S&P cuts South Africa’s debt rating to one downgrade from “junk”

South Africa's credit honeymoon ended this evening when the world's leading agency, S&P, announced an across the board lowering of the country's credit ratings. The three major ratings agencies have for some time been warning economic policy makers to get the house in order or suffer the consequences. This evening's ratings downgrade was widely anticipated.  The drop to BBB minus means South Africa is a single notch above "junk" status. Another cut would force  many global funds to sell their South African bonds with seriously negative consequences for interest rates. S&P says it will lower the ratings further if labour disruptions continue or if the Government does not hold its Budget Deficit at current levels – a tough task in the projected weak economic conditions. As Cees Bruggemans warned in his superb recent analysis, disruptive issues like the platinum strike affects all South Africans. – AH  

From Standard & Poors:

• A prolonged strike in the platinum mining sector, as well as weak domestic and external demand, has led to a contraction in GDP in the first quarter of 2014 and is likely to depress second-quarter and full-year GDP growth rates and reduce South Africa's fiscal flexibility.
• In addition, current account deficits are relatively high, and their financing relies on potentially volatile capital flows.
• We are therefore lowering the long-term foreign currency rating on South Africa to 'BBB-' from 'BBB' and the long-term local currency rating to 'BBB+' from 'A-'.
• The stable outlook reflects our view that current labor tensions will be resolved and that lackluster economic performance will not affect South Africa's fiscal and external balance beyond our revised expectations.

On June 13, 2014, Standard & Poor's Ratings Services lowered the long-term foreign currency sovereign credit rating on the Republic of South Africa to 'BBB-' from 'BBB' and the long-term local currency rating to 'BBB+' from 'A-'. We also lowered the short-term foreign currency rating to 'A-3' from 'A-2' and affirmed the short-term local currency rating at 'A-2'. The outlook is stable.

S&P also affirmed the long- and short-term South Africa national ratings at 'zaAAA' and 'zaA-1'.

The downgrade reflects our expectation of lackluster GDP growth in South Africa, against a backdrop of relatively high current account deficits, rising general government debt, and the potential volatility and cost of external financing.

A prolonged strike in the platinum sector, as well as weak domestic and external demand, led GDP to contract in the first quarter of 2014 and is likely to depress second-quarter GDP growth. The strike has led to a 25% contraction in mining and quarrying output, and contributed to the overall economy contracting by 0.6% of GDP in the first quarter of 2014. It will likely lead either to another contraction or to only-feeble growth in the second quarter as well as disappointing growth for the full year.

We now expect full-year GDP growth of 1.9% in 2014, rising to 2.9% in 2015 and 3.2% in 2016. This follows slow growth of 1.9% in 2013 and 2.5% in 2012, also partially due to prolonged strikes in the automotive sector in 2013 and the mining sector's wildcat strikes of 2012, and highlights a prolonged lackluster period for a country at this stage of development.

While South Africa's fiscal outturn has held up so far, the fiscal stance over the next few years may become exposed to lower-than-expected economic growth, pressures from a new round of public-sector wage negotiations, and increased public spending needs. Although we expect the treasury to abide by its expenditure ceiling, slowing growth may reduce revenues and possibly place overall fiscal targets beyond reach.

General government debt, net of liquid assets, increased to 40% of GDP in 2013, from 23% in 2008, and we expect it to reach 46% by 2017. Although little of the government's debt stock is denominated in foreign currency, nonresidents hold 37% of the government's rand-denominated debt.

The ratings are also constrained by sizable current account deficits. Although the rand floats and is an actively traded currency (according to the BIS triennial survey of foreign exchange dealing, it is traded in 1.1% of global foreign-exchange contracts), the portfolio and other investment flows that finance these deficits can be volatile and can vary in price. Movements could come from global changes in risk appetite or from foreign investors reappraising prospective returns in the event of growth or policy slippage in South Africa. While capital inflows have resumed since February 2014–after a period of withdrawal–another reappraisal of risk is possible. Slow growth and strikes may heighten both fiscal and external pressures.

While we think that President Jacob Zuma's newly elected administration will continue the policies of his first administration, which controlled fiscal expenditure and fostered broadly stable prices, we do not believe it will manage to undertake major labor or other economic reforms that will significantly boost GDP growth. At the same time, we also do not believe the ANC-led government will entertain radical policies (such as the nationalization of mines).

With 2014 per capita GDP estimated at $6,405, South Africa is a middle-income country. We consider its economy to be diverse, yet with wide income disparities. Per capita GDP growth has averaged a moderate 2.2% per year over the past 10 years and we forecast it to fall to an average of 2% in 2014-2017.

We consider South Africa's contingent liabilities to currently be "limited," under our criteria. Nevertheless, the government has South African rand (ZAR) 350 billion (about 10% of GDP) available in potential guarantees for the state-owned utility Eskom. Eskom currently uses about ZAR120 billion of these guarantees. Eskom's operating margins have been hurt by the lack of rate relief from the regulator as well as other factors and we believe Eskom's funding needs may require the government's guarantee envelope to increase by 2017.

The long-term local currency sovereign rating on South Africa is two notches above the long-term foreign currency sovereign rating. This is because we believe that the sovereign's flexibility in its own currency is supported by the South African Reserve Bank's independent monetary policy and a large active local currency fixed-income market.

Outlook
The stable outlook reflects our view that current labor tensions will be resolved and that lackluster economic performance will not affect South Africa's fiscal and external balance beyond our revised expectations.

We could lower the ratings if South Africa's business and investment climate weakens further, for instance if labor disputes fester. We could also lower the ratings if external imbalances continue to increase, or funding for South Africa's current account or fiscal deficits becomes more difficult or costly.

We could raise the ratings if an improvement in investment and economic growth prospects produces stronger government and external debt positions than we currently expect.