Downgrade? What ratings downgrade?
It’s easy to forget that South Africa’s credit rating was downgraded two months ago. The bond market remains in good health and government’s cost of borrowing remains low compared with emerging market peers.
A credit rating gauges a country’s credit worthiness and, theoretically, should have a big impact on the country’s borrowing costs (as reflected by the bond rate). And so it was a particularly ill-omened Friday the 13th when South Africa’s rating was downgraded in June for the first time since 1994 by Standard & Poor’s to BBB- with a stable outlook. Hours earlier, Fitch ratings announced it had revised the outlook for the country from stable to negative but did not change the rating.
But the market appears in good health and South Africa’s 10-year government bond — a benchmark because it covers a sufficient length of time for a relatively accurate measurement — shows that South Africa is borrowing money at an interest rate of about 8.1%, according to tradingeconomics.com, compared with 8.8% in January this year and far better than the heights of 11% in 2008 or 13% in 2002.
In fact, South Africa’s rate of borrowing has dropped continually over the past decade, in line with rates globally, although it spiked in the middle of 2013 when the United States announced it would start tapering off its monetary stimulus.
South Africa’s emerging market peers (barring China, whose 10-year bond rate is 4.3%) are riskier in the eyes of the market. At the time of writing, Turkey’s rate was more than 9%, Brazil’s was 12%, India’s 8.9% and Russia’s 9.5%
Cost of borrowing
“Credit ratings don’t affect cost of borrowing in the sense that markets have already priced in well in advance changes in ratings and the underlying credit quality that becomes evident through data and events,” said Peter Attard Montalto, an emerging market economist at Nomura International.
“However, in the sense that rating downgrades confirm and reinforce the picture of falling credit quality so they are correlated strongly with borrowing costs.”
Jean-Pierre du Plessis, a fixed investment strategist at Prescient Investment Management, agreed. “There is an element of it [the rating downgrade] having been baked into the price for a while.”
Mamokete Lijane, a fixed income analyst at Sasfin Securities, said the cost of borrowing is never determined by just one factor but rather a combination things, of which credit ratings are an important component.
“People become confused sometimes; they are looking for a direct linear relationship between yields and some indicator and it doesn’t quite work like that — a number of things will have an impact.”
Borrowing rates can look relatively well-supported despite negative domestic news flow, she said. The global rates environment is a critical factor. “The fact that US treasuries are as low as they are [the 10-year bond rate is 2.5%] means rates will be low globally.”
Even so, Attard Montalto said that compared with its peers South Africa’s borrowing costs are not that high, broadly speaking, for two reasons. “First South Africa is very much a better-the-devil-you-know story compared with these other countries. Markets know the risks and understand the problems in South Africa so, even if it’s a weak credit story, the chances of surprise are low compared with, say, Brazil or Turkey.
“Second, markets still believe in South Africa’s conservative macro policy framework, which helps, as well as its strong institutions, even given the rest of the problems in the country. Add into that a steep yield curve and there is attraction there to keep the level of rates relatively low.”
But there is also inflation, Lijane said, and, when comparing South Africa with its emerging market peers, the market assesses their credit ratings, inflation and inflation expectations. Lower inflation and lower inflation expectations will mean lower rates for an economy.
“Because we have inflation targeting, the mandate of the Reserve Bank, long-term inflation expectations for South Africa are well anchored, and this is a strong anchor for domestic rates.”
Du Plessis said that there has some selling in South Africa’s bond markets since the credit downgrade, and some foreigners have moved their money out. “But it hasn’t been reflected in pricing,” he said.
One reason for this, he said, could be nervousness that shares might be overpriced and are due for a downward correction soon. This, he said, has driven people into government bonds. The treasury has also been issuing long-dated bonds, of 25 years or more, which indicates a strong demand in the local bond market.
The biggest risk rests with the currency, Lijane said. “South Africa is currently running a current account deficit and constantly needs funding from offshore to meet this funding requirement. The abundance of liquidity globally has been supportive of this funding,” she said, but a shortfall here could lead to further depreciation in the rand.
But what will deter investors is often unpredictable, Lijane said. Any announcement by the US Federal Reserve about tighter monetary policy in the US could lead to lower risk appetite and trigger outflows from emerging markets. But a recovery in Europe would be good news for the local currency and bonds.
“One realises very quickly that relationships are nonlinear. Something can be unimportant until it crosses some threshold or psychological barrier and it reaches a level where it’s all-important.”