South Africa’s downgrading is no longer an “if” but a “when” – Citadel

By Mike van der Westhuizen, Portfolio Manager, Citadel

During his 2017 Medium Term Budget Policy Statement (MTBPS), Finance Minister Malusi Gigaba, announced figures that surprised even the most bearish of forecasters. Although some fiscal slippage was widely expected, it was the frank transparency with which he delivered his speech that sent the market into panic. There were few positives for him to hide behind.

A tax shortfall of R50.8bn for the 2017/18 fiscal year would translate into a budget deficit of 4.3% of GDP, a 1.2 percentage point slippage on the figures announced in Pravin Gordhan’s last budget speech in February. With limited room to cut expenditure and little talk of additional revenue measures, for now funding this deficit will need to be done through the issuance of more government debt.

In the February Budget, Treasury had aimed to stabilise the debt to GDP ratio at 52.9% by the end of fiscal year 2018/19, but this was revised upwards significantly in the MTBPS to 59.7% in FY2020/21, with the acknowledgement that it could rise above 60% in 2022. Compare this to Moody’s and S&P forecasts which had expected government debt ratios to peak at 53% and 54.9%, respectively over the medium term expenditure framework.

South Africa’s downgrading is no longer an “if” but a “when”. Both S&P and Moody’s have reviews scheduled for 24 November and, while their recent rhetoric has pointed to a wait-and-see until after the ANC elective conference approach, it would not be surprising to see at least one of them pull the trigger sooner rather than later. However, more likely, we could see South Africa’s local currency bond rating be put on review for a downgrade on 24 November, in which case the rating agency has 60 to 90 days to make the move, a period which covers both the ANC elective conference and February 2018 budget. In any case, the negative outlook from the prior downgrade (S&P on 3 April 2017 and Moody’s on 9 June 2017) needs to be resolved within 12 to 18 months, so a downgrade before the end of the first half of 2018 is inevitable.

As we head towards the December ANC elective conference the presidential race is wide open between the two front runners, Nkosazana Dlamini-Zuma (NDZ) and current deputy president Cyril Ramaphosa (CR17 as he has been dubbed). Without further clarity on who will next lead the ANC, the markets wait with bated breath. CR17 would be seen as the more market friendly candidate, while NDZ would be viewed as just an extension of the current president Zuma regime. With these two factions supposedly forming a rift in the ANC ranks, there is a slim chance that a compromise candidate could sneak in at the last minute.

Making a call on market reaction to either of the above two events is almost as difficult as predicting the outcomes of the events themselves. On the downgrade front, it can be argued that since the MTBPS the currency and bond markets have already priced in an imminent downgrade. Naturally the market could overreact to a confirmation that South Africa is officially sub-investment grade. In addition, if one was to factor in potential bond index exclusion from further downgrades, a large portion of the wall of money that has flowed into South Africa can just as quickly exit. This would almost certainly lead to further bond and currency weakness. On the other hand, we could see some short-term respite if the ratings agencies delay the fate.

On the political front, the market outcome could be seen as almost binary. A CR17 win could see a rally in the rand, bonds and SA facing equities, with arguably stronger reaction should the victory include a unified National Executive Committee (NEC). An NDZ win would spark the opposite, and it could be argued that the market has already priced in this status quo scenario to some extent.

Looking past the upcoming uncertainty, another wave of uncertainty will come unless bold steps are taken. The bottom line is that South Africa needs pro-growth economic policy that is ACTUALLY implemented and not just a regurgitation of a “wish list”. This would help to bolster the budget and the economy by sparking stronger revenue growth, purely from a resurgence in business and consumer confidence. Solve the low growth trap and a lot of other things fall into place. Regardless of what happens in late November and December, the road will remain bumpy until there is a unified ruling party. In the current politically sensitive landscape, real change looks unlikely for the time being.

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