27 Nov 2017
Credit Rating downgrades: South Africa sees only one move from investment grade to sub-investment grade on its local-currency long-term sovereign debt from the three key agencies
As expected SA was downgraded on Friday from investment to sub-investment grade, and out of the three options it was Standard & Poor’s who delivered the downgrade. SA consequently retains only one key agency investment grade local-currency (and one foreign-currency) long-term sovereign debt credit rating, both from Moody’s. S&P said “(t)he downgrade reflects our opinion of further deterioration of South Africa's economic outlook and its public finances.”
Specifically, S&P said “economic decisions in recent years have largely focused on the distribution - rather than the growth of - national income. As a consequence, South Africa's economy has stagnated and external competitiveness has eroded. We expect that offsetting fiscal measures will be proposed in the forthcoming 2018 budget in February next year, but these may be insufficient to stabilize public finances in the near term, contrary to our previous expectations.”
The three options SA faced on Friday were that either Moody’s or S&P downgraded SA’s local-currency long-term sovereign debt credit rating to sub-investment grade, or both agencies did. One agency downgrade was factored into the market (see “Credit Rating outlook for South Arica: should SA slip to sub-investment grade tomorrow, the market impact may be less than the historic norm”, 23rd November 2017, website address below).
South Africa has a sophisticated financial market, and the impact of Friday 24th November 2017’s S&P downgrade has so far today been mild on the financial markets as one local-currency downgrade was largely priced in. The rand closed on Friday at R14.13/USD, R16.88/EUR and R18.85/GBP, and currently is trading at R14.05/USD, R16.77/EUR and R18.73/GBP, having strengthened in relief at only one agency move. The R186 is at 9.40% from its close on Friday of 9.30%.
Should SA have received a downgrade from investment grade to sub-investment grade on its local-currency long-term sovereign debt from Moody’s as well as S&P on Friday the market reaction would likely have been far more severe. Moody’s has put SA on ratings review. The agency said “(t)he decision to place the rating on review for downgrade was prompted by a series of recent developments which suggest that South Africa's economic and fiscal challenges are more pronounced than Moody's had previously assumed.”
Specifically Moody’s said “(g)rowth prospects are weaker and material budgetary revenue shortfalls have emerged alongside increased spending pressures. Altogether, these promise a faster and larger rise in government debt-to-GDP than previously expected. The review will allow the rating agency to assess the South African authorities' willingness and ability to respond to these rising pressures through growth-supportive fiscal adjustments that raise revenues and contain expenditures; structural economic reforms that ease domestic bottlenecks to growth; and improvements to SOE governance that contain contingent liabilities.”
Moody’s has decided to wait until after the December 2017 ANC elective conference, and the February 2018 Budget, before publishing their re-assessment of SA’s creditworthiness. The agency explained that “(t)he review period may not conclude until the size and the composition of the 2018 budget is known next February. This will also allow Moody's to assess the policy implications of political developments during the review period and the likelihood of pressures on South Africa's key policymaking institutions persisting.”
Moody’s said it will downgrade SA if its “economic, institutional and fiscal strength … continue to weaken”, if “ measures to address funding gaps over the next two years lacked credibility or that the lack of progress with structural reforms effort would result in an environment not conducive to investment and growth. Lack of structural reforms would also send a negative signal regarding the strength of South Africa's institutions, in particular about government effectiveness in enacting sound policies. Relatedly, any developments which cast further doubt over the independence and credibility of core institutions including the National Treasury and the Reserve Bank would be strongly credit negative.”
Should SA lose its Moody’s investment grade long-term sovereign rating on the local currency front it could see debt portfolio outflows estimated between R40bn to up to R200bn (as SA’s bonds will need to exit certain key indices such as Barclays BGAI and Citi Bank’s WGBI), and so there would likely be a more significant negative impact on its financial markets than occurred with just the single downgrade received on Friday.
SA needs to retain one investment grade rating on its local-currency long-term sovereign debt from the three key agencies (Moody’s, Fitch and Standard &Poor’s) to remain in these indices and so prevent significant currency outflows which could cause severe rand weakness and higher bond yields. SA has 90% of its sovereign issuance in local currency debt and 10% in hard currency.
In order to avoid a Moody’s downgrade, with its next country review scheduled in April 2018, the agency would need to conclude that South Africa’s “policy response is likely to bring the economic, institutional and fiscal trends on a path so that these factors remain consistent with Baa3 peers; and that developments in the political economy offer the prospect of a more stable, growth-friendly institutional backdrop.”
S&P has warned that it could deliver further credit rating downgrades, which would negatively affect SA’s banking sector and so its business cycle, if “(d)ownside pressure on the ratings could develop if economic performance and fiscal outcomes deteriorate further from our forecasts. Further pressure on South Africa's standards of public governance, for example in our perception of a threat to the independence of the central bank, could also cause renewed downward pressure.”
The lower South Africa’s credit ratings fall, the more financial market volatility it will likely experience. Global financial markets are currently in a risk taking, or risk-on, phase resulting in EM countries in general having experienced strengthening currencies and bond yields. Evidence has shown that during risk-on much of the impact of the credit rating downgrades can be counteracted by this heightened risk taking, especially for mild downgrades.
However, during risk off periods, the impact on EM’s financial markets from credit rating downgrades are typically more severe (see “Credit rating downgrades: from investment grade to sub-investment grade”, 21st November), particularly when it is a severe downgrade where all credit ratings from the three key agencies are rendered sub-investment grade.
If South Africa remains on its current trajectory it is likely to lose its Moody’s investment grade ratings by the end of the first half of next year should the ANC elective conference outcome be negatively perceived by the markets and the February 2018 Budget not prove credit stable. “Moody's would downgrade the rating if the review were to conclude that South Africa's economic, institutional and fiscal strength will continue to weaken. A downgrade would likely result were the rating agency to conclude that measures to address funding gaps over the next two years lacked credibility or that the lack of progress with structural reforms effort would result in an environment not conducive to investment and growth.”
Moody’s adds “(l)ack of structural reforms would also send a negative signal regarding the strength of South Africa's institutions, in particular about government effectiveness in enacting sound policies. Relatedly, any developments which cast further doubt over the independence and credibility of core institutions including the National Treasury and the Reserve Bank would be strongly credit negative.”