Almost every South African will be aware that the international credit ratings agency, Standard & Poor’s (S&P), has downgraded our long-term foreign currency sovereign credit rating to sub-investment grade, commonly known as “junk status”. This has more recently been followed by a downgrade to sub-investment grade by a second credit ratings agency, Fitch.
What are credit ratings and what does ‘junk status’ really mean?
Countries, much like individuals, have a certain level of income and they need to spend that income on various expenses like infrastructure, medical care, the police and defence forces, social grants, education and government salaries.
The main source of income for a country is taxes. If countries spend more than they earn from taxes then they need to borrow money. Instead of borrowing from a bank, a country borrows by issuing bonds. A bond is a loan agreement where the issuer of the bond agrees to pay the lender an agreed rate of interest, for a fixed term and then to repay the loan amount in full at the end of the term.
Government bonds are a key asset class for investors. As such, an investment portfolio is almost guaranteed to include a portion that is a loan to the South African government. Investors in bonds need a way to assess whether a particular country is going to be able to honour its commitments, in relation to repayment of this debt. This assessment is done by way of credit ratings. There are three main credit ratings agencies internationally – Moody’s, Fitch and S&P. The credit rating process is no different to a credit assessment that a bank might perform on you when you apply for a loan.
If a country is a really good creditor and there isn’t any meaningful risk that the country will default on its debt then the country will get an investment grade credit rating.
Countries whose finances are not as well managed and that consequently have a higher chance of defaulting get a sub-investment grade or junk grading. As the name sub-investment suggests, these bonds are considered below investment grade or of inadequate quality or junk.
The lower a government’s credit rating the higher the interest rate they will pay on any amounts they wish to borrow. This is because lenders will be more concerned that they will not be repaid in future so they demand a higher rate of interest.
An important distinction is that a country will typically issue local currency bonds (i.e. issued in rand) as well as foreign currency bonds (US Dollars or Euros or other). Most countries have a large proportion of local currency bonds and only a small proportion of foreign currency bonds. The ratings agencies rate these two types of bonds separately and their respective ratings at any point in time may be different. The local currency rating is more important.
After this downgrade S&P has a rating of investment grade for our local currency bonds and sub-investment grade on our foreign currency bonds. Fitch downgraded both our local and foreign currency bonds to junk.
It’s also important to note that there are many different levels of credit rating and even within the sub-investment grade levels, there are varying degrees of ‘junk’. South Africa has slipped just below investment grade so we are effectively right at the top of sub-investment grade. There are many countries who are at lower levels than South Africa. We are also nowhere near the level of an actual default, which really would be a catastrophic event.
How did this downgrade happen?
It did not happen overnight. Our credit rating has been slipping over the last few years, due mainly to weak economic growth, stubborn unemployment and increasing political uncertainty.
In December 2015, the markets and the rand endured a torrid few weeks after President Zuma fired Nhlanhla Nene and replaced him with the unknown Des van Rooyen.
A crisis, and possible downgrade, was averted at that time after the decision was rescinded and Pravin Gordhan was appointed as Finance Minister. Since then, Mr Gordhan had been on a mission to avoid a downgrade. He presided over two successive budgets and the consensus was that he had done enough, by demonstrating sound fiscal discipline, curbing wasteful expenditure and providing a bulwark against corruption, to avoid a downgrade.
What a difference a month makes! No sooner were South Africans starting to relax about the threat of a downgrade than President Zuma recalled Pravin Gordhan and his deputy, Mcebisi Jonas, from an investor roadshow in the UK. The markets panicked. Then, a few days later, the President announced a cabinet reshuffle with Gordhan and Jonas replaced. The markets panicked more – the rand and banking shares took a big knock. The new Finance Minister, Malusi Gigaba, did not provide the markets with confidence that he could continue in the footsteps of the respected Gordhan.
In reaction to the increased political uncertainty caused by the cabinet reshuffle, concerns about continued fiscal prudence and a possible increase in contingent liabilities (e.g. the liability the government has to fund state owned entities like Eskom’s power stations, especially the planned nuclear build) S&P downgraded our foreign currency debt to sub-investment grade. A few days later Fitch followed suit.
What are the implications?
As with most economic events, it’s difficult to predict precisely what the impact will be. In essence, a downgrade is just an assessment of our creditworthiness. However, the tag of junk that has now been hung around our country’s neck is still detrimental and it will impact on how we are seen by foreign investors and how strong our bargaining power is on the global stage.
Some of the likely implications, based on the experience of other countries following a downgrade to junk status, are as follows:
- As was to be expected, both the rand and financial shares, weakened sharply and bond yields spiked higher.
- Market and currency volatility can be expected for some time.
- The downgrade is likely to dampen already depressed business and consumer confidence.
- Many corporates are also likely to be downgraded as they are linked to the South African economy. S&P downgraded 7 banks in the wake of the downgrade of South Africa. This will place pressure on these banks.
- A downgrade means that when South Africa needs to borrow more money, as it inevitably will, investors in the new bonds will demand a higher interest rate because of the lower creditworthiness of the country. This will translate into higher interest costs which leave less money to be spent on running and developing the country.
- A weaker rand will rule out any hope of lower interest rates in the foreseeable future, a prospect that was brightening notably over the past few months.
- The economy is expected to weaken as uncertainty holds back investment, not just by local firms but especially by foreign investors who place emphasis on ratings and the outlook for a country when making investment decisions.
- Although by no means a certainty, if we do enter a recession this would, by definition, mean weaker growth and this would, in turn, exacerbate the government’s weak financial position, put pressure on tax revenue and ultimately lead to spending cuts. Such spending cuts could manifest in reduced investment in critical infrastructure projects or everyday matters like the police force or education or health care or even possible reductions in social benefits.
- A recession, if it happens, will also place additional pressure on jobs with unemployment rising and incomes stagnating.
- Being labelled as junk status doesn’t help our cause when selling our investment case to foreign investors. They would far rather invest in a country with brighter prospects and a solid economy. As a country with a large current account deficit, we are dependent on foreign investment and if this dwindles the rand will come under even more pressure.
- Although a downgrade by one ratings agency does not mean that our bonds would be removed from global bond indices, the fact that we now have a second sub-investment grade rating will trigger this fate for some indices. It does however depend on the precise conditions that each index sets in relation to inclusion of countries and their bonds in that index. The most significant index is the Citigroup World Government Bond Index and it requires a downgrade of our local debt’s credit rating by both S&P and Moody’s – our local debt is still investment grade on both of these ratings agencies. A reference to a minimum credit rating is also likely to be a clause in most global bond fund mandates so we are likely to see further outflows from our bond market as both active and passive bond fund managers are required to sell South African bonds.
What can South Africa do to minimise the impact?
Countries that get downgraded to junk status can take anything from 2-12 years to get back to investment grade. To a large extent the path ahead of us as a country now is really one of our own making. If we choose to ignore the message that is being provided by the ratings agencies i.e. that our financial position needs attention and our growth prospects look poor, then we risk slipping further into sub-investment grade. If we choose to treat this downgrade as a wake-up call that and we work together as a nation to restore our economy to a sound footing, introduce pro-growth policies, restore political certainty and fiscal discipline, stop corruption, reduce inequality and generate solid, inclusive economic growth, then our sojourn into sub-investment grade will be short-lived and we can bounce back a stronger, united South Africa.
What should investors do?
As always, investors’ reaction to such events is more important than the events themselves. The first, really important, thing to do is not to panic and make any rash decisions based on the current market events.
It’s really the same rules as usual that apply, but possibly even more than before:
Keep focused on your objectives, which will in general be over the long term.
Diversify – across different asset classes, different sectors within asset classes, different asset managers, different geographies. Not all assets react the same way to market events. By spreading investments across assets that react differently to different market developments, the impact on your portfolio, as a whole, can be lessened.
Manage your finances conservatively in this environment – financial resilience will be important.
A downgrade isn’t good for any country but it’s also not all doom and gloom. Our response and our actions as a country and as its citizens will determine whether we drift downwards into recession and even default on our debt or we bounce back as a stronger South Africa.
As individuals it’s important to be active citizens.