SA’s potential exit from Citi’s World Government Bond Index (WGBI) — a flagship measure of local-currency, investment-grade sovereign bonds from 23 countries — looms ominously on a 90-day time horizon. This remains a concern for SA — things could unravel quickly should the country’s exit trigger material capital outflows over the course of a few days.
SA has enjoyed mandatory monthly WGBI-related capital inflows since its inclusion in the index in April 2012. This has been particularly helpful given the deterioration in the economy and the ratings-downgrade cycle that commenced at roughly the same time.
A WGBI exit comes with a good dose of pain and means a country has been relegated firmly to noninvestment grade status
Five years and many downgrades later, SA’s local-currency (LC) rating is firmly in noninvestment grade "junk" territory with S&P (BB+) and Fitch (BB+), while Moody’s rating sits one notch above junk (at Baa3).
To exit the WGBI, a country’s LC rating needs to be downgraded to noninvestment grade by both Moody’s and S&P. On Friday, S&P downgraded SA’s LC rating into junk, but Moody’s chose to wait and see, placing SA on a 90-day credit watch. This means a WGBI exit still hangs over the country. If government doesn’t find a way to fix SA’s precarious fiscal position, Moody’s will downgrade us.
Exclusion from the WGBI is not something to be taken lightly as things get worse for a country’s financial standing when it loses a rating agency’s stamp of approval and its creditworthiness is compromised, thereby limiting investment and reducing liquidity.
If and when it occurs, exclusion from the WGBI is instantaneous, taking place at month-end. Had both agencies downgraded SA last week, its WGBI exit would have happened on November 30.
This suggests that, with a 0.44% weighting in the WGBI, SA’s exclusion could trigger an outflow of R80bn-R140bn over just a few days. However, it is hard to estimate the exact magnitude of forced selling by index trackers that would occur. These trackers replicate the performance of a market index, such as the WGBI — a type of investment known as "passive".
There is also likely to be a re-allocation of SA government bond holdings from investment-grade to noninvestment-grade funds in active investors’ portfolios, particularly given the current global search for yield. These inflows could counter some of the WGBI-related passive outflows so the ultimate impact on the rand would probably be less extreme.
The market response to Friday’s ratings action suggests exactly this: the fear of a WGBI exit was so pronounced that, even though in our view the ratings reviews were worse than expected, the dollar/rand strengthened from its initial weakening. The rand’s near-term moves will now probably be determined by the ANC’s December 2017 election result, with the markets refocusing on a potential WGBI exit only from January 2018.
When rand weakness occurs
Regardless of the magnitude of potential WGBI-related outflows, the implications are clear: rand weakness occurs, leaving imported goods more costly, inflation higher and interest rates probably increasing. All these variables ultimately lower economic growth.
With a WGBI exit still looming, government will have to do something big — and quickly. A WGBI exit comes with a good dose of pain and means a country has been relegated firmly to noninvestment grade status.
When Portugal was excluded from the WGBI in January 2012, its bond yields soared from 12% to 17%. However, within a month, yields settled back to 12% as
rescue packages were affirmed and five years later, the country looks set to return to major global bond indices.
This goes to show the power of austerity and rescue packages if a country is willing to adhere to them. Things can get better but it takes time and a lot of effort.
• Schoeman is Citibank’s SA economist