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On Friday Moody’s became the last of the three major global credit rating agencies to downgrade South Africa’s local and foreign currency rating after President Zuma’s March 30th cabinet reshuffle. While Moody’s one-notch downgrade of both the foreign and rand-denominated debt ratings leaves both still in Investment Grade, the agency retained the outlook on negative.

Credit Ratings: Foreign vs Local Currency Debt

S&P Fitch Moody's
Foreign Local Foreign Local Foreign Local
Sep 15 BBB- (stable) BBB (stable) Sep 15 BBB (neg) BBB (neg) Dec 15 Baa2 (stable) Baa2 (stable)
Dec 15 BBB- (neg) BBB (neg) Dec 15 BBB- (stable) BBB- (stable) Jan 16 Baa2 (neg) Baa2 (neg)
Apr 17 BB+ (neg) BBB- (neg) Nov 16 BBB- (neg) BBB- (neg) June 17 Baa3 (neg) Baa3 (neg)
      Apr 17 BB+ (stable) BB+ (stable)      

 

They noted that the “negative outlook reflects Moody’s view that the risks to growth and fiscal strength arising from the political outlook are tilted to the downside.” They find it unlikely that a political consensus will emerge which supports investment in the economy and reinvigorates the reform effort sufficiently quickly to reverse the expected negative impact on growth and on the government’s balance sheet. In contrast, Moody’s sees the high risk that the opposite occurs. This would result in “heightened political dysfunction, continued gradual institutional weakening and diminished clarity over policy objectives.”

The key drivers Moody’s cited for the downgrade were:

  • The weakening of South Africa’s institutional framework
  • Reduced growth prospects reflecting policy uncertainty and slower progress with structural reforms
  • The continued erosion of fiscal strength due to rising public debt and contingent liabilities

Prior to the March cabinet reshuffle, it was possible to argue that the first point was debatable and that the latter two points were in the process of being reversed, helped by a more friendly global environment. Unfortunately the cabinet reshuffle has weakened the counter arguments to all three of these factors:

  • Institutional strength – The ability of the President to enact a cabinet reshuffle that he had repeatedly been warned would greatly damage the South African economy questions the strength of the checks and balances built into the country’s institutions.
  • Growth outlook – The damage to confidence will stunt fixed investment and consumer spending this year – thus damaging growth further. In addition, the rise in in-fighting within government suggests that any sensible outcome for the Mining Charter, or the resumption of Independent Power Producer Procurement Programme (IPP) signings is limited. If the relevant ministers produced a surprise positive outcome on both of these issues that would quickly boost fixed investment in South Africa in the second half of 2017, that could lead to the very quick wins that South Africa needs. Unfortunately, this seems unlikely.
  • Fiscal strength – Weaker growth will lead to lower fiscal revenues and higher debt levels. While progress is being made at the SABC, governance at South Africa’s biggest SoE, Eskom, remains questionable.

Governance is the root cause all of the recent downgrades

This is most starkly outlined by Fitch’s credit rating. Their quantitative methodology leaves South Africa firmly in investment grade at BBB. However they apply two qualitative downgrades that moves South Africa’s rating to sub-investment grade. These are for governance and the weak growth outlook.

In the table overleaf, we have summarized the factors that each of the agencies have cited as potential catalysts to stabilise/ upgrade South Africa’s credit rating, and the factors that could lead to further downgrades. These can broadly be summarised into:
a. growth factors,
b. fiscal strength (including state owned enterprises), and
c. institutional strength.

While the words used all differ slightly, they all point to the same thing. South Africa needs improved governance to stabilize the credit rating.

Fitch’s methodology points to two potential solutions to South Africa’s rating woes. The first option is a massive overhaul of governance at the most problematic State Owned Enterprises. The second would be for ministers to begin enacting growth–supportive economic policies – like a Mining Charter that would not immediately be indicted by industry or the resumption of the IPP programme. Either of these sets of actions could be enough to stabilise South Africa’s credit rating at both Moody’s and S&P for at least 12 months.

Forced selling of ZAR120bn

Without such a stabilisation, it seems likely that S&P will downgrade in November 2017 and Moody’s will follow by mid-2018. At that point, South Africa would be ejected from the Citibank WGBI, and this would result in an estimated ZAR120bn of forced selling.

Local deterioration offset by global inflows

In reality, the massive deterioration in South Africa’s outlook over the last two months has not been priced in as there has been massive inflows into emerging market debt and equity funds, which has totaled US$70bn since the start of 2017. Of this, debt funds have received US$37bn.

  S&P Fitch Moody's
Upgrade Downgrade Upgrade Downgrade Upgrade Downgrade
Growth
  • Shore up confidence
  • Provide policy certainty
Improvement in economic growth Elevated political risks which undermine confidence and growth A substantial strengthening in trend GDP growth Further decline in potential GDP – possibly due to sustained uncertainty about economic policy Enhanced medium-term growth prospects Further policy uncertainty that undermines economic growth & fiscal stabilisation – notably by the delay of growth enhancing reforms
Borrowing requirement
  • Contain expenditure
  • Commit to SoE governance
Stronger fiscal outcomes Elevated political risks that lead to policy shifts that undermine the fiscus – either through increased spending or further weakening of SOE governance and balance sheets A marked narrowing in the budget deficit and a fall in the debt/GDP ratio Marked increase in govt debt or contingent liabilities Stabilsation of the govt debt burden. A decline in the value of guarantees to SoEs would be credit positive Increased liquidity pressures at SoEs that require govt intervention – either through the activation of guarantees or other measures
Institutional Strength
  • Commit to independence of policy making
Reduction in political risks   An improvement in governance that is supportive of the business climate and public finances Rising net external debt levels that raise the probability of financing pressure Continued independence and maintenance of policy-making capabilities of key policy institutions Greater than expected deterioration in strength and independence of institutions

 

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