What happens if South Africa gets downgraded... again

MARKETS

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LOCAL NEWS

The South African Reserve Bank will announce its rates decision next week Thursday, but don’t expect a drop in interest rates. The Bank’s constitutional mandate is to “maintain price stability” (aka keep inflation down) and Governor, Lesetja Kganyago, recently said that the rand and its impact on prices and wages “remains the single biggest risk to inflation”. An interest rate cut usually causes the rand to weaken, so the Bank won't do this when are facing a ratings downgrade. Twenty-six out of 28 economists surveyed by Reuters said they expected the Reserve Bank to hold the repo rate steady at 6.75% (Prime 10.25%). (SARB, BIS, Reuters)

The acceleration in global activity that started in 2016 has picked up steam in 2017 according to the Bureau for Economic Research [“BER”], . Historically, growth in South Africa has matched global growth on nearly a 1 for 1 basis, but recently that relationship has broken down due to political and policy uncertainty in SA. The BER expects the South African economy to grow well below 2% for the foreseeable future. Key forecasts for next year include: average rand dollar exchange rate 14.16, inflation 5.1%, prime lending rate 10.25% and economic growth 0.9%. (BER)

Source: Bureau for Economic Research

Source: Bureau for Economic Research

Eskom is desperately short of cash and may run out money by January 2018. The utility’s cash reserves are expected to be R1.2bn at the end of November compared to a budget of R20bn. However, a spokesman said the utility did not plan to layoff any workers. (Business Day, Fin24, EWN).

INTERNATIONAL NEWS

Robert Mugabe’s 37 year rule of ZImbabwe appears to be at an end. On Wednesday soldiers took control of the headquarters of the state broadcaster ZBC and blocked access to government offices. The army is a key ally of former vice president, Emmerson Mnangagwa, who was fired by Mr Mugabe on 8 November in an apparent bit to establish first lady, Grace Mugabe, as his successor. The army has said that it is not carrying out a coup. Zimbabwe has an unemployment rate of 95% and the economy has halved in size since 2000. (BBC, Al Jazeera, Washington Post, Forbes, IOL)

Salvator Mundi (Saviour of the World) A 500-year old painting by Leonardo da Vinci just sold for over R6.4 BILLION on auction at Christie’s in London. Spare a thought for the relatives of British collector, Sir Frederick Cook, who sold the painting for the equivalent of less than R2,000 in 1958. (BBC, CNN)

COMMENTARY

WHAT’S GOING TO HAPPEN IF WE GET DOWNGRADED… AGAIN

A super quick recap… credit ratings 101

A credit rating is a formal opinion on how likely an individual, company or country is to repay its debt. There are 3 key agencies that provide ratings on South Africa’s government debt - Moody’s, S&P and Fitch. There are lots of different credit ratings, but the main distinction is between those that are “investment grade” and “non-investment grade”. When 2 out of 3 agencies downgrade debt to non-investment grade it is generally considered junk. South Africa’s foreign currency debt was downgraded to junk by S&P and Fitch earlier this year, but around 90% of SA’s debt is issued in rands and this “local currency debt” is still rated investment grade.

Ok… I get it, but what is happening now?

Moody’s and S&P are expected to update their credit ratings next week Friday. If Moody’s downgrades SA by 2 notches or S&P downgrades it by one notch, then SA’s local currency debt will be considered junk because it is already non-investment grade at Fitch. The dismal economic picture that was highlighted in Finance Minister Gigaba’s recent Medium Term Budget Policy Statement has increased the chances that S&P will downgrade us.

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So, what happens if we get downgraded

A lot depends on something called the Citigroup World Government Bond Index [“WGBI”]. The index was created in 1987 and measures the performance of local currency, investment grade, government bonds (i.e. SA’s rand denominated bonds). It is important because a very large group of investment funds, called index tracking funds, do away with the skill of managing a fund and simply replicate the index.

The WGBI’s rules say that South Africa will need to be downgraded by S&P and Moody’s to drop out of the index. But, if that happens index tracking funds will have to sell their South African bonds. Over 40% of South African debt is owned by foreigners and the Treasury estimates that between R100 and R180 billion rand will leave the country if we get down graded. The effects of that would be higher borrowing costs for the government and a weaker rand.

R180 BILLION sounds like a lot… will things really be that bad?

Probably not. Moody’s has historically been more lenient on SA than S&P and Fitch, so it will be bad luck if they downgrade us to non-investment grade, especially before the outcome of the ANC elective conference is known. The lower current account deficit (how much money we need to fund imports) also means that we are more resistant to cash outflows.

Most importantly though, there seems to be quite a high demand for South African bonds. The government actually raised R3.3bn of debt earlier this week. What’s interesting is that there was demand for around R10bn worth of bonds. It’s important to remember that ratings agencies issue opinions, not judgements and that SA does not exist in a vacuum. For example, Argentinean government bonds are considered more risky by the ratings agencies and yet offer investors lower returns. This is surprising as Argentina has defaulted on its debts 8 times since independence in 1816. The bottom line is that investors are aware of the political shenanigans, poor economic growth and the risk of more downgrades… and they still think that our government bonds are good value for money.

Argentine President Mauricio Macri (Source: FT)

Argentine President Mauricio Macri (Source: FT)

Party time?

Sorry, but no. The biggest impact of a further downgrade will be on business confidence and we already know that low confidence is costing SA over 1% of economic growth per year. Further downgrades will also weaken the rand, at least in the short term. A weak rand makes it highly unlikely that the Reserve Bank will lower interest rates because that tends to weaken the rand further. All this means that there will be continued resistance to private sector investment and ongoing pressure on consumers, which is bad for the economy.

Where to from here…

In a recent speech in New York, Reserve Bank Governor Lesetja Kganyago, said that “raising confidence is the cheapest form of stimulus”. Lets hope someone in government was listening.

(Bloomberg, Citigroup, FT, BIS)


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