South Africa must get ready to make sacrifices to escape junk status

Konrad Reuss, S&P Global Ratings MD for sub-Saharan Africa and SA says that the country’s investment grade status recovery depends on reform of fiscal policy, public sector reform and the willingness of the South African population to take pain to achieve it.

Speaking at the GIBS Economic Outlook conference on Tuesday, he warned that the country has not recovered in a meaningful way since the global financial crisis in 2008. In his view, South Africa lags behind both the world and emerging markets.

“SA’s first challenge is to improve economic growth, but perhaps our larger challenge, given high levels of income inequality, is to make sure growth is equitable and has wide distribution that will reduce inequality. Improvements in income distribution are key measures of achieving inclusive growth, although we must go beyond traditional measures (GDP per Capita) to monitor progress.”

Soria Hay, head of corporate finance at Bravura, an independent investment banking firm, said: “Standard & Poor downgraded its credit rating for South Africa in November 2017 to BB (below investment grade). This decision by S&P led to South Africa being excluded from the Barclays Global Aggregate index, whose inclusion criteria requires investment grade rating on its local currency debt from any two ratings agencies.

“Fitch already downgraded South Africa’s credit rating to BB+ in April 2017, and this meant that South Africa was excluded from the Barclays index as well as the JPMorgan Emerging Market Bond Index Global.”

Moody’s meanwhile adopted a wait and see approach, and retained South African debt ratings at investment grade, but put it on review for downgrade.

“Moody’s said at the time that the review period will allow the rating agency to assess the South African authorities’ willingness and ability to respond to the rising pressures through growth-supportive fiscal adjustments that raise revenues and contain expenditures; structural economic reforms that ease domestic bottlenecks to growth; and improvements to SOE governance that contain contingent liabilities,” Hay said.

Hay noted that the finance minister is expected to announce plans to plug a R50 billion hole in revenues, and will also have to provide for other demands – such as free higher education for students from low-income households which is expected to cost up to R15-billion for this financial year.

“The plan to address these issues, and many more that weigh on the budget, will provide clarity as to whether South Africa’s credit rating is doomed to be further downgraded into junk territory – or if a grace period will allow for the country to prove it can turn its fortunes around.”

After the medium-term budget policy statement budget, Moody’s expressed concern, noting that SA’s interest payments ratio exceeds the median of its peer ratings group.

According to Moody’s, more than a third of all sovereign defaults occur when countries allow fiscal imbalances to persist, resulting in unsustainably high debt burdens. When they are no longer able to service or reduce their debt, downgrades invariably follow.

S&P Global warned that non-resident ownership of South African local currency debt was now at 45%. Hay explained why this poses a potential risk: “If both Moody’s and S&P downgraded South Africa’s local currency debt to junk, South African bonds would fall out of the Citigroup’s World Government Bond Index (WGBI), causing large international tracker funds to sell out of their holdings of such bonds.

“Ejection from the crucial bond indexes means passive investors mandated to invest in local bonds would automatically have to withdraw from those investments.”

Downgrades to sub-investment grade could trigger forced selling of up to as $14 billion of outflows, according to the Bank of America. “If Moody’s, also downgrades South Africa, then far greater losses on the rand can be expected. The rand could depreciate rapidly, causing inflation to increase, putting upward pressure on interest rates and downward pressure on economic growth,” said Hay.

S&P Global also expressed concern about the low growth environment in South Africa, and the economic inequality that exists in the country. Hay pointed out that the GDP per capita expressed in dollar terms has declined by 30% since 2012.

 GDP per capita (USD)

2012 2013 2014 2015 2016
$7 599  $6 704 $6 621 $6 065 $5 299

“We could raise the ratings if economic growth or fiscal outcomes strengthen in a significant and sustained manner compared with our base case. Upside ratings pressure could also rise if risks of a marked deterioration in external funding sources were to subside, in our view, and external imbalances decline.

“Upward pressure on the ratings could also develop were policy makers to introduce economic reforms to benefit job creation, competitiveness, and economic growth,” S&P Global said.

It warned that the average time that it takes a country to move back to investment grade after it has been down-graded, is 8.3 years; ranging from slightly more than a year for South Korea (between December 1997 and January 1999) to more than 19 years for the recent upgrade of Indonesia (between December 1997 and May 2017).

It also took an average of 8.3 years for the nine sovereigns in the rising star category to lose their investment-grade ratings. It took South Africa more than 17 years (between February 2000 and April 2017).

“South Africa will only through a concerted effort by government and business reach its full potential. To a very large extent, the private sector holds the key, but government holds the door,” Hay said.

Read: How South Africa’s wealth taxes have changed over the past 20 years

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South Africa must get ready to make sacrifices to escape junk status