South Africa’s sovereign credit rating has been steadily downgraded over the last five years and now teeters on the edge of sub-investment grade (Junk) status. Treasury managed to defer a downgrade in the first half of the year, but the threat looms large as we approach reviews towards the end of the year, especially as economic growth stalls. We thought it important to share with you what a ratings downgrade could mean for South Africa.
A sovereign credit rating is an independent opinion about a country’s ability to pay back its debts on time. Ratings are publicly disclosed and used by investors and creditors in their analysis process. There are three global rating agencies that rate South Africa: Moody’s, Standard & Poor’s (S&P) and Fitch. The sovereign rating methodologies of the three agencies are broadly similar and measure five core factors to determine the final rating:
|Assessment factors||Key measurement areas|
|Institutional Strength||Policy credibility and stability, rule of law, corruption indicators, enforceability of contracts, reliability of information, degree of social inclusion, political stability.|
|Economic Growth||GDP per capita, trend of GDP growth and volatility of GDP growth.|
|External Position||External indebtedness and interest service, current account balance, level of foreign exchange reserves.|
|Fiscal Position||Net government debt to GDP, government debt including contingent liabilities, budget balance.|
|Monetary Policy||Effectiveness of monetary policy as indicated by degree of price stability, independence of central bank, level of development of financial system and capital markets.|
Source: Moody’s, Fitch, S&P.
Note: This table is a summary of key measurement areas across agency methodologies.
In recent years, the biggest threat to South Africa’s rating has been disappointing economic growth. The inability to achieve growth comes down to weak external demand for South African goods and services, unrelenting low commodity prices, domestic constraints and poor business confidence inhibiting private sector investment. All factors hint strongly at a S&P downgrade in December 2016.
Why do ratings matter?
Credit ratings are an indicator of the risk associated with the investment environment of a country. A downgrade will often spill over to the corporate, banking and state-owned company debt markets, as these companies mostly raise debt at a premium to government debt, which is viewed as the least risky borrower in a country. A downgrade will result in an overall increase in the cost of lending money in South Africa.
What happens if we get downgraded?
Possible consequences of a ratings downgrade could include: negative sentiment on foreign investment, a surge in capital funding cost, high levels of rand volatility, decreasing competitiveness of South African businesses and further focused diversification efforts by South African companies (already investing outside of SA at an increasing rate). In short, already challenging market conditions could become even more difficult.
Trillian Asset Management believes that the local government bond market is not presently pricing in a downgrade with 10-year yields currently at 8.55%. If the country is downgraded, we would expect yields to increase back to the 9.00% – 9.30% range. In addition to bond yields, credit default spreads (CDS’s) are viewed as an indication of downgrade probability based on market sentiment. South African CDS’s are currently priced at 250bps above the “risk free” US Treasuries. CDS’s are simply insurance against the default of the bond issuer. The higher the spread the higher the probability of default. When we compare South Africa to similar emerging markets who are rated one notch into the junk category, we find that Turkey is priced at 250 bps and Russia is priced at 220 bps. This would indicate that in terms of CDS pricing, South Africa’s credit rating is expected to be downgraded to junk.
From a local equity market perspective, valuations will be heavily influenced by the prevailing risk free rate (i.e. 10-year government bond yields) resulting in a likely drop in banking and SA focused company share prices.
What is also of concern is that it takes a country seven-and-a-half years (on average) to regain its investment grade rating once it has been downgraded to sub-investment grade. Changing the negative ratings trajectory would require more than what is currently being done from a policy and economic perspective to stimulate GDP growth and provide much-needed business confidence to the private sector.