/ 2 June 2016

Junk status or not, SA faces tough economic times and decisions

Going up: The Reserve Bank reports that the current account deficit for the fourth quarter of 2012 was higher than expected.
Going up: The Reserve Bank reports that the current account deficit for the fourth quarter of 2012 was higher than expected.

Even if South Africa escapes a downgrade to junk status by ratings agency Standard & Poor’s (S&P) on Friday, the country has far to go before it will be back on a sound financial footing, according to economists. 

But a closer look at South Africa’s ratings framework suggests there may be a little breathing room before the country sees a traumatic exodus of foreign investment.  The top agencies typically provide two ratings — a foreign currency rating and a local currency rating. 

The first applies to the debt a country issues in a foreign currency. In other words, it is the agency’s view of the ability of an issuing country to meet its loans obligations in a foreign currency. 

The local currency rating applies to debt issued in a country’s own currency.

In January this year, foreign debt was slightly less than 11% of South Africa’s total government debt, below the World Bank benchmark level of 15%, according to South Africa’s 2016 budget review.

This is better than many of the country’s emerging market peers, particularly African ones, who took on large amounts of dollar-denominated debt in recent years — before a crash in commodity prices and weakening local currencies left them struggling to repay their debts. 

According to S&P’s definitions, the ratings can differ when a country has a “different capacity to meet its obligations denominated in its local currency [versus] obligations denominated in a foreign currency”.

In the case of Friday’s decision, it is S&P’s foreign currency credit rating that is being closely watched. A downgrade would take us from investment grade to sub-investment grade (junk status).

S&P’s rating of South Africa’s local currency debt is two notches above junk status.  This is arguably a small silver lining amid the gloom, because it is the local currency ratings of Moody’s and S&P that keeps South Africa included in key bond indices such as the Citigroup world government bond index (WGBI). 

S&P is likely to hold off on a possible downgrading of South Africa until December, although it will be a “hawkish hold”, according to Nazmeera Moola, the co-head of fixed income at Investec Asset Management. 

Key issues flagged by the ratings agency — such as budget consolidation, with government expenditure and revenues on target as forecast in the budget — have been achieved so far this year. 

Merely sustaining this will not be enough come December, Moola said. By then, the state must have implemented more structural reforms and shown a material change in the country’s economic growth prospects to avoid a downgrade.

The risk of forced outflows is mitigated by South Africa’s inclusion in the WGBI, which is dependent on its local currency debt rating. S&P has South Africa ranked at BBB+, two notches above sub-investment grade. 

In the case of Moody’s, it is at Baa2, or one notch above sub-investment grade. For the country to be excluded from the WGBI, both agencies would need to rate local currency debt as sub-investment.

Moola said that about 70% of South Africa’s rand-denominated debt is owned locally; the rest is owned by foreigners. 

In 2007, about 7% was owned offshore and foreign ownership peaked at about 40% two years ago.  The foreign currency rating matters far more in terms of sentiment, Moola said, and a downgrade in it is likely to trigger a downgrade of the local currency rating. 

“It is comparable to your brand being damaged,” she said, adding that it may spark some sell-off of South African assets. 

When compared to other emerging markets, South Africa is not the worst of a bad bunch, she said. Although many of its peers face comparable or worse credit ratings, some of them have started implementing reforms to address constraints. 

“It is about direction of travel as well,” she said, adding that, for investors to become comfortable with South Africa, its negative trajectory needs to change.

Kevin Lings, Stanlib’s chief economist, said it is unlikely, between now and December, that South Africa’s domestic credit rating will be downgraded to junk and precipitate an automatic exclusion from the WGBI. 

But S&P has flagged the mismatch between the country’s domestic and international ratings, and it is possible it may downgrade the domestic rating instead of the international rating.  He warned that international investors are unlikely to wait for an event such as the country’s exclusion from a key bond index to leave. They assess the risks facing South Africa in line with other emerging markets.

There is no sign of a major withdrawal of funds from South Africa, but “we are aware that people have generally been lightening their positions in emerging markets and South Africa has been part of that story”, Lings said. 

With very low or negative interest rates in the developed world, “South Africa is still relatively attractive on a yield basis, especially if you consider that the rand is significantly undervalued”, he said. 

But the economic prospects of emerging markets have deteriorated, making foreign investors nervous. 

Goolam Ballim, the chief economist of Standard Bank, said South Africa’s local currency rating offers only “mild succour”. The foreign currency rating has an overarching effect on the propensity for investment, which drives economic growth. 

Given South Africa’s current account deficit, it needs to attract foreign investment to fund this growth. 

If it is unable to, it will have a material effect on the real economy. Everything from corporate earnings to share prices and individual spending will be affected, employment will decline and household incomes will “further stutter”. 

If South Africa was downgraded to junk status, it might still be viewed as preferable to Brazil, for instance, but the pool of funds available for sub-investment grade assets is substantially smaller, he said. “Invariably your inflows are smaller anyway and you are bottom feeding.” 

South Africa’s poor economic growth has been an enduring concern for ratings agencies, although it has been acknowledged that global economic factors are a significant cause of poor growth. 

Suggesting that “we should accept that our hands are tide” is the wrong policy response, Ballim said. In the face of stagnant growth, nations are competing to grow their share of global supply and to gain a greater share of global trade. 

It is crucial that South Africa develop an even sharper policy response “to get more of a shrinking cake”.

Ballim estimated that about 40% of South Africa’s lost potential is a result of three local factors: a poor electricity supply, a precarious labour market and an “unbecoming political economy”.