Welcome to the Wild West of junk
Volatility will come — proving only growth can get us out of here
● It was SA’s most peaceful ratings round for a long while. In this month’s scheduled updates from Moody’s, S&P Global Ratings and Fitch, all three agencies kept their ratings on SA unchanged.
Their reports contained the usual warnings about SA’s increasingly unaffordable public debt and inability to implement growth-boosting reforms. But they were sunnier than they’ve been for some time on the short-term economic and fiscal outlook.
It was in stark contrast to last year’s drama, when in March Moody’s finally became the last of the three to junk SA’s rating — just a day after the hard lockdown began, and amid a Covid-inspired crisis in global and domestic financial markets.
That was followed in April by downgrades from Fitch and S&P, which already had sub-investment grade, further down the junk scale. Then, in November Moody’s and Fitch took the rating one more notch down into junk territory. The result is that SA is now two notches below investment grade on the Moody’s scale and three on the S&P and Fitch scales — and the Moody’s and Fitch ratings have negative outlooks, so there’s potential for further downgrades.
But do ratings still matter, now that SA is roundly rated junk, or as markets call it “speculative grade” or “high yield”? And does it really matter how far down the junk scale it is? That last relegation by Moody’s to junk status had been long feared as it would mean SA’s ejection from the world government bond index (WGBI), potentially triggering massive capital outflows as investors sold their South African government bonds.
As it turns out, we may never know if it did, because the markets were in such turmoil at the time, with capital flowing out of emerging markets so fast, it was hard to disentangle how much of SA’s outflows were downgrade-driven.
But it was not the moment of impact that was significant; the real change, as one economist puts it, is this: “The kind of people who invest in you changes; we used to be able to attract all this money from nice, cosy long-term pension investors; now it’s the Wild West — impatient hedge funds who demand high yields and jump out quickly.”
That increases volatility in the market and puts upward pressure on bond yields.
Says RMB economist Kim Silberman: “What’s been evident is that because we are not in the WGBI our markets have less natural flows from the offshore investors who tracked the index. It’s definitely had an impact on the demand for bonds and the liquidity of the market and the volumes of trading; that makes pricing harder and it has had an impact on bond yields.”
And if SA were to slide further down the ratings scale, from the double-B to the single-B ratings band, it would be a big deal: “Investors price that differently,” she says.
“The further down you go the more speculative investors you get and that creates high levels of volatility,” says Citi economist Gina Schoeman, who warns that while the “hedgies” are long on SA for the moment, with commodity prices booming, that could change very quickly.
“If we want any hope of ever achieving an upgrade we need to stop going further down,” she says.
If ratings matter for capital flows and bond prices, they matter too because it’s worth listening to the external independent assessment they provide. So what are they telling us? One clear message from last week’s rating agency reports is that SA’s growth prospects for the next couple of years are looking bouncier, thanks to base effects after last year’s large economic contraction and the cyclical jump in commodity prices.
But that’s not going to last. The agencies no longer have much faith in SA’s ability to implement reforms that will make a real difference, and growth is likely to subside over the medium term to the 1%-2% pre-Covid crisis levels. S&P expects growth of 3.6% this year, moderating to 2.5% in 2022 and below 2% in 2023/2024. Moody’s sees 4% this year but beyond this “technical recovery” it forecasts growth to remain weak, just in excess of 1% over the medium term.
“Although the government has advanced a number of reforms to ease existing constraints, structural issues — labour market rigidities, mistrust from the business community after state capture that weakens confidence and investment — remain largely unaddressed in SA,” says Moody’s in its annual credit analysis, published last week. It also cites SA’s inequality as a factor that complicates the reform process.
Fitch is the most optimistic on growth this year at 4.3% — but also expects mediumterm growth of less than 2%, with tight public finances and electricity shortages holding back growth.
“We are not factoring in a large impact from the government’s reforms, which seem limited in scale and slow in implementation,” says Fitch. S&P says “structural constraints, a weak pace of economic reforms and low vaccination rates will continue to constrain medium-term economic growth and limit the government’s ability to contain the debt-to-GDP ratio”.
That is perhaps the even clearer message from the three agencies: that SA’s fiscal crisis is really a growth crisis, and cutting spending on its own will not be enough to stabilise the public debt ratio, as the government promises.
The agencies seem less worried than might have been expected about the government’s ability to deliver the public sector pay cuts on which the budget’s debt stabilisation plan hinges — Moody’s has said its own estimate of the increase in the wage bill is higher than the government’s. They give the government credit for the fact the latest fiscal numbers were better than expected due to strong revenue collections and because it used the unexpected revenue windfall to reduce its weekly debt issuance, so helping to cut borrowing costs. They give SA much credit, too, for its strong financial markets and strong institutions such as the Reserve Bank.
But without sustained higher economic growth, they still see public finances deteriorating, possibly dangerously, over the next few years, especially if the government has to put further funds into state-owned enterprises, particularly Eskom.
Moody’s has a “fiscal strength” rating on SA of Caa2, two notches below SA’s overall Ba2 rating, mainly due to the rising public debt burden. Though SA can afford a higher debt burden than many of its peers, due to its “deep investor base and favourable debt structure”, says Moody’s, affordability is becoming an ever greater risk, with interest payments consuming an ever higher chunk of the budget.
In essence, unless SA can start growing its economy faster than it grows its interest bill, it has little hope of fixing its finances.
Says S&P: “A particular concern is that even if, on the back of tough political decisions, personnel expenditure can be reduced from current levels, the increase in interest payments over the same period implies there will be little progress in narrowing the large fiscal deficit or debt to GDP — except under scenarios of significantly higher GDP growth than we currently project.”
Junk status and the Covid crisis could and should have galvanised SA into urgent action to fix its ailing economy: sadly, as the rating agencies see it, they have not.
We used to be able to attract all this money from cosy, long-term pension investors; now it’s … impatient hedge funds