rating at 2 or more agencies, large numbers of investors may be forced to sell, which decreases the bond price and increases the interest rate the entity has to pay to borrow money.
Why do we have this problem?
Changing finance ministers, the rand touching 18 to the dollar, policy uncertainty and wasteful government expenditure means that for the past few months SA has been on a largely self-inflicted slide towards a downgrade. Unfortunately we now have to add uncontrollable factors like the driest year on record to the list of challenges. The severe drought has hurt growth and higher food prices will increase inflation. SA’s Reserve Bank is mandated to maintain price stability, so higher inflation will create pressure to raise interest rates (which it did so by 0.5% last week). Higher rates will further reduce growth (the Reserve Bank’s rule of thumb is that each 0.25% increase in interest rates slows GDP growth by around 0.1%). According to Moody’s, “current levels of tax and other government receipts fall short of the government's spending needs by 3 percent to 4 percent of GDP annually”. The weak growth outlook will make it difficult to raise taxes to plug this gap and address the effects of the drought. MY concern is that new Finance Minister Pravin Gordhan can say what he likes about prudent fiscal spending in his budget speech on 24th February, but without signs of improving growth, we may have a downgrade problem.
What will a downgrade mean?
Articles about the implications of SA being downgraded to “junk” have been circulating since 2014. Ratings agencies can sometimes take months to act and financial markets certainly don’t bother waiting for them. Indeed, the chart opposite shows that in September 2015 (before the finance minister shenanigans) trading in credit default swaps (a measure of risk) already had SA flagged as “junk”
Financial markets move in anticipation of a downgrade, which means that the news itself may not be as dramatic as expected. Brazil was downgraded to junk by S&P in September 2015. As a result the currency fell 1.8% against the dollar, the stock exchange ended the day 0.3% down and bond risk measured by credit default swaps rose 0.12% points ... hardly cataclysmic. Importantly this was off the back of a downgrade by a single agency. If Moody’s had downgraded as well the effect would have been more severe. Make no mistake though; a downgrade of SA’s debt would be a huge negative for the country and the economy.
Where to from here?
SA has been on the verge of a downgrade before. In 1994 government debt was 50% of GDP and interest repayments 5% of GDP. The economy was contracting and the country was heading for an IMF bailout. Finance Minister Trevor Manuel was able to steer the country through the crisis with a series of tough budgets. These lessons seem to have been lost on the current administration that has spent billions of rands backing ineffective leadership teams at state owned enterprises such as South African Airways.
Since December, the government, President Zuma and business have been on a massive charm offensive to try and protect SA’s investment grade rating. In one sense this is reassuring because SA’s leadership now clearly understands the importance of listening to the ratings agencies. At another level it is frustrating because it seems that they are focused on driving/ influencing / fooling the ratings agencies instead of really fixing the economy.
China, commodity prices and the US Fed aren’t helping SA, but if we take aggressive steps to correct the county’s internal impediments to growth then financial markets will reward the country and the credit rating will take care of itself. The Economist newspaper believes that liberalizing electricity generation alone could add 1% to GDP and that a similar contribution could come from private investment in ports and railway lines. Lets hope that Mr Gordhan can repeat the feats of his predecessor and that South Africa’s developmental state priorities do not detach the country from economic reality.
(Sources: Business Day, Reuters, Moody’s, Bloomberg, Prudential, Biznews, The Economist)
ANDREW LOUW CFA