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Be proactive to avoid a downgrade warns S&P

08 June 2016 Jonathan Faurie

On 3 June, ratings agency S&P announced that it would not be changing its investment grade outlook for South Africa. This is a major boost for the country as we face tough economic challenges and disappointing GDP growth. But does this mean that we are out of the woods and that we can return to business as usual? With another ratings assessment looming towards the end of the year, economists are full of advice on how to toe the line.

Watch the blindspot

One thing that is certain is that government, and the public, cannot carry on with their every day lives thinking that the rating agencies are not monitoring the market. While South Africa retrained its BBB+ rating for local denominated debt and BBB- rating for foreign denominated debt, S&P warned that the outlook for the market remains negative.

In a release to the media, Lesiba Mothata, Chief Economist at Investment Solutions, pointed out that in its assessment, S&P took note of the progress the country has made in turning around the local electricity supply situation where  there has been a hiatus on load shedding and none is scheduled for the winter months.

The ratings agency also noted the functionality of South Africa’s institutions and National Treasury’s commitment to maintaining low fiscal deficits and implementing sustainable debt management strategies.

South Africa’s renewable energy programme, which has demonstrated strong partnerships between government, labour and business, has made a positive contribution to the assessment on electricity supply.

Strong institutions - including the independent judiciary, the South African Reserve Bank and National Treasury (despite the political machinations amongst its leadership) – all remain world class and have solidified an investment-grade rating.

However, S&P warned that in its December review, given the weak growth profile for South Africa, it could downgrade South Africa  to sub-investment grade should the proposed policy measures fail to ignite growth. It has highlighted the need for legislative clarity in the mining sector and labour relations as key economic areas, which, if reformed, could make a positive contribution to growth.

Implications for investors

Mothata added that it must be noted that 90% of debt issued by National Treasury is in Rands. South Africa’s inclusion in the global bond benchmark, Citi WGBI, was based on the rating of local-currency denominated debt.

On this measure, South Africa is unlikely to be downgraded to junk status - it would take an Arab Spring-type event to induce such a rating. Although there could be volatility around a rating decision on the 10% of the debt issued in foreign currency, it would not be too dramatic.

“In general, we believe that the investment risk-reward ratio is currently skewed towards risk, so sound risk-management principles will serve investors well. We have seen good active asset managers positioning themselves more conservatively, with lower equity exposure - on those mandates that permit - as well as maximum offshore exposure. Within local equities, asset managers have favoured the rand hedge companies which derive their income from offshore sources,” said Mothaba.

What can the Rand expect?

It is clear that any avoidance of a ratings downgrade is heavily dependent on economic growth and the reduction of fiscal debt. But with the growth outlook pinned at 0.6% for the year, we need to seriously ask what S&P means when it says that it needs to see examples of growth.

In a release to the media, Dr Adrian Saville, Chief Strategist at Citadel, points out that South Africa is a small, open economy. Export industries, including agriculture and resources, make up the economic bedrock, which makes the country reliant on the world economy.

“About a third of GDP is made up of imported goods and services, making South Africa vulnerable to imported inflation; about two-thirds of JSE earnings are influenced by currency conversion. Other economic elements, such as foreign capital and foreign tourism, highlight the importance of international exposure to the South African economy. As such, the economy is influenced by currency fluctuations and is vulnerable to sudden or sharp price moves away from fair value,” says Saville

Facing risk

Saville adds that this context helps underscore the point that all business face three types of risk, namely:
- Macroeconomic risk or country risk;
- Mesoeconomic risk or industry risk, which references elements such as technologies that transform the way in which companies do business; and
- Microeconomic risk or business risk, which refers to company-specific risk.

“Rather than being seduced by emotion which clouds judgement, it befits us to interrogate from an objective stance the status, stature and strength of South Africa’s primary business risk: the Rand. In short, while emotion and popular sentiment suggest the rand is a fractured currency, is this the case, or is the rand simply fragile, and in need of time – or some other catalyst – to allow the currency to recover?”

We can see Saville’s case, but need to question what this catalyst will be. Commodity demand is low and has never recovered from the hey-day’s when China was a major trading partner. Coupled with this is the drought South Africa is currently facing which means that agriculture won’t be a major catalyst.

Editor’s Thoughts:
For a long time, the South African economy has been described as a one-trick-pony that is too reliant on the mining sector for growth to be sustainable over the long term. Looking beyond political stability, government needs to find a new sector which will accelerate growth in the economy. What will that be? Please comment below, interact with us on Twitter at @fanews_online or email me your thoughts jonathan@fanews.co.za.

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