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Further into Junk

Outcome of rating:

  • Standard and Poor’s Global Ratings (S&P) affirmed its SA foreign-currency sovereign rating at BB- and kept its local-currency rating steady at BB, which reflects known weaknesses in the economy --- no change to its stable outlook on the rating

  • Moody’s downgraded both ratings to Ba2 and maintained a negative outlook, due to a further expected weakening in SA’s fiscal strength

  • Fitch downgraded both ratings to BB- and maintained a negative outlook to reflect high and rising debt, very low trend growth and extreme inequality

Reasons for rating decision:

  • The pandemic has intensified SA’s economic challenges and social obstacles to reforms --- lower capacity to mitigate the COVID-19 shock

  • Fiscal consolidation and the Economic Reconstruction and Recovery Plan face high implementation risk

  • Deterioration in debt affordability

  • Poor financial performance of state-owned enterprises (SoEs) --- exacerbated by crisis

  • Challenges to business environment --- labour market rigidities and unreliable power supply

  • Lofty expectations on freeze in government wage bill

Negative outlook reflective of:

  • Larger-than-forecasted deterioration in debt burden and debt affordability

  • Chance of additional financial demands from SoEs

  • Potential for higher interest rates

Rating agency forecasts

  • Moody’s expects the SA economy to contract by 6.5% in 2020 (Fitch: negative 7.3%) before recovering by 4.5% (Fitch: 4.8%) in 2021

  • Moody's sees the budget deficit expanding to 15.4% of GDP in fiscal year (FY) 2020/2021 (Fitch: 16.3%) before narrowing to 11.8% in FY2021/22

  • Moody’s expects the government debt ratio to reach 93.3% by FY2021/22 from 70.8% in FY2019/20

  • Fitch forecasts a rise in government’s debt ratio to 94.8% by FY2022/23

Triggers for negative ratings action

  • Materially faster rise in SA’s debt burden and further related pressures on debt affordability

  • Additional difficulties in implementing growth-enhancing reforms

  • Persistent shocks to primary expenditure or revenues

  • Sustained rise in the level or volatility of interest rates

  • Diminished access to funding at interest rates that would further endanger debt sustainability

  • Destabilising large net capital outflow

Trigger for positive ratings action

  • A rating upgrade is unlikely in the near future, given the negative outlook by Moody’s and Fitch

  • An outlook change to stable could occur on:

  1. Efforts to arrest the increase in government’s debt burden

  2. Confidence in stronger growth prospects

  3. Labour market or power sector reforms

  4. Agreement with labour unions on a wage deal that moderates future wage increases

Rating strengths

  • Well-regulated and resilient banking sector --- despite likely rise in credit losses

  • Fully flexible exchange rate regime

  • Favourable debt structure --- long tenure of 13 years and mostly denominated in local currency

  • Low share of foreign-currency denominated debt --- 11.8% of total government debt

  • Net external debt in line with peers

  • Very large local non-bank financial sector --- assets = 160% of GDP

  • Caps on foreign holdings contain external financing risks

  • Societal openness and smooth political changes

  • Effectiveness of core institutions --- judiciary and the central bank

Rand implications

  • Only five out of the 23 analysts surveyed by Bloomberg expected a rating downgrade, given the pending outcome of the ongoing government wage bill negotiations and the broad-based effect of COVID-19 on SA’s peer group

  • The rand temporarily spiked to R15.47/US$ --- hopes for an early dissemination of a viable COVID-19 vaccine has alleviated volatility in markets, prompting investors to participate in riskier asset classes, including the SA rand

  • Non-residents share of total local government bonds has fallen from a peak of more than 40% in early 2018 to 29% --- any outflows following the recent downgrade are likely to be small given previous outflows

Investment Implications

  • By definition, the rating downgrades further into junk status imply that holders of SA sovereign debt should include a higher risk premium in the valuation of the asset class to reflect a higher future risk of default --- however, international precedent has shown that ratings downgrades within the non-investment grade bracket is less consequential for sovereign yield levels than a downgrade from investment grade status to junk, as the latter move could have mandate implications for bond holders and, hence, trigger forced selling --- as such, SA’s exclusion from global bond indices after it was downgraded into junk status by Moody’s in March this year was of more importance to yields

  • In addition, the current downgrades happen against a general risk-on global backdrop, driven by the US election outcome and indications that the approval of efficient vaccines against the COVID-19 virus is not too far off --- this has ignited a global capital flow into risky asset classes, including emerging market bonds

  • Furthermore, the expectation that SA inflation is likely to sustainably remain below the mid-point of the inflation target (4.5%) in the coming years has provided a positive fundamental underpin for SA bond yields and assures attractive prospective real yields for investors in the asset class --- as such, we only expect a marginal negative effect on local yields, if any, due to the negative rating action

What does this mean for SA?

  • Higher borrowing costs for government will crowd out spending on much-needed social and economic programmes

  • A further knock to business sentiment could lead to lower rates of fixed investment, weaker growth and increased downward pressure on employment

  • A further negative bias on ratings could lead to a more depreciated currency --- higher cost of imported goods --- raised inflation and limited extent to which the SA Reserve Bank can keep monetary policy accommodative

  • On Moody’s scale, SA's sovereign rating is now in line with Brazil, but above Turkey (B2) --- on Fitch’s scale, SA ranks in line with Turkey and Brazil

  • At 234 points, SA’s five-year corporate default swap spread (CDS) is 263 points below the April 2020 COVID-19-related peak --- it is trading 60 points higher than Brazil’s CDS and 143 points below Turkey’s CDS

Further into junk - Nov 2020 (002)
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