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Moody’s downgrade could trigger ‘Domino effect’, but unlikely – Azar Jammine

By Azar Jammine*

Leading credit ratings agency Moody’s is expected to release an updated review of South Africa’s credit rating today, 11th August. Given that the agency had already downgraded South Africa’s credit rating early in June and placed the new downgraded ratings on a “negative outlook”, one might argue that there is indeed a reasonable chance that the agency might downgrade the country’s credit rating further. Such a move would be crucial, because currently Moody’s is the only one of the three credit ratings agencies which is still assigning an investment grade rating to both the foreign currency denominated and local currency debt of the country.

A further credit rating downgrade by Moody’s would therefore take its credit rating on South African bonds also down to junk status, in line with that of S&P in respect of its foreign currency denominated debt and Fitch in respect of both foreign and local currency debt. Such a move would heighten fears of S&P likewise following suit in November to downgrade its local currency debt to junk status. Were the credit ratings by both Moody’s and S&P on their local currency debt to be downgraded to junk, South African bonds would fall out of the World Government Bond Index (WGBI), causing large international tracker funds to sell out of their holdings of such bonds.

The Rand could depreciate rapidly, causing inflation to increase, putting upward pressure on interest rates and downward pressure on economic growth. It is estimated that sales of South African government bonds in such circumstances could amount to between R100bn and R150bn. Of course, a move by Moody’s to downgrade South Africa’s credit rating tomorrow would not immediately cause South Africa’s bonds to be downgraded by S&P in such a way as to precipitate the fall out of the WGBI. However, it would raise considerably the chances of such an event taking place in November when S&P reduce its credit rating. In anticipation of such a move, the Rand could therefore weaken sharply.

However, a downgrade by Moody’s already today is unlikely

One might argue that the inability of parliament to support the vote in parliament on Tuesday against the exit of President Zuma as leader of the country might have increased the chances of Moody’s downgrading the country’s credit rating tomorrow. President Zuma’s leadership has become associated with State capture, corruption and inefficient government. In particular, poor governance at state-owned enterprises (SOEs) and the associated increased likelihood that such enterprises will call upon government guarantees to rescue them, might be seen as jeopardising the country’s solvency more than before.

Moody's
Moody’s credit rating agency building, New York.

With the absence of a Zuma exit, fears of an increase in South Africa’s indebtedness in the face of State capture and weakening SOE governance, might therefore be viewed as heightening the case for a further downgrade in the country’s credit rating. In addition, economic growth declined in the 1st qtr, plunging the economy into its first recession since the global financial crisis of 2009, increasing chances of the country’s fiscal parameters for budget deficit reduction, not being met due to insufficient tax revenue being collected. However, one doubts very much whether the ratings agency will accept that the current parlous economic situation, to which State capture, corruption and inefficiency associated with the Zuma administration has become permanently entrenched.

Firstly, the agency is likely to be anxious to study the MTBPS in October as the first concrete evidence of the extent to which the National Treasury has indeed been captured by corrupt forces. It will examine the MTBPS to assess the new leadership of the Treasury, following the appointment of new persons as Finance Minister, Deputy Finance Minister and Director-General over the past four months. Some would have argued that the decision announced by the Minister of Finance to bail out SAA with a R13bn package, will be seen as a classic example of the manner in which the Zuma administration is now more free to disburse funds to rescue badly run SOEs resulting in part because it has appointed management to oversee the running of SOEs to persons who are closely linked to Zuma rather than on the basis of the inherent competence. However, in a statement a few days ago, S&P denied that the loan would increase chances of a credit rating downgrade. Instead, S&P argued that recent events have simply entrenched the status quo in terms of corporate governance.

Secondly, Moody’s is likely to argue that there is too much uncertainty ahead of the December electoral conference for it to make a call on the medium-term future of the South African economy in terms of the way in which the economy will be run. An appropriate change in leadership in December could assuage many of the fears about State capture and an abandonment of fiscal discipline. In all probability, therefore, the agency will merely issue a warning again about a potential worsening in the economic environment and the possibility that it will be forced to downgrade the credit rating on South African again.

Yet potentially ominous technical formations on the Rand

An employee holds South African Rand notes in this arranged photograph in London, U.K. Photographer: Jason Alden/Bloomberg

Even if Moody’s were to go ahead and downgrade South Africa’s local currency debt to junk status, the fact is that the prospect of South Africa being eliminated from the WGBI also depends on S&P undertaking such a move as well as Moody’s. S&P is only set to review South Africa’s credit rating on 24th November. Accordingly, South African bonds would not immediately fallout of the WGBI until such time as S&P were to follow suit.

Nonetheless, a decision by Moody’s to downgrade further today, which as we have suggested is unlikely, would in all probability elicit a sharp depreciation in the Rand in anticipation of S&P announcing in November that it was following in Moody’s footsteps. In this regard, one identifies some extremely interesting technical formations on the Rand. The Dollar’s one-year downward trendline against the South African currency is currently located at around R13.50. An upward break of this support level for the Rand would therefore stand to see a considerable depreciation in the currency.

Secondly, the R13.60 level proved to be an important support level II months ago when the Rand depreciated sharply following the last Moody’s downgrade. One identifies an inverted head and shoulders formation which suggests that if the Rand weakens beyond R13.60, considerable further currency depreciation could be in the offing. Extrapolation of the projections of such a formation points to the Rand depreciating to above R14.75 to the Dollar. Finally, there appears to be a wedge formation also developing on the Rand, pointing to the possibility of a sharp breakout from recent trading ranges in either direction.

For the present, the R13.50 to R13.60 support range seems to be holding, but one cannot be sure that Moody’s will be as forgiving about South Africa’s current credit rating as is currently envisaged. Historically, Moody’s has been the most tolerant of the three credit ratings agencies in terms of its assessment of the country’s fiscal situation. However, this cannot be taken for granted. We continue to believe that there is slightly more downside than upside potential on the Rand. The currency remains relatively speaking out-of-favour compared with other emerging market currencies, notwithstanding the high interest rates available on South African government bonds.

  • Azar Jammine is the chief economist at Econometrix.
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