12 Jun 2017

Moody's expected downgrades see marginal rand impact, coming so soon after negative news of recession, but agency places SA on negative outlook

Annabel Bishop

Chief Economic

After closing at R12.94/USD, R14.48/EUR and R16.43/GBP on Friday, the rand has strengthened mildly, despite Moody’s downgrade of SA’s ratings to Baa3 (last rung of investment grade or IG) for both local and foreign currency (LC and FC respectively) long-term sovereign debt (LSD).

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Global risk-on has boosted both the rand’s, and local currency debt’s, performance for SA. Additionally, markets had also already largely factored in the expectation of SA’s recent downgrades that occurred.

The global risk-on phase has been aided by particularly low yields in developed economies (DM) offering a good differential. The inflows have strengthened the rand, proving the current risk-on cycle to be an opportune time to receive downgrades from a yield and currency perspective.

SA still has two LC IG ratings (from Moody’s and S&P, albeit with negative outlooks on the last rung of IG). Investors are likely reaping the yield differentials (with DMs) on SA’s IG debt while they can, as negative outlooks signal further credit rating downgrades.

Credit rating downgrades in emerging markets (EM) have previously been followed by some yield strength - in Brazil and Russia in 2015, and with Turkey also seeing some strength after its late 2016, and early 2017, downgrades, albeit interrupted by its political events.

However, from an economic perspective, SA’s 2017 (April and June) credit rating downgrades are expected to negatively affect domestic confidence measures, with some large corporate fixed investment, and consumer expenditure, decisions likely put on hold.

Depressed confidence readings aided the economy into recession over Q4.16 and Q1.17, negatively affecting spending and investment, which means that the two key growth drivers of the domestic economy were subdued, with unemployment rising.

In particular, concerns over political and economic policy uncertainty for the future is negatively impacting sentiment, and so negatively impacting consumer and business decisions to take on more long-term debt.

Moody’s drivers for its downgrade are “reduced growth prospects reflecting policy uncertainty and slower progress with structural reforms“, “the weakening of South Africa's institutional framework; and “the continued erosion of fiscal strength due to rising public debt and contingent liabilities”.

When uncertainty is severe enough, confidence over the future performance of the economy falls. This further reduces business confidence (and so fixed investment), and also further reduces consumer confidence, as consumers worry about employment and earning prospects.

Moody’s “negative outlook reflects the continued downside risks for growth and fiscal consolidation associated with the political outlook. … economic and fiscal strength will remain sensitive to investor confidence and hence uncertainty surrounding political developments, including prospects for structural reforms intended to raise potential growth and flexibility in fiscal expenditures.”

Moody’s rationale for keeping SA investment grade is “deep domestic financial markets and a well-capitalized banking sector; a well-developed macroeconomic framework; and low foreign currency debt. Moreover, deterioration in the factors driving the downgrade has been gradual.”

The agency continues “(i)mportantly, adherence to the Constitution … accountability and the rule of law continue to be the key pillars of strength of South Africa's institutions, with South Africa's institutions on balance still stronger than those of emerging market peers.”

However, the political and governance volatility in SA has led Moody’s, normally more positive than the other two key ratings agencies, to worry that SA’s “institutional strength/framework, have materially decreased”, along with its “governance and/or management”, and its “economic fundamentals”.

“The future trajectory of the rating will depend on the government's success in safeguarding South Africa's institutional, economic and fiscal strength. Indications that the strength and independence of the country's institutions have diminished to a greater extent than in Moody's baseline scenario, or that the emerging policy framework has become even less predictable or has shifted in a way likely to undermine economic or fiscal strength, could lead to a further downgrade.”

“Further delays in growth enhancing reforms would be suggestive of such a shift. Downward pressure could also develop if liquidity pressures begin to reemerge at state-owned enterprises that would elicit pronounced government intervention, be it through the activation of guarantees or other measures.”

The IIF shows this year to end May, US$152bn worth of EM bonds and equities were purchased (net of sales) by non-residents, mainly into Emerging Asia. IIF data for SA shows US$3.51bn worth of foreign net purchases of debt, but US$3.48bn of net outflows from SA’s equity market.

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