Ratings slash could ‘destroy our soul’
| South Africa must remain aware of the debt pitfalls into which Brazil, Greece have fallen, analysts warn
A RATINGS downgrade to junk status not only has the potential to set back the economy in the short and longer term but could also have a significantly negative impact on local financial markets.
South Africa needs to learn to live within its means. The government needed to deliver on its promise of tighter fiscal policy and, at the same time, to begin implementing policies to promote economic growth if it was to stabilise debt to GDP at a manageable level and avoid a series of ratings downgrades, said John Orford, a portfolio manager at Old Mutual Investment Group.
“The risk is that if the government fails to deliver tighter fiscal policy and better growth, foreigners could decide to sell the South African government bonds they own.
“This would likely have a very destabilising impact on the economy, resulting in a further weakness in the rand and sharply higher interest rates, potentially setting off a vicious cycle of weaker growth and higher debt to GDP,” said Orford.
“While this remains a risk scenario, it’s one that should be foremost in the minds of both the government and the people of South Africa. In this context, the recent budget’s commitment to reducing government expenditure is welcomed.” Impact on the markets The threat of a possible ratings downgrade is already affecting the markets. Markets, by their very nature, are forward-looking — they anticipate and price for the future. What this means is that these anticipated market consequences are gradually factored in, even before a downgrade actually happens. This is already happening, with much of the junk status already priced into the interest rate market.
“What we’re currently seeing is that the market has already assumed a downgrade on South Africa’s credit ratings. Our credit default swap spreads already trade in line with junk-rated countries and the yields on our foreign currency debt have already widened out to levels similar to junk-rated countries,” said Orford.
This means market movements once a downgrade is announced may therefore not be significant, provided the longer-term outlook stabilises.
South Africa has a higher sovereign risk premium than Turkey or Russia, both of which have been downgraded to non-investment or junk status.
“Investors are already demanding higher sovereign risk yield pick up on South African debt than these countries,” said Guy Toms, chief of fixed interest strategy at Prescient.
“To this extent, junk status is already priced into our yields. The yield compensation for sovereign risk premium could go higher — towards the levels that Brazil trades at — but this is unlikely given that Brazil is significantly worse off in terms of its ability to service debt as it has a large fiscal deficit and a high degree of dollar-denominated debt.”
If South Africa were to be downgraded to junk status, the cost of capital would rise and the return on equities would fall. Domestic interest rates would also come under increased pressure.
“The sovereign risk premium could widen in the short term as investors exit the markets. However, in terms of valuation relative to other similar economies, there is little scope for South African risk premiums to rise by anything more than 1% from current levels relative to its peers,” said Toms.
A downgrade would further result in bond investors experiencing losses, while equity investors would in all likelihood see declining returns.
Government bonds would be excluded from global bond indices, resulting in declining foreign demand for bonds, further weakening the rand and pushing inflation higher.
A downgrade should be cause for grave concern for investors, said Wilfred Moyo, investment and economic strategist at Metropolitan.
“Rising interest rates will devalue existing bonds, causing losses in the bond market although they will result in higher yields and thus higher income per rand invested. A downgrade could also create problems for funds that are required to hold good-quality or AAA-grade investments,” he said.
“Professional investors, including pension fund and asset managers, may struggle to get good-quality investments as they have tight mandates that don’t allow for exposure to junk investments.”
There was no doubt that the outlook had deteriorated, said Orford, with less-attractive local opportunities for investors.
“Companies are going to become more selective in terms of their local investments, while many will be looking at rather investing offshore.
“From a government expenditure point of view, the more money that is spent on servicing debt, the less budget there is available to grow the economy, and that’s where the negative loop for creditworthiness comes into play.
“Fortunately, we’re still a long way off the debt spiral that countries such as Greece and Brazil have fallen into, but with low growth prospects, the recent sharp increase in our debt levels is a cause for concern,” said Orford.
Impact of a ratings downgrade on consumers
South African consumers will be hard hit should there be a ratings downgrade. Think higher interest rates on any loans and credit card debt, increased taxes, higher inflation, decreased job security, higher unemployment, a further weakening of the rand and overall negative economic growth.
Further financial pressure on households would be unavoidable.
Should South Africa be downgraded, the country would find itself structurally locked into a low-growth environment, which would further highlight historic fault lines, said Goolam Ballim, chief economist at Standard Bank.
“Once marked down, a sub-investment grade rating can take more than five years to unshackle,” he said.
“It has the ability to destroy a nation’s soul and leave that economy stricken for years.”
Although ratings downgrades did occur from time to time and were not unusual, a downgrade to junk status would be disastrous for the economy, said Professor Jannie Rossouw, head of the School of Economic and Business Sciences at the University of the Witwatersrand.
“However, South Africa has done nothing in the past week to convince agencies not to downgrade South Africa. That a new presidential plane is being considered at a time when we need to be reining in expenditure says it all.
“Added to this, the tug of war that is currently taking place between the finance minister and the head of state is totally unacceptable and is something that South Africa can ill afford right now,” said Rossouw.
But these skirmishes would in all likelihood become a hallmark of 2016.
Ballim said: “These clashes are a natural evolution as the reformers attempt to appropriate further ground and the self-serving crowds agonise that their term may be stumbling to a loud end.
“South Africa is on course for a shake-out this year, with a bitter contest determining who prevails.
“This is the ruling party’s sternest test in years, as the nation hangs precariously on the precipice of a frightening downgrade scenario.
“In football parlance, it’s not the peril of a yellow or even a red card, but the equivalent of being banned from the game for the remainder of one’s useful career.”
What ought to bind us now is a deep sense of common cause framed by pristine governance and an aggressive economic growth agenda.
Any further policy blunders or shocks to what was already a very fragile economy would consign South Africa to junk status, said Toms.
“The more that is done to create a stable investment environment, the cheaper South Africa’s cost of borrowing will become.
“For now, all eyes will be on government in following through with its public-spending efficiency drive and on the country’s economic performance.”
Critically, South Africa needed to implement tight fiscal policy to stabilise debt to GDP, said Orford.
The most sensible way to navigate this risk was for investors to ensure they were invested in an appropriate multiasset fund and for consumers to manage their debt carefully given the higher interest rate.
“It’s a tough environment right now, but we’ve been through tough environments before.”
In football parlance, it’s not the peril of a yellow or even a red card, but the equivalent of being banned from the game for the remainder of one’s useful career