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Further into junk

24 November 2020 Momentum Investments
Sanisha Packirisamy, Economist at Momentum Investments

Sanisha Packirisamy, Economist at Momentum Investments

Herman van Papendorp, Head of Investment Research & Asset Allocation at Momentum Investments

Herman van Papendorp, Head of Investment Research & Asset Allocation at Momentum Investments

1. 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

2. 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:
• Larger-than-forecasted deterioration in debt burden and debt affordability
• Chance of additional financial demands from SoEs
• Potential for higher interest rates

3. 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

4. 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

5. 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:
o Efforts to arrest the increase in government’s debt burden
o Confidence in stronger growth prospects
o Labour market or power sector reforms
o Agreement with labour unions on a wage deal that moderates future wage increases

6. 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

7. 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

8. 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

9. 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

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