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EDINBURGH — South Africa dodged a bullet when credit ratings agency Moody’s Investor Services put the country on review for a downgrade rather than reducing its status, as rival agency S&P and Fitch did, notes London-headquartered global newspaper, the Financial Times. This four-month reprieve creates an opportunity for the South African government to send a signal to the international community that it will undertake a political and economic overhaul. International investors are asking why Moody’s rates South Africa more favourably than Argentina and Ukraine, which both have reform programmes. Yields on South African bonds reflect the assumption that a Moody’s downgrade is on the way. The South African government and investors may think none of this matters, with bonds and the currency recovering after former finance minister Pravin Gordhan was fired. But look beyond the short term opportunities to buy, as respected economist Dr Azar Jammine of Econometrix has, and it is evident that the S&P and Fitch teams have given up on South Africa for now. – Jackie Cameron
Dr Azar Jammine*
- The outcome of the credit ratings reviews by S&P and Moody’s revealed a mixed result. S&P did indeed downgrade the credit rating on South Africa’s local currency debt to junk status, but Moody’s has deferred its decision to do so until after next year’s Budget. As a result, the worst-case scenario of South Africa falling out of key world government bond indices in such a way as to precipitate a huge outflow of capital from sales of domestic bonds, has been averted for the present. The earliest date at which such an outcome can now materialise is March next year.
- Essentially, S&P has given up on South Africa being able to restore its fiscal strength and promote higher economic growth over the next few years, whereas Moody’s seems to have given the government an urgent opportunity to undertake the structural reforms needed to promote higher economic growth and alleviate the fiscal deterioration. The latter rating agency also seems to give greater credence to the importance of having deep financial markets, a stable and sound banking system, a solid spread of maturities for government debt, as well as deriving the benefits of having a freely floating exchange rate and democratically-oriented institutions. S&P in contrast has taken the view that irrespective of the ANC’s presidential electoral outcome, there are likely to be huge impediments to undertaking reforms that might improve the economic growth and fiscal outlooks.
- The uncertainty surrounding the possibility of further credit ratings downgrades and South Africa falling out of world government bond indices, therefore remains in place. In such a situation, the Rand is likely to remain under pressure, but not to collapse. The one ray of hope that we see is that real economic growth might surprise on the upside and as a consequence could serve to prevent the worst-case scenario materialising in 2018.
Both views on credit ratings downgrades have been partially vindicated
Clients will be aware of the uncertainty with which we have been looking ahead for several months at the S&P and Moody’s credit ratings and reviews which were due to be released on November 24th. Over this period we were arguing that there was a very high probability of the credit rating on S&P and Moody’s local currency debt ratings being downgraded to junk. However, we were uncertain as to whether or not these ratings agencies would give the country the benefit of the doubt and wait to see what panned out in the ANC’s electoral conference in December and the subsequent policy adjustments that this might bring forth, before taking the final action in downgrading. We had argued that ratings agencies that had already placed the outlook on South Africa’s credit rating to negative, had 12 months in which to either go ahead with a downgrade or restore a stable outlook.
This meant that S&P had until April to make up its mind and Moody’s until June. In the event, S&P seems to have decided that there is no point in holding off a ratings downgrade to junk despite not yet knowing for certain what the outcome of the ANC’s electoral conference might bring, whilst Moody’s has decided instead to place the country’s rating on review. It has been fairly transparent in suggesting that it wishes to see what the electoral outcome might be and subsequently to wait to see what measures are announced in the February 2018 Budget before deciding whether to join S&P in downgrading South Africa’s local currency debt.
As we have frequently argued, a junk status rating for local currency debt by both the S&P and Moody’s would precipitate South African government bonds having to fall out of key world government bond indices. Such an event would lead to tracker funds which base their asset allocation on the breakdown of the various world government bond indices being driven to sell out of South African government bonds.
The resultant outflow of funds could amount to over R100bn, or even R150bn, leading to a rapid depreciation of the Rand’s exchange rate, with inflationary consequences and potential upward pressure on interest rates. This could damage economic growth still further, thus exacerbating the ability to raise sufficient government revenue to reduce the budget deficit and constrain the increase in the public debt.
S&P has given up hope of an early restoration of fiscal strength, Moody’s hasn’t
On Thursday last week Fitch credit ratings agency had left its credit ratings at one notch below investment grade (ie the best junk rate rating) in respect of both foreign currency debt and local currency debt. Encouragingly, however, it maintained the stable outlook assigned to South Africa’s credit ratings. In the case of S&P, it maintained the one notch differential between the rating of foreign and local currency debt even while reducing the rating on local currency debt to junk status.
This meant revising down its rating on South Africa’s foreign currency debt to two notches below investment grade, thus allocating the worst rating of all to this form of South Africa’s credit rating. On the other hand, so long as Moody’s persists with keeping South Africa on review rather than going ahead with a further downgrade, its rating on both local and foreign currency debt remains at the lowest rung of investment grade just above junk status. The difference between S&P and Moody’s in deciding whether or not to go ahead with downgrading South Africa’s debt to junk status lies in the fact that S&P appears to have given up even bothering to wait until the outcome of the ANC’s electoral conference before going ahead with its decision.
Essentially, S&P has decided that no matter what the outcome of the presidential election, South Africa is going to struggle to restore the strength of its fiscal position. In the case of all three ratings agencies, three main problems manifest in South Africa’s fiscal situation. Firstly, because of the low rate of economic growth and the downward revisions of growth forecasts over the past year, including by all three ratings agencies, the projected growth in government revenue is just too low to accommodate a reduction in the budget deficit in the face of difficulty in reducing government expenditure due to social pressures. Secondly, there is deep concern about the possible liability for government emanating from poor corporate governance and low or negative returns at state-owned enterprises (SOEs). This might exert further upward pressure on South Africa’s debt metrics should guarantees granted to the SOEs by government be called up.
Thirdly, worries continue that economic growth remains unacceptably low and that under such circumstances fiscal consolidation requires dramatic action to curtail expenditure, a required development which is unlikely to be forthcoming. The difference between S&P and Moody’s is that the former believes that no matter what the electoral outcome in December, whoever succeeds president Zuma as leader of the ANC will be unable to effect structural changes to ameliorate the country’s fiscal situation for a long while.
In contrast, Moody’s suggests that if it sees sufficient action to address structural weaknesses in the economy being taken by a new leadership in the aftermath of such an electoral outcome, it might yet hold off a downgrade to junk. In this regard, the forthcoming February 2018 Budget is obviously perceived by the agency as being the litmus test of required action to improve the fiscal situation. Clearly, the agency is still providing a ray of hope that an appropriate new leader of the ANC will bring about changes in the structure of the economy and manifest the intention to effect such changes in next year’s Budget in such a way as to give a renewed sense of hope that some action is being taken to prevent the public debt from getting out of hand.
Several negative structural features identified by S&P
Similar structural weaknesses in the South African economy are identified by all three credit ratings agencies. The aspect of unacceptably low economic growth goes without saying. S&P picks up on this by arguing correctly that capital investment remains unacceptably low and this is likely to constrain an improvement in economic growth in the longer term. It argues further that even though there have been encouraging signs of an improvement in the country’s trade balance, this has less to do with increased competitiveness from an export point of view and more to do with an unwillingness to increase capital investment, leading to a lower rate of growth in imports of capital equipment.
In other words, the improvement in the balance of trade and a reduction in the current account deficit are a function of economic weakness rather than strength. Part of the reason also why S&P seems to have given up on South Africa’s being able to address its structural weaknesses, lies with the labour market situation. Clearly S&P does not foresee any major amelioration in the standoff between the stance of employers and that of workers in the economy, no matter who leads the country. One reads into the agency’s stance a perception of the ideological divide between market-friendly and interventionist policies persisting.
Finally, S&P highlights the difference between South Africa and other emerging markets in tackling inequality. It argues that whereas other similar countries have made some inroads into reducing inequality, this is not the case with South Africa where such inequality has been exacerbated. We have frequently suggested that the causes of this lie in the very poor outcomes of the domestic educational system which leaves such a high proportion of the workforce unable to command a job, or alternatively not to be able to perform a job that adds sufficient value to accommodate remuneration of a level that will allow for reduced inequality. Furthermore, the concentrated structure of the private sector, with so much power residing in the hands of big rather than small business, also constrains the ability of the economy to reduce inequality.
Fortunately, some positive structural attributes re-emphasised by Moody’s
On the other hand, as was the case with Fitch’s credit rating review on Thursday, Moody’s did at least re-emphasise some of the positive features of the South African economy which still justify an investment grade rating.
These include the depth of its financial markets, the strength of its banks, the well-diversified maturity spread of its government debt, as well as the fact that the country operates on a flexible exchange rate regime which can insulate the economy from the worst ravages of exchange rate depreciation.
Moody’s also draws attention to the ongoing strength of many of the country’s institutions such as the judiciary and other vibrant democratic non-governmental organisations. The presence of such institutions provides it with confidence that the country can indeed tackle its fiscal challenges under the right circumstances. In the case of S&P, even though the organisation acknowledges the persistence of institutional strength, it nonetheless points out various areas of deterioration in this attribute.
The most important of these is the manner in which S&P expresses its alarm at the deterioration of the ability of the South African Revenue Services to collect taxes. Nonetheless, one derives some encouragement from the fact that the credit ratings agencies are still prepared to acknowledge some residual strengths in the economy. The most important of these would appear to be the ongoing independence of the Reserve Bank in the implementation of monetary policy, something which is not prevalent in many other emerging markets.
Uncertainty to continue prevailing, but with a strong message to forthcoming president of the ANC
The mixed nature of the credit ratings reviews by S&P and Moody’s unfortunately leaves continued uncertainty in the outlook for the country’s credit ratings and through this for financial markets in the next few months.
This is not disastrous and has at least allayed the worst-case scenario for the present, but can unfortunately not eliminate the possibility of such a scenario still materialising through the course of 2018. As a result, it is unlikely that the Rand can make significant gains in coming months. Instead, the currency might experience a continuation of bouts of significant weakness as some bondholders increasingly anticipate the country’s bonds having to fallout of world government bond indices.
Essentially, it suggests that the Rand will trade somewhere between R14 and R15 over the next few months, without eliminating the possibility of a much more substantial depreciation in the event that Moody’s does go ahead with downgrading the country’s local currency credit rating in March. Under such circumstances, there is little chance of domestic interest rate relief, but at least it does mean that the Reserve Bank will be reticent to increase interest rates.
What if economic growth does turn out to be stronger than previously anticipated?
There is a final point worth making on a more positive note. In recent weeks and months we have increasingly pointed to the possibility that real economic activity might after all turn out to have been stronger than anticipated.
We have argued that, contrary to the fact that economic growth forecasts have progressively been downgraded in recent years in each important budgetary presentation, it is not inconceivable that for a change we might find a situation in which the government, as well as analysts, begin to revise economic growth forecasts upwards. In their latest credit ratings reviews, all three ratings agencies downgraded their forecasts for South Africa’s economic growth by a good few decimal points for both 2017 and 2018.
We are now increasingly posing the question as to whether or not the 0.6% to 0.7% prevailing forecast for economic growth in 2017 and the 1.0% to 1.2% growth forecasts for 2018, might not turn out to be unduly pessimistic. In the event of this suspicion turning out to have been correct, it is just conceivable that the ratings agencies will recognise that the deterioration in the country’s fiscal situation might not turn out to be as aggressive as currently anticipated. In the case of Moody’s, at the margin, this might assist in the agency staving off downgrading the country’s credit rating to junk in March.
Under such circumstances, the worst-case scenario of South Africa falling out of key world government bond indices might yet be avoided. However, common wisdom suggests that the probability of such a positive outcome is less than 50%.
- Dr Azar Jammine is the chief economist at Econometrix.
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