Hope is not enough now that SA has felt the pull of the downgrade vortex
Junk status for foreign currency debt is bad enough but we will reap the whirlwind if local currency is relegated
Two years ago, on these pages, we warned that SA was on course to lose its sovereign investment grade credit rating (BBB-or above). Sadly, this projection has become reality. After the rating downgrades of a fortnight ago, two of the three main ratings agencies (S&P Global Ratings and Fitch) now rate the country’s foreign currency as subinvestment grade (BB+), with Fitch also rating the local currency as "junk".
Though this is a huge setback, worse may be to come as SA now faces the danger of losing its local currency investment rating by all rating agencies. This would be a much bigger blow, with the country likely to take years to recover from the dire consequences. As things are, heightened economic and policy uncertainty are likely to kick-start a chain of events that will further damage an already frail economy.
When bombarded with negative shocks, such as now, companies and consumers tend to turn defensive. We will see this in lower business confidence making companies even less inclined to invest and hire. This at a time when corporate fixed investment is already contracting in real terms and headcounts are barely growing. With the future now even muddier, predicting near-term sales will become that much harder. Consequently, production will be sacrificed in the interim, with inventories run down instead.
Consumers’ behaviour is bound to change, too. In response to a sure deterioration in the consumer mood and rising job insecurity, precautionary savings are likely to climb, hampering spending. Outlays on discretionary items will bear the brunt of more belt-tightening to come.
Compounding these developments will be the specific growth-constraining effects of the latest downgrades involving the government, state-owned enterprises (SOEs) and banks. With the resultant higher cost of new borrowings in foreign currency and rand terms, an ever-growing public sector interest bill (already R180bn a year and counting) will continue to sap the economy’s tax-generating capacity by absorbing funds that could have been used to boost GDP growth.
Banks have been downgraded, not through any fault of their own but simply because their ratings are capped by the sovereign’s (through the loans they grant the government and the concentration of revenues they derive from the local economy).
The resulting consequences will be more than just a drop in profitability and lower tax payments to the fiscus. To comply with Basel rules, banks will now have to keep more capital against the increased credit risk that comes with their lower-rated public sector debtors. More capital held for such purposes means less is available to sectors that want to grow and create jobs. On a geared basis, following the downgrades the pool of bank-wide loanable funds has just shrunk by about R80bn (or 2% of GDP).
There are some positive growth factors to consider though. Externally oriented sectors could gain from the rise in global growth, high commodity prices and the weak rand. In turn, a recovery in these sectors would also benefit others that have them as clients. A rebound in agriculture would help, too. Yet, these positive effects will be eroded by the damage to be done by the looming shock to confidence, fixed investment and consumer spending.
Against this backdrop, Finance Minister Malusi Gigaba faces a harsher landscape than the one the Treasury painted just two months ago. Then finance minister Pravin Gordhan tabled a budget based on GDP growth rebounding from 1.3% in 2017-18 to 2.1% in 2018-19.
With GDP growth rates conceivably to be half those the Treasury predicted in February, tax revenue will be hit hard
But this trajectory still required new tax adjustments to raise an additional R43bn in revenue, while the spending ceiling had to be lowered (again) by R52bn to ensure a budget deficit target of 3.1% of GDP in 2017-18, falling to 2.8% in 2018-19.
With GDP growth rates conceivably to be half those the Treasury predicted in February, tax revenue will be hit hard. Even if the tax multiplier recovers to above one (which is not guaranteed), such a growth shock would still lower initial tax-revenue estimates by as much as R40bn over the next two fiscal years. To stick to the original budget deficit and debt sustainability targets, the fiscal consolidation measures already in place will have to become even more aggressive. Failing this, the resultant fiscal slippage may well trigger more downgrades, potentially even resulting in the sovereign losing its local currency investment rating by all ratings agencies.
The timing of the latest downgrades has been fortunate. Not only is the world still flush with liquidity, but commodity prices have rebounded and domestically, the current account deficit has shrunk. A combination of these factors has boosted sentiment towards high-yielding emerging markets. Equally, since the government has very little foreign debt, the forced selling by investment grade-sensitive creditors as a result of SA’s exclusion from some hard-currency global bond indices isn’t going to run into billions of dollars. Against this backdrop, the muted reaction from financial markets thus far is understandable.
But even a continuation of some of these factors won’t prevent a more substantial market correction (and the severe real economy repercussions) that will follow should SA become junk rated in all respects. While now being excluded from some hard-currency global bond indices, SA still features in some major local currency ones, including the Citigroup World Government Bond Index (WGBI), where investment grade is a hard criterion for membership.
As such, should the government lose its local currency investment grade rating by S&P and Moody’s, and so be excluded from the WGBI, it could lead to forced selling and a "cliff effect" as investment grade-sensitive investors collectively sell bonds in a relatively short time.
While the exact size of the WGBI (and other) benchmarked funds is hard to come by, conservative estimates, including those from the IMF, point to an eye-watering R100bn to R120bn that could exit the local bond market in the event of exclusion. Absent other capital inflows, such a flow reversal would dramatically weaken the rand, necessitating a sharp increase in policy and, by default, prime interest rates.
A silver lining is that as the old investor base exits, new "high yield" investors will step in. But it’s difficult to see this readily and fully offsetting the rating-sensitive outflows without an adequate jump in bond yields (cheapening in the price of bonds).
SA’s inclusion in the WGBI in 2012 lowered the 10-year bond yield by about 100 basis points. If this was reversed, the direct first-round effect would raise the debt service bill by about R2bn per year. This may sound small relative to estimated consolidated government spending of R1.6-trillion in 2017-18, but R2bn could hire more than 6,000 teachers or nurses, or build more than 16,000 RDP houses.
Equally, it’s worth remembering that the government already spends more on servicing its debt than it pays, for example, on social grants. The second-round effects on growth and revenues, as well as on SOEs’ funding costs, will put more pressure on the government to borrow or raise taxes, while further impairing already fragile parastatal balance sheets.
When the government is already borrowing to pay interest, a rising debt service bill holds the potential to lead to an explosive debt trajectory in the absence of stronger economic growth. We could hope that the current benign global backdrop persists to mitigate the impact of such potential investment grade-sensitive bond outflows and so help to contain the debt ratio and lift revenues. But hope isn’t a strategy.
It’s not impossible that the government intensifies its efforts to regain investment grade status, but it won’t be painless or happen soon. History shows it takes, on average, seven to 10 years to regain investment grade status. It’s therefore clearly better to address the rating weaknesses earlier rather than later. The countries that managed to successfully claw their way back from junk status did so only by biting the bullet and deeply entrenching an ethos of fiscal discipline, while pursuing pro-growth reforms such as business-friendly policies and the restructuring of SOEs.
Consequently, there’s no need for SA to reinvent the wheel. The claw-back strategy is tried and tested. The main thing to do now is for Gigaba and his colleagues to stick broadly to the same credible formula followed by such countries and to some extent by Gordhan. To do so will be made more difficult by populist pressures and national general elections in 2019. But what needs to be done must be done, especially if cabinet ministers have the best interests of the country’s citizens and the next generation at heart, as they say they do.
• Le Roux is chief economist and Nel fixed income strategist at Rand Merchant Bank.