IT’S NOT ROCK BOTTOM
SA still has a little way to go before we hit ‘real’ junk status
Most of the terrifying predictions about what “junk” status will do to the economy are based on “real” junk status, which South Africa is not yet consigned to. Despite that, the effect of the Cabinet reshuffle on South African government debt is already being felt.
Most of the damage was done by the reshuffle before either Fitch or S&P Global’s downgrades this week, with junk status already “priced into” the rand and the yields on government bonds.
S&P did not blame the downgrade only on the Cabinet reshuffle, but also cited the state’s contingent liabilities, particularly its guarantees to Eskom – a theme picked up by Fitch.
Government 10-year bond yields weakened from 8.3% to 8.84% before either downgrade.
Treasury’s handful of bond auctions since the reshuffle already reflect investors demanding higher interest rates, which could quickly translate into billions in additional debt service costs.
The question now becomes whether South Africa will see more downgrades – and how much of that has already been “priced in”.
It is widely accepted that credit ratings seldom tell investors things they don’t already know, said commentators this week.
The muted market reaction to Fitch’s downgrade announcement on Friday underscores this.
South Africa’s government bonds were already trading at yields comparable to those of governments that do have junk status, and they have been for more than a year already.
John Ashbourne, an economist with Capital Economics in London, predicts that a downgrade by itself will not lead to a huge increase in debt costs.
Even in the case of Brazil, which he said South Africa was “unfairly” compared with, markets adjusted before the country got junk status last year.
Adrian Saville, chief strategist at Citadel Wealth Management, said South Africa’s government debt had objectively been at sub-investment grade for a year or more.
“If you put all the nonsubjective data into a model – things such as government’s debt levels, the current account deficit and the growth rate – it would suggest we are sub-investment grade,” he said.
“If you look at the 10-year spreads, I’ll be as bold as to say it is already in the price,” he said of the yields on South African bonds. “We are priced where we should be, so if there is a market reaction [to a downgrade], it would be moving away from [an objective price].”
JUNK AND ‘REAL’ JUNK
The S&P downgrade left South Africa’s important randdenominated debt one level above junk, formally known as speculative or “noninvestment grade”.
The debt that got junk status is the 11% of national debt denominated in foreign currencies. Fitch, however, rated all government debt as junk. The other major ratings agency, Moody’s, is expected to downgrade South Africa soon, but it may still keep the country one level above junk.
Chris Gilmour, investment manager at Barclays, said: “Generally, you are considered real junk if two of the three agencies rate you as speculative.”
If South Africa’s local currency debt becomes real junk, one consequence could be exclusion from international bond indices such as the Citi World Government Bond Index.
Being in it creates automatic demand for South African bonds. Falling out would instantly lead to sell-offs. This would, however, require both Moody’s and S&P rating local currency debt junk, which neither have yet done.
SO WHAT IS THE DAMAGE?
If further downgrades to local currency debt are prevented, the damage could still be limited to what has already been seen this week.
The real economic effect of downgrades depends on a chain reaction that starts in the capital markets, specifically government bonds.
Less demand for rand-denominated assets such as bonds means a weaker rand, which means higher inflation because South Africa imports most of its oil and many other things.
When inflation rises, the SA Reserve Bank has to raise the repo rate to try to contain inflation under the target of 6%. A higher repo rate then leads to higher interest on consumer credit.
The ultimate hypothetical effect of a downgrade is then a combination of higher interest on government debt, which hurts the budget; higher inflation, which hurts consumers; and, ultimately, higher interest rates for everyone with debt.
Absa this week circulated a hypothetical scenario where a downgrade makes consumer credit costs rise by three percentage points, turning the 10.5% interest on a hypothetical mortgage into 13.5% interest – a potentially terrifying blow to middle class incomes.
“The SA Reserve Bank may not do it [raise the repo rate] if the rand remains stable to the extent that it has, but I think another 5% move to about R15 per dollar will force it to raise rates,” said Saville.
Gilmour said: “The 3% [increase in interest] only really comes into play with further downgrades, especially at a local currency level. The current nervous political situation gives ample scope for such an eventuality.
“It is imperative that South Africa maintains its local currency investment-grade rating.”
Gilmour said that just the S&P downgrade could necessitate a rate increase: “It would not surprise me to see an increase of at least 25 basis points, and more likely 50 with an outside chance of 100.”
A basis point is equal to one hundredth of a percent, meaning a 50-point increase raises the repo rate from 7% to 7.5%.
Another 5% move to about R15 per dollar will force the SA Reserve Bank to raise rates