S&P negative outlook: South Africa heading towards the junk cliff

Madness, staying on the same course and expecting a different result. Applies to the current situation South Africa is in. Government is the first to point fingers for the predicament, especially as the country experiences an impending economic slowdown while assuming all is well in its own house. And the big concern is that all roads seem to point to junk (a bit like the streets of Johannesburg at the moment). Sitting one notch above junk status with both S&P and Fitch (following Fitch’s downgrade yesterday) and on a negative outlook with S&P, the writing seems to be on the wall. And simple science shows it’s far easier to avoid a hole than to dig oneself out of it, and digging out of junk status brings with it a whole host of new challenges. Below is how Standard & Poor’s views the current situation:

  • South Africa’s pace of economic growth remains slow. External demand is weak, with low commodity prices, and the country faces domestic constraints including an inadequate electricity supply and overall weak business confidence inhibiting substantial private sector investment.
  • Nevertheless, the National Treasury is broadly maintaining its prudent fiscal consolidation through hard expenditure ceilings. We forecast fiscal deficits to gradually reduce, with net debt stabilizing at around 45% of GDP over 2015-2018.
  • S&P estimates that the current account deficit will have been smaller in 2015 than in 2014 owing to lower oil prices, weak domestic demand, and import compression from the weaker rand, while external portfolio inflows have remained fairly stable. We expect external deficits will moderately increase in the next few years as the economic environment improves. The country’s financing will remain subject to changes in investor sentiment.
  • S&P is therefore revising the outlook on South Africa to negative from stable, and affirming our ‘BBB-‘ foreign currency and ‘BBB+’ local currency ratings on the country.
  • The negative outlook reflects our view that GDP growth might be lower thanwe currently expect, or that fiscal flexibility might reduce owing to contingency risks from state-owned entities with weak balance sheets.

Where to from here. Below are two pieces of analysis from Stanlib’s Kevin Lings and Nomura’s Peter Attard Montalto. – Stuart Lowman

By Kevin Lings

The decision by S&P to revise down South Africa’s credit rating outlook is an extreme concern. Furthermore, the reasons provided by S&P are very clear and hard to dispute. In fact S&P highlighted that they could lower the ratings if GDP growth does not improve in line with their current growth expectations, or if state-owned enterprises require higher government support than they currently expect.

They also have concerns about the funding of the country’s external imbalances (current account), especially if the imbalances increase. While S&P has given South Africa credit for the government’s commitment to fiscal prudence and an expectation that the growth rates will improve once the electricity constraint is relieved, the downside risks have increased. The most notable deterioration is the slowing growth, as well as the increased fiscal burden created by many of the public corporations.

More positively, S&P indicated that they could revise the outlook back to stable if they observe “policy implementation leading to improving business confidence and increasing private sector investment, and ultimately higher GDP growth”.

By Peter Attard Montalto

Peter Attard Montalto, senior emerging markets economist, Nomuro International
Peter Attard Montalto, senior emerging markets economist, Nomuro International

S&P revised its outlook on South Africa to negative whilst affirming its BBB- rating. Whilst our narrative has been that SA will not avoid going over the IG/junk cliff edge given a lack of urgency on structural reforms – the statement from S&P pulls this forward to be a much more immediate risk given its focus on downside growth risks and additional support needed for parastatals. This may well move from a 2018 risk to 2017 or even earlier depending on how the political room to manoeuvre changes.

S&P’s outlook revision was a bit of a surprise and reflects a change in view albeit within the same framework. We had expected a bearish statement today, but there was no change. For us originally the sub-investment grade theme was always about institutional quality and political will to reform (something S&P always hung on to). That framework remains, but S&P now sees the risk that parastatals support puts greater a drag on the fiscus (on balance sheet) as well as the fact that growth may surprise to the downside, and structural reforms are not occurring to boost it and improve business confidence. Reading between the lines, the implication is that S&P sees the political and institutional space at risk for reform potential and for the National Treasury (NT) to be able to manage contingent liability and parastatal risk as shrinking or at risk of shrinking. The negative take here is important and reflects the fact that whilst Eskom improvements have occurred, medium-term financial (tariff and procurement) risks remain. Equally there is the SAA story, which can deteriorate rapidly next year.

Unsurprisingly, S&P still places a lot of faith and benefit of the doubt on NT to run conservative fiscal policy and sees ‘core’ fiscus issues and risks as limited within the NT framework of expenditure ceiling, etc. The risk is that this core conservatism (i.e., what NT has control over) gets largely overshadowed by the wider political issues and constraints on the public sector that NT has no control over. In this sense, today’s move isn’t NT’s ‘fault’.

S&P highlighted downside risks to growth as a potential driver for a cut. S&P is at 1.4%, 1.6%, 2.1% for 2015, 2016 and 2017, roughly in line with us at 1.3%, 1.6%, 2.2%, though we have highlighted the ‘ease’ of getting a 1.0% print next year.

We believe a downgrade to junk is (still) on the way. As we lay out in our recent trip note (here), we see growth risks to the downside, and a lack of political space for structural reforms, and a better fiscal picture in the short run eventually coming up against political constraints in the medium run. On both structural reforms and fiscal, there is a realisation for a need for reform and consolidation at the highest levels of government and the ANC. These same people understand the risk of downgrades and sub-investment grade.
However, we do not believe they understand (even after today) the need for timely, urgent prioritisation of consolidation and reform. Political balancing and rent extraction is just too important for now. A massive domestic risk shock and accompanying market shock will be needed to shift this. That probably will only come with a downgrade to junk. Policy makers will not change beforehand. This is why we believe SA is heading toward the junk cliff.

The way S&P’s framework has flexed now makes this a more immediate risk. We originally took a view around politics and timing and saw junk status after the 2017 elective conference – a 2018 story. We now think it can be a 2017 story or even H2 2016 (from S&P) if downside growth risks are realized (a scenario that is not baseline but is of high probability). Moody’s has further to shift, so the double-junk story may still remain a 2018 story barring an earlier bigger shock.

Read also: IMF confirms SA’s toxic economic cocktail of tanking growth, low confidence

It is important to note that S&P has said local ratings (which are two notches above foreign) can fall faster by two notches on parastatal risks materialising. This is important for index inclusion and shows how the story can potentially deteriorate more rapidly.

All this said, credit still trades as if average rates are around BBB- (negative) and equally a strong backstop from locals having to buy bonds under the capital control framework remains. A big repricing on credit here therefore seems unlikely, but means credit markets may move more in sync with the political space and parastatal stories. We worry particularly about the local curve. With the exchange control backstop and supportive foreign holdings for now, a sharp repricing higher will likely be sudden and violent when it does happen. Again, given the trust S&P puts in fiscal, this kind of action will most likely happen on the political and parastatals stories. Given increased official and semi-official sector funding however, for Eskom this may take a little time to emerge.

Standard & Poor’s outlook

The negative outlook reflects our view that GDP growth might be lower than we currently expect; for instance, due to persistent electricity shortages, continued weak business confidence, or labor disputes escalating again. The outlook also reflects our view that fiscal flexibility might reduce owing to contingency risks from state-owned entities with weak balance sheets.

We could lower the ratings if GDP growth does not improve in line with our current expectations, or if state-owned enterprises require higher government support than we currently expect.

We could also lower the ratings if external imbalances increase, or funding for South Africa’s current account or fiscal deficits becomes less readily available. A reduction in fiscal flexibility could also lead us to lower the local currency ratings, potentially by more than one notch.

We could revise the outlook back to stable if we observe policy implementation leading to improving business confidence and increasing private sector investment, and ultimately contributing to higher GDP growth.

  • Kevin Lings is chief economist at Stanlib
  • Peter Attard Montalto, senior emerging markets economist, Nomuro International