SA’s $8bn problem if local debt is downgraded

Two of the primary global credit rating agencies (Standard & Poor’s and Moody’s) are due to announce the outcomes of their review of the respective credit ratings of South Africa on Friday evening, 24 November 2017. Depending on the result, there could be far reaching effects on both the rand and local government bonds.

Fitch’s announcement on Thursday was less significant though, as the agency has already assigned a sub-investment grade local currency credit rating to South Africa. In addition, the rating assigned to a country by Fitch is not a determinant of a country’s bonds in the Citigroup World Government Bond Index (“WGBI”).

The WGBI is the most used global bond index for both indexation and benchmark purposes and requires at least one rating agency between S&P and Moody’s to assign an investment grade credit rating to the local currency government bonds for inclusion in the index.

Current situation

Following the cabinet reshuffle on 31 March 2017 and subsequent political events, all three the major rating agencies reacted by downgrading their credit ratings of South Africa as follows:

DescriptionS&PFitchMoody’s (S&P equivalent)
Foreign currency international scale ratingBB+BB+BBB-
OutlookNegativeStableNegative
RankingSub-investmentSub-investmentInvestment
Local currency international scale ratingBBB-BB+BBB-
OutlookNegativeStableNegative
RankingInvestmentSub-investmentInvestment
Date of last rating action3 April 201723th November 20179 June 2017

Table 2: Ratings assigned as at 20 November 2017

Outlook

Following the delivery of the medium-term budget speech (MTBPS) by Finance Minister Malusi Gigaba on 25 October 2017, all the major rating agencies expressed concern regarding the deteriorating finances of the South African government. These concerns stemmed from the slippage in fiscal revenue and resultant increase in the forecast budget deficit.

Historically, the government has targeted gradual fiscal consolidation in the medium-term, which provided the rating agencies with a sense of comfort on the finances of the government. However, during this MTBPS, National Treasury forecast that the budget deficit would remain fixed at c.3.9% over the next three years, resulting in government debt to gross domestic product (GDP) continuing to increase to over 60% of GDP by 2021. This presupposes that no remedial action is taken of which none were proposed in the MTBPS.

The lack of a concrete plan to remedy the situation was one of the primary differences between this MTBPS and those of other finance ministers, and that has greatly contributed to the slippage in the bond yields and exchange rates.

Although most market commentators expected a downgrade to the South African credit rating, most anticipated this to occur following the ANC elective conference in December 2017 and the delivery of the full budget in February 2018. However, the recent statements by the credit rating agencies have raised the probability of further rating downgrades occurring on Friday.

Possible outcomes

The announcements on Friday have four notable outcomes:

  • Neither Moody’s or S&P takes any further action on the South African credit rating;
  • Moody’s downgrades the local currency and foreign currency international scale rating from Baa3 (BBB- S&P equivalent) to Ba1 (BB+ S&P equivalent), while S&P’s rating remains unchanged;
  • S&P downgrades the local currency international scale rating from BBB- to BB+ while Moody’s rating remains unchanged; or
  • S&P downgrades the local currency international scale rating from BBB- to BB+ and Moody’s downgrades the local currency international scale rating from Baa3 to Ba1.

Possible bond yield movements

Our base case scenario is that the agencies will either place the rating on review for downgrade or pause until post February next year, making the double downgrade by both agencies a lower probability event. We do, however, expect a downgrade by both before June of next year unless we see significant alterations in policy and the local economic forecasts.  

For each of the above outcomes the market would react differently. By far, the worst outcome would be if both S&P and Moody’s cut the local currency rating to sub-investment grade. South Africa would then fall out of the WGBI and the funds tracking this index as a benchmark would become forced sellers.

The magnitude of this forced selling is difficult to determine, but could be as high as $8 billion (R112 billion at R14.00 exchange rate).  While we believe that most yield reaction of the downgrade to junk has already occurred, we would not be surprised if the benchmark R186 Government Bonds experiences a further sharp selloff to 9.85% or even higher over the short-term.

Historically, yields have recovered in the weeks and months post a downgrade to junk status and it is likely that we would see a similar effect. What could hamper this, however, is the political and policy uncertainty that is likely to remain until the budget next year February.

A short-term relief rally of 25 basis points or so would, however, probably materialise if we retain our position in the WGBI post the ratings release on 24 November.

Over the medium-term, the primary factor determining where our yields settle will be the global backdrop and the risk on/off appetite. South African rates have benefited from the search for yield that was exacerbated by quantitative easing (QE) policies that followed the global financial crisis. The risk is that the unwind or tapering of the QE could disrupt the inflows.

Given that South African bonds currently yield in excess of CPI +5%, we at Ashburton Investments remain fairly constructive on bonds for as long as global inflation remains under control and central banks globally taper their buying programs very gradually.

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