Friday’s “self-inflicted” Ratings Agency downgrade to take SA just one notch above “junk”

The wages of sin is death, The wages of economic mismanagement is a downgrade by the global Ratings Agencies. On Friday, the misguided South African economic policymakers are about to get a very cold shower after ignoring numerous warnings to change their ways. And as SARB Governor Gill Marcus told the nation this week, the pain we're all about to face through higher costs of servicing Government debt, is self-inflicted. The Zuma Administration is finally learning that you cannot have your cake and eat it. Social engineering, consistently attacking the most productive sector of its society and an anti-business approach can only be taken so far. Eventually the golden goose stops laying the eggs that kept everyone in relative comfort. Old Mutual's Izak Odendaal stripped away the veneer in our insightful interview on CNBC Africa's Power Lunch today. – AH   

ALEC HOGG: Joining us now to discuss South Africa's current economic landscape is Izak Odendaal. He's an Investment Strategist at Old Mutual Wealth. Okay Izak, we've just had a downgrade on our economic prospects for this year from none other than the Reserve Bank Governor (Gill Marcus). All the economists I've spoken to say that she's optimistic with numbers she's putting on the table. We have the credit rating agencies, who are in the throes perhaps, of downgrading the country's debt rating. I wonder if you can just give us some good news. Maybe you have some?

IZAK ODENDAAL: Yes, I suppose that at this stage people are scratching around for good news. Certainly, the local outlook is quite gloomy. The good news is that the global outlook is a lot better. The American economy is still growing. Europe is exiting the recession, it's set to grow at about one percent this year, which obviously is not particularly exciting, but bear in mind that Europe has been detracting from global growth for quite a while now. The Japanese economy is still in a bit of an experimental phase, but they should also post positive growth this year, along with China, which is also growing positively, albeit slower. Basically, the biggest economies in the world are still growing. South Africa typically, is a small boat on this big ocean and as the tide lifts, our boat lifts along with it. Provided of course that we could plug some of our more obvious holes and leaks.

ALEC HOGG: They do say that when you're in a hole with a bunch of crocodiles biting at your bum, then there's no time for strategy. You have to sort out those crocodiles and get out of the hole. It does seem, with the AMCU platinum strike and now with NUMSA wanting to do something similar and talking even stronger language on the economy. If the worst happens, what happens to this country?

IZAK ODENDAAL: It's interesting that in a speech about two days ago, the SARB Governor Marcus used the term 'self-inflicted' and she said that we can no longer blame what's happening globally for our woes. What's happening to the economy is basically our own fault, but it's within our means to fix. These strikes are very concerning. The spill over from one industry into another is also very concerning. It's encouraging to see that government is more involved now in terms of trying to get the parties…to get them to negotiate, but the labour relations environment was one of the issues that the rating agencies noted. That was back in December already when they warned of a potential downgrade and certainly, things have not improved since then.

ALEC HOGG: That's an understatement. Are you then expecting the downgrades to come through and be quite sharp?

IZAK ODENDAAL: I think there's a fair possibility of a downgrade – let's put it at more than 50 percent.

All the factors that the ratings agencies listed, have deteriorated – most significantly, the growth outlook as you mentioned upfront.

We'd be lucky to get two percent growth this year. Why that's important for the ratings agencies is of course, that they're interested in 'can government pay its bills? Can government pay interest on its bonds and obviously, if the economy is slower, tax revenues for government is slower, and it becomes difficult for government to close the deficits and bring down the overall debt-to-GDP ratio.

ALEC HOGG: We have a country as we well know, with a social safety net, which you can debate one way or the other, but that's only affordable when you have higher rates of economic growth. So as the rate of growth contracts… Is that what the rating agencies are worried about, that we have these fixed costs if you like, that we just can't get out of the way and we've built them in the system?

IZAK ODENDAAL: I think more than the social welfare side of things is the Public Sector Wage Bill.

The size of the government's employee book increased substantially over the last five years. In addition, they received very generous salary increases.

Yes, the government is running with quite a high cost base at the moment, and it's difficult to bring spending down. The Treasury wants to bring spending down to about two percent per year growth in real terms…not even cutting growth, but just reducing the growth rate of spending. If you then take that to the next issue that people are wondering about 'are we going to have a recession', then one of the problems we have is there's very little room in fiscal policy to stimulate the economy, as was the case in 2008, because government is trying to close the deficit and reduce its overall debt levels.

ALEC HOGG: I wonder. I asked David Shapiro a little earlier if the dots were being joined. Perhaps in this expansion of the public sector, which is being lauded as creating jobs, I wonder if the dots are being joined there as well. Because you don't actually create jobs in the public sector. You extract more taxes from the private sector to pay for the people that you're putting into jobs.

IZAK ODENDAAL: That is true. Obviously, if people are doing their work and if those jobs have a reason, that can add to the productivity of the economy. However, we also know that's not really the case in South Africa. Our public sector is not usually productive. The big issue is as much as the public sector has grown jobs, the private sector has pretty much been shedding jobs. Another thing that's worrying the ratings agencies is the very weak rate of job creation in the local economy. Actually, it's an issue for all of us.

ALEC HOGG: Isak, let's assume that the rating agencies come out with what is anticipated – in other words, a downgrade – how will that impact the country? How will that impact the man in the street?

IZAK ODENDAAL: The main thing is the factors that the ratings agencies are looking at…these are well known, so there's nothing new from a market point of view about all these issues for example, the weak growth, unemployment, and the labour relations issue. The impact on financial markets, should the announcement be made on Friday, is probably not going to be that big. The real issue is if we have a downgrade on Friday, we would only be one notch above 'junk' status. And if you drop into 'junk' status, then there's a whole class of global institutional investors who will not want to hold your bonds. That effectively raises government's borrowing costs. Seeing as we're still running a deficit, government still needs to borrow a substantial amount of money each year. Under those circumstances, it will be paying more for its borrowing. Just as an aside, the cost of borrowing – the interest payment – is already the fastest-growing item in our annual budget. We're already spending about R100bn per year, just paying coupons on money that we borrowed already.

ALEC HOGG: The unintended consequences of doing things that you don't know, you don't know. That was Izak Odendaal from Old Mutual Wealth.