Junk-grade movie to unfold in slow motion with more drama in the mix
Downgrade has direct effect on how much it costs government and other public and private entities to borrow
Finally, SA fell off the investment-grade cliff into junk territory. Yet by Friday, when Fitch became the last of the three ratings agencies to pronounce, junking the ratings on the country’s rand-denominated debt and its hard-currency debt, the rand and bond yields hardly responded.
In part, that was because they had already tanked over the previous two weeks in response to the cabinet reshuffle to which the ratings agencies were responding, with the rand now about 10% lower than it was before the shock road-show recall on the Monday before the reshuffle. It was also partly because the world is so enamoured with emerging markets even a downgrade did not dent SA as much as it might have. And to a greater or lesser extent, the downgrade has been priced into financial markets for at least the past year.
But the real reason is that this ratings movie will play out in slow motion, not all at once. That applies as much, if not more, to the real economy as it does to financial markets, which have yet to digest the effect of the downgrades so far fully. Chances are there is much more drama to come.
S&P Global Ratings has given SA’s foreign-currency rating — for debt in dollars, euros or yen — a one-and-a-half notch downgrade, cutting the rating to subinvestment grade, junk status, and putting it again on negative outlook for a possible further downgrade. S&P still has the local-currency rating, for rand debt, at one notch above the foreign-currency rating, so the local rating is still investment grade, though only just. Fitch cut the foreign and local rating to junk, but on stable outlook. Moody’s has put the rating on watch for a downgrade within the next three months. Moody’s still has SA at two notches above junk status, but is surely looking at whether it should go down two notches rather than one.
S&P could junk the local rating as well when it next reports in June, and Moody’s too could take the local and foreign rating down to subinvestment grade, if not now then later in 2017. The permutations and combinations are important. Junk on two agencies’ scales matters a lot more than junk on one, and it matters too which agencies. A downgrade will raise the cost of new borrowing here and abroad, add to the pressure on the public purse and make it more expensive for banks and state-owned entities to borrow, making debt more costly for all citizens.
It will put downward pressure on the rand as capital flows out, so putting upward pressure on inflation and prompting the Reserve Bank to look at further interest rate hikes, weakening economic growth further, which in turn would damp tax revenues and put even more pressure on the public purse. That could trigger further downgrades, making for a vicious spiral, the worst-case scenario.
But that movie may play out only over time. There is the direct effect of the downgrades on how much it costs the government and other public and private entities to borrow, here and abroad. There is also the indirect effect on capital flows, the rand, inflation, interest rates and ultimately growth.
The technicalities matter a great deal to how immediate the effect and how profound. The foreign-currency downgrade is big for investor confidence and for how markets see SA’s risk, but it directly affects only foreign debt, which in SA’s case, unlike many other emerging markets, is a small proportion of total government debt, accounting for about 11% at end-March. The cost of borrowing will go up for new debt that the government and companies will issue on foreign markets. The universe of investors who might buy that debt will shrink because some have mandates that prevent them buying noninvestment grade debt.
But it is in the local-currency debt that the real downgrade risk lies, not only because it is on SA’s well-developed domestic market that the government — with state-owned companies, banks and private companies — does most of its borrowing, but also crucially because foreign investors have in the past decade bought in hugely into SA’s rand-denominated, local-currency debt. Foreigners hold 35% of the government’s rand debt. A large but as yet unknown chunk of that stands to be sold off if S&P or Moody’s follow Fitch in junking the local-currency rating.
Some of those foreigners are active fund managers, who make their own decisions about what to invest in, depending on their mandates from the pension funds and individuals on whose behalf they invest. Others are so-called passive funds that simply track various indices and have no discretion about what and when they sell if SA falls out of investment grade.
But each index has a different definition of investment grade. Fitch does not count for Citi’s World Government Bond index (WGBI), in which SA was included in 2012, but SA’s rand-denominated bonds need investment-grade ratings from Moody’s and Fitch to stay in it. A $6bn sell-off by the WGBI trackers would follow if SA were junked by one or the other. Another JP Morgan index requires an investment-grade rating from all three agencies, so SA is already out of that one, with a sell-off of about $900m expected by the end of May. In total, estimates are that local-currency downgrades will trigger foreign-bond sell-offs of at least $8bn-$10bn or even as much as $13bn. The resulting capital flight cannot be good for the rand, especially since inflows from the tracker funds have reportedly continued in the past number of weeks, so even more money stands to go out later.
How the active foreign-fund managers will react is not yet clear. Though some have mandates that tie them to agency ratings, they have increasingly tended to do their own risk assessment in recent years, with ratings just one input.
Finance Minister Malusi Gigaba plans a road show soon. Investors and ratings agencies who had got used to a minister and Treasury team who know the language and how the game is played will be meeting a new minister with a questionable history regarding stewardship of state-owned enterprises and possibly a new external director-general, all appointed through a questionable process.
How that will play out remains to be seen, but the content of what they do is more pertinent to what happens to SA’s ratings and to the foreign funding on which it depends.
Gigaba has been on a steep learning curve and he is no doubt beginning to realise just how tough it will be to stick to promises of fiscal consolidation and policy continuity while delivering radical transformation and nuclear energy. If he is to have any chance of arresting a speedy downgrade spiral and preventing the severe economic fallout in terms of investment, growth and jobs, the new minister would have to commit to do what the old one did. Whether Gigaba is willing or able to do that is the question — precisely the one the ratings agencies have asked.