23 Nov 2020

South Africa's slide down the credit curve continues

Tertia Jacobs

Treasury economist

In a surprise move, Moody’s and Fitch have downgraded South Africa’s credit rating by one notch while S&P left the rating unchanged.

Moody’s and Fitch downgraded South Africa’s long-term foreign-currency and local-currency rating on Friday by one notch while S&P left the rating unchanged at BB- with a stable outlook.

 

Moody’s downgraded the rating by one notch to Ba2 from Ba1 and maintained a negative outlook. Fitch lowered the rating by one notch from BB to BB-with a negative outlook.

 

Fiscal risks have been exaggerated by Covid-19:

 

  • Concern about the implementation and effectiveness of economic reforms;
  • Sharply rising sovereign debt levels and associated costs of debt
  • A lower tax base and ability to contain the public sector wage bill; and
  • Friction and rigidities in the labour market.   

The downgrades came as a surprise. Bloomberg consensus forecasts showed that 5 out of 23 economists surveyed expected a downgrade by Moody’s and 4 out of 21 the Fitch downgrade.

Reasons for the downgrades

The downgrade by both rating agencies reflects the assessment of the effect of Covid-19 shock on fiscal strength, which has deteriorated following the pandemic's impact on the economy.

 

The reasons for the downgrades are:

 

  1. rising debt-to-GDP trajectory
  2. weak growth trend, and
  3. social obstacles to reforms and a high level of inequality.

The downgrade risk is presented by uncertainty over the ability of government to stabilise government debt in coming years and reflects doubt about the ability of the government to implement the Economic Reconstruction and Recovery Plan (ERRP) and stabilise the public sector wage bill.

 

Moody's rationale

Moody’s noted that their concern is that South Africa’s capacity to mitigate the shock over the medium term is lower than that of many sovereigns given significant fiscal, economic and social constraints and rising borrowing costs.

 

"The risks to the government’s ability to implement structural reforms and fiscal consolidation needed to lift the growth trajectory and lower the budget deficit, has risen”.

 

Growth is forecast to remain structurally low at 1% in real terms over the medium term (National Treasury forecasts real GDP growth in 2022 and 2023 of 1.7% and 1.5% respectively). 

 

While Moody’s acknowledges the progress being made in the fight against corruption, the labour market is increasingly challenging which creates friction between government, corporates and trade unions, further impeding reform implementation. A cornerstone of President Ramaphosa’s ERRP is a social compact between the key stakeholders in the economy.

 

The forecast of fiscal metrics is closer to government’s passive scenario presented in the Supplementary Budget Review (SBR) than the October 2020 MTBPS, which factors in a containment in the public sector wage bill over the MTEF period.

 

The debt-to-GDP ratio is projected to reach 110% by FY2024 and includes guarantees extended to SOEs of ~5% of GDP (Government’s passive scenario projected an increase in the debt trajectory to 114.1% of GDP compared to the October 2020 MTBPS forecast of 94.6%.)

 

The scarring from the Covid-19 pandemic on the economy is expected to have a lingering impact on (1) revenues with (2) borrowing costs set to rise further.  Interest payments could reach 25% of revenues over the medium term (National Treasury forecasts an increase to 23.7% by FY23).

 

The negative outlook reflects the downside risk to the base line projection to growth and fiscal consolidation which could worsen the debt burden and debt affordability, as well as factoring in additional financial assistance to SOE’s and specifically Eskom.

Fitch rationale

The Covid-19 shock is expected to have lasting effects on growth, with reference to the weakening of investment spending and ongoing challenges emanating from power supply, labour market inflexibility and subdued domestic demand prospects.

 

Trend growth in real GDP growth is expected to be 1.5% (after base effect lifts growth in 2021 to 4.8% and 2.5% in 2022).

 

The ability of government to implement the ERRP is doubtful and even if implemented, the effect of the reforms would be limited and take time to accumulate.

 

The fiscal metrics factors in (1) lower revenue receipts; and (2) a higher wage bill. Fitch expects a reversal of this year’s wage freeze, as well as above-budgeted settlements over the MTEF period. Wage negotiations will be complicated by the upcoming local elections and the close alliance of the ANC with Cosatu.

 

Fiscal support to SOE’s such as Eskom faces upside risk over the MTEF period. 

 

Strengths:

  • The long average maturity of local and international government debt of 14 years. A shift to more short-term issuance has raised the redemption profile to around 3% of GDP FY23, which is manageable. Monetary policy easing supports government’s funding costs.
  • The free floating currency, a low share of FC denominated debt in total government debt (11.8%) and the large local non-bank-financial sector (with assets of around 160% of GDP) are important shock absorbers.

 

Risks:

Foreign capital outflows, large foreign holdings of LC debt (at 29%) and a widening of the current account deficit when domestic demand stabilises, are risks. Net external debt is in line with peers but the reserve adequacy ratio of international reserves, is relatively low.