Junk status – what is the bottom line?

If one opens any newspaper, a topic that stands out is the demise of the South African economy and its impending downgrade to junk status.

How bad is it really? Will the downgrade affect companies? And if it does…how will it affect them? FAnews caught up with Lesiba Mothata, Chief Economist at Investment Solutions to find out what junk status might mean for South Africa.

What is the chance of South Africa being downgraded to junk status?

There is a significant chance that Moody’s Ratings, which has a better credit assessment than Standard and Poors and Fitch, will catch up and downgrade South Africa to the bottom end of investment-grade credit quality.

Markets have fully priced-in this possibly, and have already begun to discount a situation where Standard and Poors pushes South Africa into sub-investment grade by year-end.

Movements in domestic bank shares, government bond markets and derivative markets (credit default swaps) all suggest investors expect South African debt to be sub-investment grade within the next 18 months. The probability of a junk-status assessment for South Africa is more than 50%.

If junk status happens, what are the direct implications for companies operating in the rest of Africa and in other countries?

The effect on financial services companies depends on whether the junk status downgrade is orderly or not. A disorderly downgrade has the potential to significantly increase the cost of funding and result in a deep recession.

Given that South Africa remains firmly in investment grade on its rand-denominated debt issued by the National Treasury, a downgrade to junk status is expected only on the foreign currency-issued debt. International credit rating is important, but for financial services firms with large exposure to South African Rand-based income and assets, the effect of junk status may be limited.

The cost of funding will certainly increase for these firms, but the investment grade that is likely to be maintained on rand-issued debt will cushion the possible negative effects.

The feedback from operations based in sub-Saharan Africa and elsewhere is channelled primarily through the Rand. A depreciation of the Rand could improve earnings derived from overseas markets. An orderly downgrade may result in some depreciation of the Rand, given that the local currency remains grossly oversold, but there is a greater probability of it strengthening to below R14 to the Dollar.

However, factors negatively affecting the Rand remain: possible additional Fed rate increases, a continuing slowdown in the Chinese economy and the related decline in commodity prices, and possible capital outflows from broader emerging markets.

Even if it were to sell off further, the Rand may pull back but stay in oversold territory. The rand-hedge properties of countries earning revenue from South Africa and elsewhere will remain a benefit.

Have South African companies already been affected by the recent downgrades?

Spreads between South African debt issued in global markets and US Treasuries of similar maturity have increased substantially in recent months, indicating the cost of funding for domestic firms has become dearer.

Large corporates aiming to raise finance in international markets have begun to pay more on such debts, and the cost to investors of insuring debt against company defaults has also increased.

In this environment of weak domestic growth and surging inflationary pressures, companies are likely to see falling profit margins and potentially intensifying payroll restructuring. There has been a sharp rise of retrenchments in mining and non-mining industries, which has added to the already dire employment situation in South Africa.

How bad is junk status for us as a country?

Investment Solutions’ study of countries similar to South Africa that were dropped to sub-investment grade shows it takes, on average, six years to recover. It took 12 years for Colombia to regain the coveted investment grade after it fell from grace in 1999 due to high fiscal deficits and large debts.

Romania, given its large public sector wage bill and pension benefits combined with robust credit creation, was tipped into junk in 2008 and took six years to recover to investment grade. South Korea, however, took just one year to bounce back after being burnt in the 1997 emerging-market crisis that saw bankruptcies surge in the heavily subsidised conglomerates (chaebol) sector.

So recovery can be slow or quick depending on how the authorities respond. In the Colombian case, the authorities continued with constitutionally mandated revenue transfers to municipalities, tightened fiscal policy, maintained a large stock of debt and undertook limited reform well into the sixth year of the downgrade.

In contrast, authorities in Seoul moved quickly to introduce labour flexibility, reform the banking sector, and offer no guarantees to state-owned enterprises. Within six months, although countries normally in a crisis as severe as South Korea’s are ostracised from global capital markets, Seoul was able to issue a bond in foreign currency given the high level of confidence of international investors in the credibility of the turnaround efforts.

How bad can junk status be for South Africa?

It really depends on how authorities respond. A Colombian-type snail’s-pace response will result in a longer stay in junk. An agile, fast-paced response similar to South Korea’s could see asset markets responding positively.

What will it take for South Africa to move up from junk status?

Implementing economic reform aimed at lifting South African growth is the only way to regain investment-grade status. As seen in all three cases - Colombia, Romania and South Korea - with varying degrees of determination, opening up the economy, making labour markets flexible and ceasing costly guarantees to non-performing state-owned enterprises could quickly turn around the decline.

The South African delegation that engaged investors during an international road show in March returned with plans to re-emphasise small and medium enterprises in the growth strategy by examining the many institutions available for small business funding, repositioning vulnerable industries such as agriculture and mining, and also prioritising industries with large job-creation multipliers such as tourism.

It was promised that by May a detailed plan of action with clear, implementable milestones would be announced. These could contribute significantly to growth if properly constructed. However, the proof of that pudding remains in its implementation.

Will junk status affect the adviser dealing with the investor-in-the-street?

Clients have been deeply concerned about the potential effect of junk status. While there should be discomfort about the potential outcome, nuances need to be considered.

Little media attention is placed on the difference between debts issued by the National Treasury in local currency (Rand denominated) and foreign currency (allotted in international Eurobond markets, mostly US dollars).

Of the total stock of debt, the lion’s share issued by the Treasury is in rands (90%), while the remainder (10%) is allotted in foreign currency. All three rating agencies have a better credit-quality rating associated with the 90% of issued debt in local currency.

South Africa is firmly in investment grade on this measure, which is higher than the near-junk (or sub-investment grade) rating on the international debt. If South Africa is downgraded to junk for the latter, it will have an effect, but it will not be the end of the world. It would take a significant event for the 90% of rand-denominated debt to be tipped into junk. A catastrophic event similar to an Arab Spring could prompt such an outcome.