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:

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:

Efforts to arrest the increase in government’s debt burden
Confidence in stronger growth prospects
Labour market or power sector reforms
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