National Budget and the risk of a credit downgrade

Alwyn van der Merwe from Sanlam Private Wealth.

Finance Minister Pravin Gordhan’s National Budget Speech on 24 February was arguably the most anticipated in modern South African history. He had the tough task of balancing government’s books at a time when the local economy is under severe pressure.

Muted revenue growth does not normally allow for expansionary fiscal policy, let alone in an environment where government’s debt path is rapidly going in the wrong direction. This debt and the low growth prospects for the local economy led to rating agencies Moody’s and Standard and Poor’s downgrading the outlook of our credit quality to ‘negative’ in December 2015. The change in outlook simply means the status of foreign-denominated South African debt is likely to be downgraded from the current low medium investment grade to non-investment grade – popularly known as junk bond status – if the country does not address the deteriorating fiscal position and the below-par economic growth trajectory. The National Budget had to put these rating agencies at ease on both counts. Following the budget, the question is whether the Minister has succeeded. And if he has failed, what are the implications for financial markets in South Africa?

The jury is out on the first question. Although many observers believed the Minister had a strong mandate to address the unacceptably strong growth in government expenditure on non-productive projects, his attempts were rather tame. In fact, for the current fiscal year expenditure still expanded and he only budgeted for ‘back-ended’ discipline on the expenditure front. Initially, government addressed the growing debt problem by increasing taxes from an already very narrow tax base. Hence, the rating agencies need to assess whether the fiscal authorities will have the political will and mandate to execute on the expenditure front in 2017/18 and 2018/19.

The Minister has for now put credible measures on paper that should result in the stabilisation of government debt. We are not convinced he has done enough to direct spending to productive areas in the economy. He has – without much detail – referred to the role that state-owned enterprises should play ‘in boosting growth and development’. We all know this asset base of R1 trillion struggles with its own problems and urgently needs intensive care to turn into the economic dynamo it deserves to be.

Many observers – even after the credible Budget speech – don’t believe we’ll escape a downgrade in the rating of our foreign-denominated debt. Should this occur, what will the implications be for financial markets and our clients and investors?

First, South Africa will be stigmatised by having its debt associated with ‘junk’, a term that doesn’t sit well with any self-respecting nation. We will also be associated with countries that have a track record of economic mismanagement and the reputation of being a high-risk investment destination.

Second, the downgrade will have financial implications. A downgrade below investment grade could force a relook at South Africa’s inclusion in all important global bond indices. Although the credit quality is not the sole factor determining inclusion in these indices, it might well influence the continued inclusion over time. South Africa is currently included in the Citigroup’s World Government Bond Index (WGBI). For this index, the rating of the local- denominated debt is taken in consideration. Local debt quality is rated two notches above junk status. Hence, we believe the risk of an immediate omission out of the indices and therefore wholesale selling of our bonds as a result of a credit downgrade is overstated.

Third, one should remember markets often respond to potential events well in advance. The announcement of the replacement of Minister Nhlanhla Nene in December sent shock waves through financial markets. The rand, which was already on a slippery slide, lost 10% in less than a week following the announcement. The currency now also trades at three standard deviations below its adjusted purchasing power parity level. We believe the rand has already absorbed an enormous amount of bad news.

SA bond yields – both local- and foreign currency-denominated – spiked on the announcement. The yield on a government bond maturing in 10 years spiked by a startling 180 basis points, which represents massive capital destruction and panic from investors. It is unlikely a downgrade will trigger similar emotions over a sustained period.

Finally, when foreign investors buy a foreign-denominated South African government bond, the investor can insure against the potential default risk on the bond. This insurance is no different to any other insurance. When the risk of the insured asset is perceived to be high, the cost of insurance will also be high. The graph below clearly reflects how the price of insurance – so-called credit default swap – has gone up by almost a hundred basis points. It means that early in December an investor paid US$3 to ensure US$100 of a South African 10-year government bond against default risk. Following the Nene debacle, the cost of insurance escalated from US$3 to US$4, or a whopping 33 percentage points.

Source: Bloomberg

The price of insurance against default on a similar Russian government bond is cheaper! Our assessment is that we have already seen a material price response in financial markets. In short, prices have already adjusted. And in fact, should the quality of our debt be downgraded, it could hardly come as a shock or a surprise. An aggressive response is unlikely following the price movements in December 2015.

Much of the uncertainty mentioned above was also captured in the movement of locally listed share prices. The share prices of companies that rely predominantly on South African- based revenue were under pressure. In recent weeks we’ve witnessed selective interest in some of these shares. We have largely avoided them – with bank exposure the exception – in our client portfolios. It might well be the time to relook the investment case for these shares as their valuations reflect significant doom and gloom.