Not out of the woods
DOWNGRADE
outh Africans breathed a sigh of relief on Friday night when the country escaped being downgraded to junk status by S&P Global Ratings. However, SA has been put on notice and remains perilously close to losing its investment grade status.
S&P affirmed SA’s foreign currency rating at “BBB-” on the bottom rung of the investment grade ladder, as well as its “BBB+” local currency rating. SA’s ratings outlook remains “negative”.
The rand rallied to R14,88/US$ on Tuesday, a gain of about 4.5% from before the S&P announcement, its strongest level in weeks.
SHowever, in six months’ time, on December 2, SA will face another ratings review from S&P and Fitch, and again another six months after that. Each time they will be asking the same question: has SA done enough by way of growthenhancing structural reforms to turn its economy around?
For now, the united front presented by business led by Jabu Mabuza, the president of Business Unity SA, and government, as represented by finance minister Pravin Gordhan — the “Team SA” approach — has held the sceptics at bay.
However, it cannot forever mask the fact that, outside of national treasury, the rest of government mostly lacks the political will to undertake these reforms.
Because of this, there is a real danger that national treasury — in its presentations to Moody’s, Fitch and S&P on the steps being taken to resuscitate growth with business — may have overpromised.
If SA is unable to deliver — especially on the tough reforms to the labour market, state-owned enterprises (SOEs) and on the minerals regime — confidence and growth are likely to languish. A downgrade to junk would not be far behind.
From 1994, SA’s credit ratings improved continuously. It achieved an investment grade rating from Moody’s in 1994, S&P in 1996 and Fitch in 2000, but the tide started to turn in about 2010.
Over the past few years, the country has been marked down repeatedly by all three agencies mainly because its economic performance has deteriorated, worsening its public finances and increasing social and political tensions. During this time government has failed to engage convincingly in structural reform.
If SA loses its investment grade rating it’s likely to trigger capital outflows, rand weakness, higher inflation and interest rates and rising bond yields. This would raise the cost of investment for the public and private sectors alike. Consumers, too, would have less money to spend. This means growth would be lower — how much lower would depend on the extent of negative market reaction.
According to studies on the economic fallout that occurred in six of SA’s peer countries that have been downgraded to junk status in the past decade, SA can expect to experience a recession that will last almost two years (see graphics on page 23).
“No single downgrade on its own is a catastrophe but every downgrade matters,” says Stellenbosch University professor Stan du Plessis. “Every downgrade will push bond yields higher, push up the interest bill and make it even harder to achieve the primary surplus. You can only get there if you can overcome the force of the interest
bill, and every time you get knocked by a rating agency that becomes a steeper hill to climb.”
There is little doubt SA’s journey back to stability would be long and arduous.
Despite what’s at stake, Nomura strategist Peter Attard Montalto has little conviction that SA can turn its promises of policy reform into action and avoid a junk rating in December.
“We still firmly believe that SA’s propensity to make policy mistakes, the lack of key reforms, and uncertainty in the economy mean we are on a near inevitable path towards sub-investment grade,” he says.
BNP Paribas Securities economist Jeff Schultz also believes SA will be downgraded to junk status by S&P, most likely on December 2. The main catalyst, he thinks, will be SA’s inability to adhere to its fiscal consolidation targets due to disappointing growth.
By his estimates, financial markets are pricing in a 65% chance that SA will ultimately lose its investment grade rating (see box on page 22). In its statement, S&P spells out four structural measures that are needed to place the SA economy on a firmer footing and allow it to keep its investment-grade rating.
The country needs a reliable energy supply; labour market reform to reduce damaging strikes and raise youth employment; clarity on the minerals regime; and a reduction in political infighting and interference in state institutions.
On the first point, S&P accepts that Eskom is making progress in improving the availability of electricity, including by sourcing power from independent producers, and that “this will likely reduce some of SA’s economic bottlenecks”.
However, energy experts say it is premature to cry victory. Yes, there has been progress but load-shedding has mainly been avoided because of a substantial reduction in base-load demand from industrial users due to the weak growth environment. The bottom line is that electricity will probably remain a constraint on growth until 2018.
The second area is labour reform. While treasury is optimistic the Nedlac talks will result in secret strike balloting being made mandatory, leading to fewer workplace disruptions, no legislative amendments of any substance are being negotiated. A code of good practice for behaviour during strikes may be the only real achievement but it would not be binding on the parties.
The third measure on which S&P seeks clarity involves the finalisation of the Mineral & Petroleum Resources Development Act (MPRDA) amendments as well as resolution on the Black Economic Empowerment (BEE) codes affecting mining.
S&P notes that the finalisation of labour and mining reforms could engender “a positive confidence shock” to the SA economy.
“Of all the meetings we had, the one with the deputy president [Cyril Ramaphosa] gave us some timelines that they’re working on,” said S&P associate director sovereign ratings, Gardner Rusike, in an interview with the Financial Mail. “They’re expecting to achieve some form of agreement regarding the labour amendments within three months.”
However, S&P fears that negotiations on labour and mining reform could be more protracted than expected and that, even if concluded, these agreements could be difficult to implement.
Attard Montalto’s view is that government “is taking two steps back as it takes two steps forward”.
For instance, he argues that the BEE requirements contained in the new mining charter will offset any positive effects from the finalisation of the MPRDA amendments, while the adoption of a national minimum wage would counteract the benefits of making secret strike balloting mandatory, should either be achieved.
“We think it will become increasingly obvious through the second half [of the year] that the close co-operation between government and business is not an accurate reflection of what is going on — it is a close co-operation between national treasury and business that is occurring,” Attard Montalto says. “Linked to this, we see a continued lack of policy leadership on economic policy from President Jacob Zuma and other departments pushing in other directions.”
Citibank economist Gina Schoeman makes a similar point in noting that while the greatest credit must go to the judiciary, Reserve Bank and national treasury for getting SA this far, now the rest of government has to step up to the plate.
S&P’s fourth requirement is that political tension, evident in disputes between key government institutions and within the ruling ANC, must be held in check.
“We believe that these political factors, if they continue to fester, could weigh more on investor confidence than inconclusive labour or mining sector reform,” it warns.
In short, fix the politics and you fix the economics. Nobody understands this better than treasury whose head, Gordhan, continues to fight for his political life.
Since the February budget, the Hawks
IF SA IS UNABLE TO DELIVER — ESPECIALLY ON THE TOUGH REFORMS TO THE LABOUR MARKET, STATE-OWNED ENTERPRISES AND ON THE MINERALS REGIME — CONFIDENCE AND GROWTH ARE LIKELY TO LANGUISH. A DOWNGRADE TO JUNK WOULD NOT BE FAR BEHIND
special investigating unit has been questioning Gordhan aggressively about the “rogue unit” that he established at the SA Revenue Service during his time as commissioner and which may have employed illegal surveillance while investigating tax fraud.
Only after Gordhan hit back last month, accusing the Hawks of ulterior motives and subverting the law, did they back off and deny any intention to arrest him, as had been widely speculated in the media. But this was not before Gordhan had revealed what was at stake. Describing the Hawks’ “harassment” as an attack on institutions meant to strengthen democracy, like national treasury, he warned: “Millions of people will pay the price (there will be less money to relieve poverty and support job creation programmes) if this subversion of democracy is left unrestrained and unchallenged.”
Political analyst Nic Borain doesn’t believe Gordhan is now in a stronger position politically, despite having prevented a downgrade. Though he does say that if SA’s ratings had been chopped, Gordhan probably would have been more vulnerable.
So, if Gordhan is no longer finance minister in December, how is that likely to affect S&P’s next ratings decision? “We’ve taken a lot of comfort in national treasury’s fiscal stance,” Rusike responds. “We view it as an institutional position. So even if the leadership changes, as long as the fiscal stance doesn’t change, that’s what matters.”
Another important consideration, he adds, would be what effect Gordhan’s removal would have on investment and confidence and whether it affected the reform momentum with business begun under his watch.
“If negative, it means it’ll be difficult to turn the economic growth story around, which is key to maintaining the rating.”
Treasury says the main benefit of S&P’s ratings affirmation is that it has bought SA more time to deliver on nascent reforms aimed at achieving faster growth and placing public finances on a sustainable path.
But it agrees that the next six months are “critical” and there is a need to intensify efforts to boost the economy.
So despite the welcome stay of execution, treasury officials weren’t partying it up on Friday night at the head office in Pretoria.
“I wouldn’t say people are popping champagne corks but at least it’s one piece of good news,” said Michael Sachs, head of national treasury’s budget office.
“There’s been a lot of hard work behind the scenes by the minister and governor but we’re not out of the woods,” added Reserve Bank deputy governor Kuben Naidoo. “Essentially the country has six months to improve its debt and credit metrics.”
On the fiscal side, S&P is impressed that government is showing greater resolve to reduce SA’s fiscal deficits at a faster pace than it had initially expected, as per the 2016 budget targets of 3.2% of GDP this year, 2.8% in 2017, and 2.4% in 2018.
It expects treasury to stick broadly to these targets based on a combination of tight expenditure restraint and SA’s resilient tax buoyancy. In SA, tax collection has often performed better than suggested by nominal GDP growth, it notes.
But S&P agrees with the prevailing consensus that real GDP growth is going to underperform again this year. It has lowered its 2016 GDP forecast from 1.6% six months ago to just 0.6%. It expects growth to rise to 1.5% in 2017 as cyclical factors like weather patterns and SA’s terms of trade improve.
But given SA’s structural shortcomings, it does not expect growth to climb above 2% before 2019. (This sub-par forecast assumes that future interest rate hikes by the US Federal Reserve will not roil emerging markets and that China will remain moderately supportive of world growth.)
In February, treasury forecast growth of 0.9% this year, rising to 1.7% in 2017 and
2.4% in 2018. Updated forecasts will be released by treasury in the October minibudget and are sure to be revised down — as they have been in each of the past five years.
Sachs told the International Monetary Fund (IMF) last year that he would “eat his hat” if SA’s debt-to-GDP ratio didn’t stabilise over the next three years.
Treasury’s plan is clear. By curtailing real main budget non-interest spending growth to about 2% over the medium term, it aims for the primary budget balance to narrow to 0% of GDP by 2017/2018, which should stabilise the debt ratio. (This assumes that borrowing costs remain low and that GDP growth recovers.)
S&P expects it to succeed, almost. It expects SA’s net general government debt to stabilise a little higher and a little later than treasury’s budget projections (at around 48,6% of GDP in 2018/2019 compared to treasury’s target of 46.2% in 2017/2018).
But what matters is that S&P believes SA will get net debt to stabilise under 50% of GDP over the medium term, despite its own weaker growth forecasts. This is an important vote of confidence in treasury’s fiscal management. Also positive is that S&P views SA’s contingent liabilities as limited. Nevertheless, it warns of risks from state-owned enterprises with weak balance sheets.
Net government debt and used government guarantees together account for close to 55% of GDP, according to S&P. It warns that downward rating pressure would mount if this surpassed 60% before 2019.
“Overall, S&P’s assessment of SA was less critical than we had expected, which is very encouraging,” says Stanlib chief economist Kevin Lings. “Instead, the tone was relatively well balanced, with S&P flagging both negative and positive factors.”
Attard Montalto worries, however, that by being “a little more optimistic” than expected, S&P may have teed SA up for some disappointment come December because, by then, the country’s lack of progress on structural reforms may well be apparent.
Moody’s fiscal assessment of SA, delivered on May 6, was even more generous than S&P’s. It concluded that SA’s government debt ratio is likely to stabilise in the current fiscal year (2016/2017).
Overall, Moody’s retained SA’s foreign currency rating at Baa2 — one notch above S&P and Fitch and two notches above junk status — though it kept its ratings outlook as “negative”.
What was surprising was not so much the fact that Moody’s expressed total conviction that treasury would succeed in stabilising SA’s fiscal trajectory, but that it would also succeed in driving a recovery in the growth rate.
S&P does not share Moody’s conviction that SA is turning the corner.
“Our number one concern about SA is growth,” says Rusike. Linked to that is the important metric of SA’s wealth level in US dollars.
With GDP of $4,900/capita, SA lies just outside the range of $5,400-$15,000 that S&P considers applicable. But since S&P expects SA’s wealth level to rise over the medium term as growth recovers, its ratings assume that SA is going to make it into the bottom of this range or remain close to it.
“The problem is that low growth will weaken SA’s wealth level,” Rusike explains. “Political risk could also weigh on growth through causing weakness in the rand which would raise the cost of doing business. It would also cause SA’s dollar-based GDP/capita to fall. This could affect our economic assessment of SA and the whole rating could fall to non-investment grade.”
S&P has chosen to keep its ratings outlook on SA “negative” to reflect the potential adverse consequences of low GDP growth and to signal that it could lower SA’s ratings this year or next if policy measures do not turn the economy around.
Similarly, Moody’s “negative” outlook recognises that while government has taken important first steps towards fiscal consolidation, “deeper structural reforms to restore business confidence and raise the economy's growth potential are in their very early stages”.
There are three main positive factors that underpin SA’s investment grade rating, according to Rusike: the potential for structural reform now that business, government and labour are pulling together; the potential for faster fiscal consolidation; and the enduring strength of institutions like the judiciary and the public protector.
Despite being concerned at allegations and evidence of state capture, he says S&P hasn’t marked down SA’s institutional strength. In fact, it has taken comfort from the constitutional court’s ruling on the Nkandla matter, especially the way it spelt out the role parliament and the executive must play in upholding the constitution and protecting the office of the public protector.
S&P assumes that SA will continue to maintain fairly strong and transparent institutions, including an independent media. It also assumes SA will experience continued broad political institutional stability and macroeconomic policy continuity.
That said, S&P notes that the socioeconomic dynamics of race and skewed income distribution have the potential to shift policy towards intervention and income redistribution at the cost of headline GDP growth.
In sum, S&P could cut SA to junk status if GDP growth fails to improve in line with its current expectations, or if local institutions are rendered weaker by political interference.
On the other hand, it could revise the outlook to “stable” if policy reforms result in improved business confidence, rising private sector investment and, ultimately, higher growth.