Borrowing costs to increase
South Africa's R3.2-trillion infrastructure stimulus could come at a hefty price after Moody's credit rating agency downgraded the big five banks.
South Africa’s R3.2-trillion infrastructure stimulus could come at a hefty price after Moody’s credit rating agency downgraded the big five local banks this week by one notch, raising their cost of foreign borrowings.
For Standard Bank, Absa, FirstRand, Nedbank and Investec the downgrade of their senior debt and deposit ratings effectively means that, as borrowers in the international markets, the cost of doing business for securitisations—the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit—will rise. The cost of foreign borrowings in international loan and bond markets will increase.
The downgrades came exactly a week after Finance Minister Pravin Gordhan presented a fiscally conservative budget as South Africa embarks on a huge infrastructure drive. This raised a red flag with Moody’s, which, working on a probability of the future, warned about the “the country’s increasingly constrained public finances” and its ability to rescue banks in future.
Although the banks do not anticipate any major fallout from the downgrade on their credit portfolio, the cost of funding for foreign currency-denominated lending, such as United States dollar-denominated term financing in African infrastructure and local mining-related projects, will increase.
“For banks, corporates and individuals wanting to borrow foreign currency, either for acquisitions, imported products or infrastructural finance, accessing that capital will become a lot more expensive,” said Andries du Toit, group treasurer of FirstRand.
It could also push up the cost of complying with Basel III capital and liquidity (the availability of cash to meet immediate obligations) requirements, because banks have to raise long-term funding more on the global markets since South Africa does not have a big enough savings pool to tap. “To the extent that the proposed Basel III liquidity rules will force the South African banks to access financing in the offshore markets, the cost of complying with Basel III rules could increase further,” said Standard Bank.
The banks were not surprised by the news because Moody’s had placed them on a credit watch in November last year. The ratings agency was careful to point out that South Africa’s banks were financially strong, but said the downgrade was a reflection of South African authorities’ reduced capacity to provide support to all the banks if they were simultaneously in financial distress.
The downgrades, said Moody’s, was part of its global assessment of the systemic support levels incorporated in banks’ deposit and debt ratings that addressed the growing difficulties governments face in extending systemic support to their banking systems.
The warning came in a week when the rand hit a five-month high of just below R7.50 to the dollar on better-than-expected gross domestic product (GDP) growth of 3.2% for the fourth quarter of last year and as the European Central Bank released a second round of unlimited three-year funds to about 800 banks, increasing liquidity in the market. This boosted appetite for higher-yielding risky assets because cash will need to find a home, propping up the rand.
But there was also a threat of a sovereign rating downgrade. “This reduced capacity — is also signalled by the negative outlook on South Africa’s A3 rating in November 2011, which reflects the potential of increased pressure on the government’s finances,” said Moody’s.
This could affect the ability of state-owned enterprises to access capital cheaply and to fund the 43 mega infrastructure projects mentioned in the budget off their own balance sheets. “If a state-owned enterprise had to issue a bond on the London Stock Exchange, for example, it would make funding for infrastructure more expensive,” said Du Toit.
Is Moody’s justified?
The budget showed some reduction in the projected fiscal slippage that occurred during 2011, but clearly the rating agency felt that not enough had been done. “A better budget outcome would clearly have been fiscal consolidation—fiscal deficit reaches 3% of GDP in 2013-2014 as per the 2010 projections, instead of 2014-2015. This would likely have given the agency greater comfort,” said Investec economist Annabel Bishop.
It is debatable whether the downgrade was justified, considering South African banks are sound, well capitalised, profitable and providing investors with acceptable returns. But there are major concerns that local banks are not sufficiently liquid at present to meet Basel III liquidity requirements.
The banks have reiterated many times that although they were well capitalised, they faced liquidity problems and would be unable to meet the standards set by the global rules. The liquidity coverage ratio requires a bank to hold sufficient high-quality liquid assets to cover its total net cash outflows over 30 days and the net stable funding ratio requires the available amount of stable funding to exceed the required amount of stable funding over a one-year period of extended stress.
David Hodnett, Absa financial director, said the bank had been prudent in its liquidity risk management, increasing its long-term funding ratio by 120 basis points to 26.8% during 2011, as well as improving its loans-to-deposits ratio to 88.1%. At December 31 Absa held surplus liquid assets of R27-billion, which were over and above regulatory requirements. “This announcement will not detract from Absa’s intent to focus on liquidity risk and improving its strong liquidity and capital position ahead of the implementation of Basel III.”
But Irwin Lim Ah Tock, a banking specialist at Pricewaterhouse-Coopers, said South African banks would fail to meet either ratio due to structural issues. The South African government, running a low public-debt-to-GDP ratio (about 38.5%), was limiting government bonds’ availability to meet the liquidity coverage ratio, he said. Equally, the shortage of retail savings limited stable funding to meet the net stable funding ratio.
The treasury is considering various policy measures, yet to be announced, to address these structural issues and new regulations are expected to be placed before Parliament this year.
The five South African banks mentioned weathered the global financial crisis well, have no exposures to the sovereign debt crisis of certain troubled European countries and remain largely focused on the rand-based South African economy.
South African banks are sitting on about R3-trillion in assets. At the end of June last year Standard Bank had total assets of R837.8-billion, Absa R742.4-billion, FirstRand R616.7-billion, Nedbank R580.1-billion and Investec R251.7-billion.
On the back of cost-cutting by the major banks, revenues are starting to increase. On the same day as the downgrade, Nedbank chief executive Mike Brown announced that the bank’s headline profit was up 31% in the year to December 2011, boosted by growth in non-interest income of R15.4-billion—an increase of 16.6%—and net interest income, which was 8.6% higher at R18-billion. Similarly, on Tuesday FirstRand reported that normalised earnings grew 26% to R5.8-billion in the six months to December.
The revenues can be partly explained in the private sector credit extension figures, which show corporates are borrowing again (see graph).
“The likelihood of systemic support required by these banks in the immediate future is considered to be low,” said Hlengani Mathebula, head of strategy and communications at the Reserve Bank.
“In line with the Basel regulations, debt instruments forming part of banks’ capital adequacy requirements will be regarded by the registrar of banks as capital. However, as in the past, the Reserve Bank remains committed to the financial support of the systemically important South African banks.”