SA avoids junk but outlook turns negative; Kevin Lings expects full downgrade next year

Moody’s Investors Service media statement

Moody’s Investors Service (“Moody’s”) has today changed the outlook on the Government of South Africa’s ratings to negative from stable and affirmed the Baa3 long-term foreign-currency and local-currency issuer ratings.

Moody’s also affirmed South Africa’s Baa3 long-term foreign-currency and local-currency senior unsecured debt ratings, its (P)Baa3 senior unsecured medium-term note (MTN) and Shelf foreign-currency ratings, as well as its (P)P-3 short-term foreign-currency Other Short Term rating. In a related decision, Moody’s changed the outlook to negative from stable on ZAR Sovereign Capital Fund Propriety Limited’s rating and affirmed its Baa3 foreign-currency backed senior unsecured debt rating. ZAR Sovereign Capital Fund Propriety Limited is a special purpose vehicle whose debt issuance is ultimately the obligation of the South African government.

Moody’s decision to change the outlook to negative from stable reflects the material risk that the government will not succeed in arresting the deterioration of its finances through a revival in economic growth and fiscal consolidation measures. The challenges the government faces are evident in the continued deterioration in South Africa’s trend in growth and public debt burden, despite ongoing policy responses.

While high unemployment, income inequality and the social and political challenges they imply for policymakers are long-standing features in South Africa, the obstacles that they pose to the government’s plans to raise potential growth and contain fiscal deficits are proving more severe than expected a year ago. Acute financial stress for state-owned enterprises (SOEs), in particular Eskom Holdings SOC Limited (Eskom, B2 negative), continues to require sizeable ongoing support from the government. The development of a credible fiscal strategy to contain the rise in debt, including in the 2020 budget process and statement, will be crucial to sustain the rating at its current level.

The Baa3 rating affirmation takes into account the country’s deep, stable financial sector and robust macroeconomic policy framework, set against ongoing challenges related to weak potential growth and strong fiscal pressures.

South Africa’s long-term local-currency bond and bank deposits ceilings remain unchanged at A2, and the long-term and short-term foreign-currency bond ceilings are also unchanged at A3/Prime-2. The long-term foreign-currency bank deposits ceilings remain at Baa3, while the short-term foreign-currency bank deposits ceiling remains at Prime-3.

Ratings rationale

Rationale for changing the outlook to negative from stable

Lower growth forecasts reflect deeply entrenched constraints on growth and reform

Socio-economic features in South Africa including structurally high unemployment and income and wealth inequality are longstanding and deeply-entrenched constraints on the country’s growth potential. Deep inequalities – South Africa’s income inequality is among the highest globally, as measured by the Gini index – and resistance to reforms from key stakeholders limit the government’s room to adopt and implement structural reforms.

In the last two years, it has become increasingly apparent that those constraints are challenging the government’s ability to implement reforms that would durably lift growth, to an even greater extent than previously expected. Moody’s has revised down its medium-term growth projections to 1-1.5%, barely in line with population growth, from earlier expectations of a gradual pick-up towards 2.5-3%.

Job creation remains a central problem, with unemployment at a multi-year high of 29% in the third quarter of 2019. Gross fixed capital formation has been contracting on a year-on-year basis since the second quarter of 2018, as private companies see limited prospects of an improvement in the business environment. Productivity, the level of output per worker, has remained stagnant, in contrast with the steady, even if sometimes limited, growth seen in other countries at similar income levels.

The government has promoted a number of initiatives in response to these long-diagnosed issues. However, its ability to implement those initiatives in a way which generates broadly-based sustainable growth has faced obstacles in part from outstanding vested interests, in part from the social and political challenge of imposing measures that are initially likely to be detrimental for parts of the population. For instance, while the new mining charter has finally been introduced, it is unlikely to boost the sector’s investment, with regulatory uncertainty persisting amid ongoing appeals against some provisions of the charter. The government has also introduced multiple initiatives in the labour market including the Youth Employment Service programme, but none on a scale likely to materially increase employment. Other politically and socially sensitive reforms such as land reform have seen slow progress given the government’s need to balance the social and political objective of allowing land restitution, including through expropriation without compensation, and the economic objective of preserving investor confidence.

The negative outlook signals in part Moody’s rising concern that the government will not find the political capital to implement the range of measures it intends, and that its plans will be largely ineffective in lifting growth.

Strong, wide-spread fiscal pressures leave government debt on an upwards trajectory

Low growth is exacerbating the pressures on South Africa’s fiscal position. The government debt burden has risen further than was expected a year ago and will rise still more in the coming years.

South Africa is one of the few countries globally where the average interest rate on government debt markedly exceeds – by an estimated 3 percentage points in fiscal year 2018 – nominal GDP growth. Given that condition, the government debt-to-GDP ratio will continue rising unless the government is able to generate large primary surpluses. The likelihood that it is able to do so has fallen materially.

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The above-inflation wage indexation agreement, which runs until fiscal 2020 (ending on 31 March 2021), continued transfers to SOEs including the planned capital support for Eskom, and a fast-growing interest bill limit the scope for spending restraint. Meanwhile, acute financial stress for certain SOEs, including but not only Eskom, point to likely ongoing sizeable transfers and broader contingent liabilities for the foreseeable future.

As a result, scope for spending restraint is mainly in relation to purchases of goods and services (15% of total government spending) and a reduction in headcount numbers in the public sector, most likely through natural attrition.

On the revenue side, Moody’s expects that tax collection performance will improve over the medium term as the South African Revenue Service’s efforts to improve tax compliance yield some results, with taxes increasing at a faster pace than nominal growth from 2021 onwards. Over the near term, however, tax revenues have underperformed budget targets in fiscal 2018 and the 2019 main budget execution for the first six months suggests that this will be once again the case for full fiscal year 2019.

In the absence of any further policy response, the combination of rising expenditures and underperforming revenues will cause the fiscal deficit to widen to 6%-6.5% of GDP over 2019-22, from around 4% over 2015-18. Government debt will continue to rise to around 70% of GDP by end of fiscal year 2022, from 57% as of end of fiscal 2018. Taking into account the 7.5% of GDP in government guarantees to SOEs that Moody’s includes in the government debt perimeter from fiscal 2019 onwards, debt will approach 80% of GDP at the end of fiscal 2022 and remain on a rising trajectory. In Moody’s view, the combination of low potential growth and high and inexorably rising debt as outlined in the Medium Term Budget Policy Statement (MTBPS) published this week would not be consistent with a Baa3 rating. The current rating rests on the government’s ability to quickly develop a credible strategy to halt and ultimately reverse the rise in debt.

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Such a strategy has not been forthcoming to date. The MTBPS represents a further step towards developing one. It broadly quantifies the ZAR150 billion (3% of 2019 GDP) additional cost saving measures that will be needed to balance the main budget net of interest and support to Eskom by fiscal 2022, its fiscal target, and stabilise government debt. It does not yet identify what those measures will be, other than that they will focus on containing the public sector wage bill. The MTBPS also reiterates that additional operational and financial reforms will be needed to curb the drain on public finances from Eskom and SOEs in general. In short, this week’s announcements do not yet represent a developed, credible fiscal strategy. The development of a credible fiscal strategy to contain the rise in debt, including in the 2020 budget process and statement, will be crucial to sustain the rating at its current level.

Rationale for affirming ratings at Baa3

The Baa3 rating reflects South Africa’s deep, stable financial sector, resilience to a prolonged period of low growth, and a robust macroeconomic policy framework. The South African Reserve Bank has a demonstrated track record in implementing credible and effective monetary policy and preserving financial stability. Moreover, the government remains committed to fighting the so-called “state capture“, even though the process will take time to gain legitimacy and show results in improved institutions and business environment.

Balancing these relative strengths, South Africa’s institutions continue to be tested by weak growth and strong fiscal pressures.

Environmental, social and governance considerations

Social considerations are material for South Africa’s credit profile and their implications for the economy and public finances are a driver of the negative outlook. Deep socio-economic inequalities complicate the implementation of reforms which would otherwise unlock the economy’s potential, and contribute to tensions that fuel latent political risk .

Governance considerations are material to South Africa’s credit profile. South Africa’s ranking under the Worldwide Governance Indicators is in line with that of Baa3-rated sovereigns, and the strength of key institutions, in particular the South African Reserve Bank and the Treasury, continue to support the rating. Set against those qualities, the broader erosion in institutional strength induced by the corruption of the Zuma administration is an important factor behind the erosion in South Africa’s credit profile in recent years. The legacy that era has bequeathed of poor governance of SOEs, and of Eskom in particular, remains a key drain on fiscal resources and also weighs on South Africa’s fiscal strength.

Due to its geographical location, South Africa is subject to frequent climate-related shocks such as droughts, which undermine the agricultural sector’s performance and have weighed on growth in recent years. That said, the country’s economic diversification and sophisticated agricultural techniques mitigate the impact of environmental considerations on South Africa’s credit profile.

What could change the rating up

A rating upgrade is very unlikely in the near future. Moody’s would likely change the rating outlook to stable if it were to conclude that the government will succeed in stabilizing its debt ratios over the medium term, by reining in expenditures, improving tax compliance and by lifting potential growth.

Moody’s will have regard to a number of factors in this respect, including the government’s progress early on in its tenure in delivering the additional fiscal adjustments which the MTBPS identifies are needed, but also in addressing long-standing issues related to corruption and the financially weak SOEs sector, and in particular at Eskom. If achieved, these should ultimately enhance business confidence and private sector investment prospects.

What could change the rating down

South Africa’s ratings would likely be downgraded were Moody’s to conclude that those conditions will not be met and that South Africa’s fiscal and/or economic strength will continue to erode. Ultimately, this conclusion would likely reflect diminishing prospects that growth will be sufficient to preserve current income levels for the majority and halt the rise in government debt over the medium term. Signs of diminishing resilience to external financing shocks would also exert downwards pressure on the rating.

More immediately, a decision to downgrade the rating would reflect growing clarity that the government will not be able to further develop and implement its fiscal and economic strategy to halt and ultimately reverse the debt trajectory. The 2020 budget in particular will be a key indication in Moody’s view of whether or not the government is committed to the fiscal consolidation recommended by the MTBPS.

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GDP per capita (PPP basis, US$): 13,630 (2018 Actual) (also known as Per Capita Income)

Real GDP growth (% change): 0.8% (2018 Actual) (also known as GDP Growth)

Inflation Rate (CPI, % change Dec/Dec): 4.4% (2018 Actual)

Gen. Gov. Financial Balance/GDP: -4.2% (2018 Actual) (also known as Fiscal Balance)

Current Account Balance/GDP: -3.5% (2018 Actual) (also known as External Balance)

External debt/GDP: 47% (2018 Actual)

Level of economic development: Moderate level of economic resilience

Default history: At least one default event (on bonds and/or loans) has been recorded since 1983.

On 31 October 2019, a rating committee was called to discuss the rating of the Government of South Africa. The main points raised during the discussion were: The issuer’s economic fundamentals, including its economic strength, have not materially changed. The issuer’s institutional strength/ framework, have not materially changed. The issuer’s fiscal or financial strength, including its debt profile, has materially decreased. The issuer has become increasingly susceptible to event risks.

The principal methodology used in these ratings was Sovereign Bond Ratings published in November 2018. Please see the Rating Methodologies page on www.moodys.com for a copy of this methodology.

The weighting of all rating factors is described in the methodology used in this credit rating action, if applicable.

Regulatory disclosures

For ratings issued on a program, series, category/class of debt or security this announcement provides certain regulatory disclosures in relation to each rating of a subsequently issued bond or note of the same series, category/class of debt, security or pursuant to a program for which the ratings are derived exclusively from existing ratings in accordance with Moody’s rating practices. For ratings issued on a support provider, this announcement provides certain regulatory disclosures in relation to the credit rating action on the support provider and in relation to each particular credit rating action for securities that derive their credit ratings from the support provider’s credit rating. For provisional ratings, this announcement provides certain regulatory disclosures in relation to the provisional rating assigned, and in relation to a definitive rating that may be assigned subsequent to the final issuance of the debt, in each case where the transaction structure and terms have not changed prior to the assignment of the definitive rating in a manner that would have affected the rating. For further information please see the ratings tab on the issuer/entity page for the respective issuer on www.moodys.com.

For any affected securities or rated entities receiving direct credit support from the primary entity(ies) of this credit rating action, and whose ratings may change as a result of this credit rating action, the associated regulatory disclosures will be those of the guarantor entity. Exceptions to this approach exist for the following disclosures, if applicable to jurisdiction: Ancillary Services, Disclosure to rated entity, Disclosure from rated entity.


Government’s response to Moody’s statement

Government notes the decision by Moody’s to affirm South Africa’s long term foreign and local currency debt ratings at ‘Baa3’ and also revise the outlook to negative from stable. South Africa’s credit ratings by Moody’s remain investment grade (one notch above non-investment
grade).

According to Moody’s, the outlook revision reflects the following:

  • The material risk that the government will not succeed in arresting the deterioration of its finances through a revival in economic growth and fiscal consolidation measures.
  • The challenges the government faces are evident in the continued deterioration of South Africa’s economic growth and public debt burden trends, despite on-going policy responses.

The ‘Baa3’ credit rating affirmation reflects South Africa’s deep, stable financial sector and robust macroeconomic policy framework, set against on-going challenges related to weak potential growth and strong fiscal pressures. The agency further acknowledges the South African Reserve Bank’s demonstration of a good track record in implementing credible and effective monetary policy and preserving financial stability.

The rating affirmation affords South Africa a narrow window to demonstrate faster and concrete implementation of reforms that are already underway aimed at lifting growth and returning public finances to a more sustainable path. Economic reforms have to be implemented without delay. Government has made progress on the measures that the President announced in September 2018: visa regime to support tourism, approval of the revised Integrated Resource Plan providing certainty around government’s preferred energy mix, and release of telecommunications policy directive for spectrum licensing providing a framework to enable the regulator to issue licenses.

While the progress is encouraging, Government is fully aware that short- and medium-term reforms are urgently required to improve economic performance over the next several years.

The discussion document titled ‘Economic Transformation, Inclusive Growth, and Competitiveness: Towards Economic Strategy for South Africa’ was released by the National Treasury in August 2019, and a revised version on 30 October 2019, putting forward an approach to promote investment, job creation and restore growth momentum. The document aims to address the largest binding constraints such as network industries, export-focused reforms and increasing competition in the economy.

The 2019 Medium Term Budget Policy Statement acknowledges that debt stabilisation involves difficult decisions that imply short-term costs for the economy and the fiscus. Growth in government’s compensation bill needs to be addressed and additional revenue measures may be needed in order to reduce government’s debt burden. Moody’s expects tax collection performance to improve over the medium term as the South African Revenue Service’s effort to improve tax compliance yield some results. Options to be considered in addressing government’s wage bill include pegging cost-of-living adjustments at or below CPI inflation, halting automatic pay progression and reviewing occupation-specific dispensations for wages. Government will discuss these matters with labour in due course.

Additionally, Government is providing medium-term support to Eskom to secure energy supply and to honour the state’s contractual obligations. The National Treasury and the Department of Public Enterprises are instituting a series of measures to bring discipline to the utility’s finances, encourage Eskom to run their power stations better, improve operational efficiencies and to step up the timelines for restructuring the business into three entities to facilitate transparency, cost efficiencies, optimal investment in infrastructure and improved operational efficiencies. Following the release of the Eskom Special Paper on 29 October 2019, most operational changes are expected to be implemented before the end of 2021.

While the Minister of Finance, Mr Tito Mboweni, had hoped for a different outcome, he acknowledged the rating action by Moody’s with a heavy heart. In his words, “Fellow South Africans, now is the time to roll our sleeves and do what we have to do. It is now or never. We need all hands on deck. Government, labour, business and civil society, we need each other more than ever before. This country is ours and it is only us who can turn it around”.


Expect a full downgrade next year

By Kevin Lings*

On 1 November 2019, Moody’s Investors Service decided to keep South Africa’s international long-term credit rating unchanged at Baa3, BUT revised the outlook from stable to negative. This was largely expected by the market following the release of the government’s MTBPS on Wednesday 30 October. However, in the months leading-up to the MTBPS many analysts had assumed that Moody’s would keep SA’s credit rating as well as the outlook unchanged at the end of 2019.

The shock deterioration in South Africa’s fiscal parameters, presented by the Minister of Finance in the October 2019 MTBPS, together with the lack of detail in the MTBPS explaining how government intends to remedy the fiscal deterioration clearly  forced Moody’s to change their outlook for South Africa’s credit rating. The weak economic environment, a further revenue shortfall and the additional funding requirements by SOEs meant National Treasury was always going to have to report further fiscal slippage. However, the extent of deterioration announced by Minister Mboweni on 30 October exceeded all expectations.

In the two days following the MTBPS the Rand/Dollar exchange rate has declined by just over 3% and the 10-year government bond yield has weakened by 50bps. The negative rating outlook will, unfortunately, increase market uncertainty suggesting that periods of strength in the Rand and bond market will tend to lack conviction until the rating position from Moody’s is resolved.

South Africa has been on a Baa3 rating by Moody’s (with a stable outlook) since 23 March 2018, although as recently as September 2012 Moody’s had assigned South Africa an A3 rating. The credit rating was cut from A3 to Baa1 on 27 September 2012. When Moody’s first rated South Africa back in 1994, they assigned the country at Baa3 rating, which is equivalent to the country’s current rating. This means that a revision down by Moody’s in 2020 would suggest that they now view South Africa as a greater financial risk than back in 1994. Sad.

Moody’s has revised down its medium-term growth projections for South Africa to 1% to 1.5%, barely in line with population growth, from earlier expectations of a gradual pick-up towards 2.5% to 3.0%. At the same time they argue that with the inclusion of the Eskom debt guarantees, government’s total debt will approach 80% of GDP at the end of fiscal 2022 and remain on a rising trajectory.

In essence Moody’s states that “the decision to change the outlook to negative from stable reflects the material risk that the government will not succeed in arresting the deterioration of its finances through a revival in economic growth and fiscal consolidation measures.

In making the decision to revise South Africa’s credit rating outlook from stable to negative Moody’s made the following four highly critical comments about the government’s fiscal position.

  1. The government has promoted a number of initiatives in response to the weakening growth and fiscal dynamics. However, “its ability to implement those initiatives in a way which generates broadly-based sustainable growth has faced obstacles in part from outstanding vested interests, in part from the social and political challenge of imposing measures that are initially likely to be detrimental for parts of the population”
  2. The negative outlook signals in part Moody’s rising concern that “the government will not find the political capital to implement the range of measures it intends, and that its plans will be largely ineffective in lifting growth”.
  3. South Africa is one of the few countries globally where the average interest rate on government debt markedly exceeds – by an estimated 3 percentage points in fiscal year 2018 – nominal GDP growth. Given that condition, the government debt-to-GDP ratio will continue rising unless the government is able to generate large primary surpluses. The likelihood that it is able to do so has fallen materially.
  4. This week’s MTBPS does not yet represent a developed, credible fiscal strategy

As far as Moody’s is concerned the current Baa3 credit rating rests on the “government’s ability to quickly develop a credible strategy to halt and ultimately reverse the rise in debt”. In that regard the 2020 budget in particular will be a key indication of whether or not the government is committed to the fiscal consolidation recommended by the MTBPS. Achieving this in the current time-frame appears highly unlikely.

Overall, the tone of Moody’s credit assessment of South Africa’s is extremely harsh (for good reason) and significantly different from recent reviews. Risks that Moody’s defended just a few months ago have now become points of significant criticism given the sharp deterioration in the MTBPS. It also appears that Moody’s is placing a lot of emphasis on the National Budget in February 2020 to see if government is able to articulate a much clearer fiscal strategy that can be implemented.

At this stage we would conclude that the chances of Moody’s downgrading South Africa’s credit rating to below investment grade in the first half of 2020 is well above 50%.

  • Kevin Lings is chief economist at Stanlib.