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The Impact of South Africa’s Credit Rating Downgrades

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A lacklustre 2016, which saw South African GDP shrink by 0.3%, has been followed by a series of political own goals in 2017. The disastrous cabinet reshuffle, which culminated with the axing of finance minister Pravin Gordhan, ended with the inevitable rating downgrades. Days after the dismissal of Gordhan, both Fitch and Standard & Poor’s downgraded South Africa’s credit rating to BB+, a non-investment grade, which may have severe implications for the South African economy.

The short-term impacts of this have already resulted in an increase in public borrowing costs, and the pressure on public funds is magnified by lower than projected GDP growth. In the medium to long term, a number of other scenarios may play out, including further increased borrowing costs and currency impacts.

The ratings downgrades may also jeopardise key public infrastructure projects and lead to further losses in investor confidence, which has plunged from the buoyant levels seen throughout 2013 and 2015.

As it stands, South Africa currently sits at the bottom of the AT Kearney global FDI Confidence Index and risks losing its place in the index altogether. Further downgrades would see South Africa dropped from widely used global bond indices, with JP Morgan already having removed South African bonds from their own. 

Regaining investment status for South Africa is certainly no formality and looks very unlikely to occur without sweeping political changes. While Brazil took 12 years to regain its investment status, a quick comeback is certainly possible, as shown by Thailand and South Korea who both recovered in under two years. 

Unfortunately, the ripple effects of the potential investment flight from South Africa and hits to the country’s infrastructure may also threaten the growth prospects of neighbouring nations. However, perhaps most galling of all, is that it was all self-inflicted.

Download the full report here.


The economic and political backdrop to the cuts

South Africa faced a challenging year in 2016, as soft commodity prices, poor domestic demand and excessive unemployment stymied economic growth. While the rand made considerable, albeit unsteady, gains in 2016 having depreciated in December 2015 after President Jacob Zuma removed Finance Minister Nhlanhla Nene from office, political turmoil continued to affect South African stability last year. In November 2016, both Moody’s and Fitch kept South Africa’s credit ratings marginally above investment grades, but were acutely aware of domestic risks from political uncertainty and a poor business climate.

Following a lacklustre end to 2016, which saw South African gross domestic product (GDP) contract by 0.3%, many analysts were hoping for a bounce-back in early 2017. In contrast, it has been a turbulent start to the year for Africa’s third largest economy1. In late March, following repeated political rifts, President Zuma dismissed Finance Minister Pravin Gordhan and uprooted 19 others within his cabinet.

Gordhan was respected as a stable, judicious economic leader, and his dismissal once again undermined South Africa’s fragile economic outlook. The action triggered rating agency Standard & Poor’s to lower South Africa’s sovereign credit rating down a step from BBB- to BB+, sending the country into noninvestment, or ‘junk’, territory. Days later, fellow rating agency Fitch followed suit, downgrading to the same level. 

The rationales for the moves were similar: Fitch noted ‘recent political events, including a major cabinet reshuffle, would weaken governance and could compromise the state of public finances’2. Standard & Poor’s similarly cited the threats to investor confidence, economic outlook and the risks of further budgetary slippage3.  While Fitch cut both foreign and local currency ratings to non-investment grade, Standard & Poor’s rated South Africa’s local currency one step above junk at BBB-. Meanwhile, Moody’s decided to hold South Africa’s credit rating on review until later in the year. 

With regards to economic growth, South Africa fell well short of expectations at the start of 2017. With the country still reeling from the ratings downgrades, it was confirmed in June that South African GDP had contracted by 0.7% in Q14. The significant fall in GDP, driven by weak manufacturing and trade performance, meant South Africa had plunged into its first technical recession since the financial crisis.

Shortly following this news, Moody’s cut South Africa’s credit rating to Baa3, one step above non-investment grade, and assigned a negative outlook to the nation. The drivers of the downgrade were ‘weakening institutional outlook’, ‘reduced growth prospects’, and ‘erosion of fiscal strength’5.

Observed public impacts of the rating downgrades

The downgrades have triggered a number of short-term impacts.

Currency depreciation

Prominently, the cut to junk status caused a sharp depreciation of the rand against the US dollar. After reaching a 20-month high in late March, the currency lost 13% against the US dollar within a week. Currency devaluation may lead to increased export competitiveness, and could attract investment, but equally may push up inflation through raising the cost of imports. However, many of the key advantages
of the depreciation are undermined by political instability, the root of the devaluation. Furthermore, the volatility of the rand may further weaken investor confidence.

FX_Rate_ South_African_rand_per_ US_dollar

Increased public borrowing costs

Secondly, the downgrades increase public borrowing costs, acting like an interest rate rise for the government. The yield on bonds surged immediately following the cuts, increasing future public financing costs. As highlighted by the rating agencies, the state of South African public finances is already precarious, with large amounts of funding devoted to state-owned enterprises (SOEs) such as Eskom, the subject of a recent energy sector scandal with the government. The pressure on public funds is further magnified by lower projected GDP growth as this will decrease tax receipts, potentially leading to a revenue shortfall for the Treasury.

Political pressure

The downgrades also compounded pressure on Zuma, who has been heavily criticised as irresponsible for undermining the country’s economy by mismanaging his cabinet. Immediately following Standard & Poor’s move, the country’s largest union called for the President to step down. Divisions in the ruling African National Congress (ANC) have deepened since the cabinet reshuffle and downgrades. Such tensions may limit the Treasury’s ability to deny public spending, with single-interest groups and departments unlikely to accept cuts, which could lead to fiscal irresponsibility6. This serves as a risk to structural reform, and also continues to weaken hopes of stable governance, all of which are acting as deterrents to potential investment.

Potential future impacts of the ratings downgrades

While a number of short-term consequences have already been observed, in the medium and long-term a number of other scenarios may play out. These consequences are likely to be driven by the already observed impacts following the downgrades, chiefly increasing borrowing costs and currency impacts. 

As mentioned, the sovereign downgrades directly correspond to an increase in government borrowing costs. These increased costs will naturally filter through to the wider economy. Higher rates for government lending raise the risks of fiscal slippage and act as a disincentive to long-term public spending. 

Public infrastructure projects at risk

In avoiding the fiscal problems associated with raised borrowing costs, it is likely the Treasury may have to rein in spending on much-needed national infrastructural projects. 

Therefore, the downgrades may jeopardise key public infrastructural projects. Gordhan’s final budget earlier this year laid out plans for heavy investment into national infrastructure, such as roads and telecommunications, alongside continued commitment to large SOEs such as Eskom and Transnet7. Prominently, in the energy sector, the government had continued to back plans for a number of power stations through Eskom. However, the rating agencies note that government guarantees to SOEs result in large contingent liabilities for the Treasury. In order to avoid further fiscal slippage, it is clear the government must mediate some of this spending.

Key infrastructure projects which stand to be either postponed or cancelled altogether include allocations for R10.8 billion into provincial roads, R1.9 billion for high-speed internet rollout, and R16.7 billion for Metrorail trains, outlined in Gordhan’s budget8. There has been a conspicuous lack of commitment to these projects since Gordhan’s departure. It is also likely the construction sector will be hit by the impacts o on infrastructure, compounding the negative outlook for the sector9.

Loss of foreign investor confidence 

Infrastructure development may also be affected from the downgrades due to an erosion of investor confidence. In recent years, South Africa has been an attractive destination for foreign direct investment (FDI), benefitting key industries such as the energy sector. Over 2016, South Africa saw a 38% rise in FDI annually10. However, given the downside risks associated with a junk credit rating and current instability, investors may look to move to more reliable markets. South Africa currently sits at the bottom of the AT Kearney global FDI Confidence Index11, and is vulnerable to losing its place on the Index altogether.

There are precedents for the current situation in South Africa, with the country’s credit rating having been in junk territory before, prior to 2001. At the time, the prime lending rate – the lowest interest rate commercial banks can charge loan customers – rose to 24.5%, a significant barrier to consumer credit. While the prime lending rate currently stands at 10.5%, there is still likely to be an impact on the consumer side of the economy, although probably through more indirect effects. Even a slight increase in the prime lending rate may significantly squeeze households. This may have an important effect on the housing market, as any rise in the prime lending rate would result in higher monthly mortgage payments, pressurising the already-squeezed middle class. 

South African Sovereign Bond Credit Ratings

South Africa dropped from global indices 

One of the most important implications of the downgrades is the risk that South Africa could be dropped from widely used global bond indices. If Moody’s were to downgrade South Africa by a single step, this would leave the country’s sovereign debt labelled as junk by all three major rating agencies. If this occurs, it is unlikely the country will remain in leading bond indices, which require investment-grade ratings. If the country were to lose such membership of these indices, funds that track them would be forced to sell off holdings of South African bonds. Already, JP Morgan has removed South African bonds from its indices12.

Other ratings downgrades have similarly resulted in large hits to bond markets. In 2015, Brazilian bonds dropped sharply after Standard & Poor’s moved the country to non-investment grade13. Foreign investors hold around 36% of South Africa’s local government bonds; an estimated $15 billion worth of investment funds is particularly at risk of flowing out of the country. Such flight would exert more downward pressure on the rand, weaken availability of public funds, and further worsen the economic outlook of the country.

In terms of South Africa’s possible recovery to investment grade, the precedents paint a mixed picture, but indicate that regaining investment status is no formality. Russia’s downgrade to junk grade in 1996 was followed by two years of economic contraction, and it did not regain investment status until 2004. Brazil similarly took 12 years to regain its investment grade after it was cut to junk in 1994. Yet, a quick bounce back is possible, as shown by Thailand and South Korea, both recovering to investment grade less than two years after downgrades. Perhaps worryingly, the South African downgrades did not come as shocks, but were the culmination of long-standing economic and political problems, neither of which will be quickfixes but must surely be prerequisites for ratings to be upgraded.

Projected economic consequences

The downgrades have compounded the precarious position of the South African economy. Having plunged into recession in quarter one, and with public finances coming under increased scrutiny, the timing could scarcely have been worse. Political instability continues to mire the South African economy. As this report has outlined, it is inevitable that there will be negative impacts spread across many aspects of the country’s economy.

Prominently, by raising government borrowing costs, key infrastructural projects are at serious risk, investment is likely to weaken, and longterm economic goals may be undermined. The downgrades also raise serious question marks over structural and social reforms needed to address the key problems facing the South African economy, such as high unemployment and inequality. Studies of other ratings downgrades suggest there will certainly be negative consequences for South African growth; the main question will be the extent of the damage caused. 

There are also likely to be spillover effects into the wider African economy. Together making up over a third of total African GDP, Nigeria and South Africa are now both rated with non-investment grades. The ripple effects of potential investment flight and hits to infrastructure may threaten the growth of neighbouring nations too. The IMF forecasts South African GDP growth of 1% over 2017, a slightly more pessimistic projection than Fitch’s 1.2% 2017 forecast. Given the substantial downside risks raised by the downgrades, there are serious doubts as to whether South Africa can bounce back strongly from this growth level in the coming years.

Projected economic consequences

The downgrades have compounded the precarious position of the South African economy. Having plunged into recession in quarter one, and with public finances coming under increased scrutiny, the timing could scarcely have been worse. Political instability continues to mire the South African economy. As this report has outlined, it is inevitable that there will be negative impacts spread across many aspects of the country’s economy.

Prominently, by raising government borrowing costs, key infrastructural projects are at serious risk, investment is likely to weaken, and longterm economic goals may be undermined. The downgrades also raise serious question marks over structural and social reforms needed to address the key problems facing the South African economy, such as high unemployment and inequality. Studies of other ratings downgrades suggest there will certainly be negative consequences for South African growth; the main question will be the extent of the damage caused. 

There are also likely to be spillover effects into the wider African economy. Together making up over a third of total African GDP, Nigeria and South Africa are now both rated with non-investment grades. The ripple effects of potential investment flight and hits to infrastructure may threaten the growth of neighbouring nations too. The IMF forecasts South African GDP growth of 1% over 2017, a slightly more pessimistic projection than Fitch’s 1.2% 2017 forecast. Given the substantial downside risks raised by the downgrades, there are serious doubts as to whether South Africa can bounce back strongly from this growth level in the coming years.

1 IMF Economic Outlook Database.
2 https://www.fitchratings.com/site/pr/1021851. 3 http://ewn.co.za/2017/04/03/read-the-full-standard-and-poors-statement-south-africa-credit-rating-junk-status.
4 Uhttp://www.statssa.gov.za/?p=10005. 5 https://www.moodys.com/research/Moodys-downgrades-South-Africas-rating-to-Baa3-and-assigns-negative--PR_367769.
5 https://www.moodys.com/research/Moodys-downgrades-South-Africas-rating-to-Baa3-and-assigns-negative--PR_367769.
6 https://businesstech.co.za/news/columns/176567/what-will-happen-if-south-africa-is-hit-with-more-downgrades/.
7 http://www.gov.za/SPEECHES/MINISTER-PRAVIN-GORDHAN-2017-BUDGET-SPEECH-22-FEB-2017-0000.
8 http://www.gov.za/SPEECHES/MINISTER-PRAVIN-GORDHAN-2017-BUDGET-SPEECH-22-FEB-2017-0000. 9 https://www.pressreader.com/south-africa/the-mercury/20170517/282140701307924.
10 UN Global Investment Trends Monitor http://unctad.org/en/PublicationsLibrary/webdiaeia2017d1_en.pdf. 11 https://www.atkearney.com/gbpc/foreign-direct-investment-confidence-index.
11 https://www.atkearney.com/gbpc/foreign-direct-investment-confidence-index.
12 http://www.reuters.com/article/safrica-bonds-jpmorgan-idUSL1N1HF0LY 13 https://www.bloomberg.com/news/articles/2017-04-04/brace-yourself-what-the-s-p-downgrade-means-for-south-africa.
13 https://www.bloomberg.com/news/articles/2017-04-04/brace-yourself-what-the-s-p-downgrade-means-for-south-africa.

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