Our fall from grace to junk status

The recent firing of Finance Minister Pravin Gordhan and Deputy Minister Mcebisi Jonas sounded the alarm bells within Standard & Poor’s (S&P) sufficiently enough for the rating agency to hold an extraordinary meeting where it downgraded South Africa to sub-investment grade (junk status) on the evening of 3 April.

Soon afterwards, Moody’s said it is also placing the country on negative watch and could follow S&Ps lead very soon.

Treasury’s response

Newly appointed Finance Minister, Malusi Gigaba, was quick to respond to this news by assuring any other agency who wanted to downgrade South Africa that the country is committed to a predictable and consistent policy framework, which responds to changing circumstances in a measured and transparent fashion.

Treasury went on to express a desire to move away from a reliance on foreign debt, to escape the conservative eyes of Western ratings agencies, which seeks political, economic and social stability.

Civil servant woes

Speaking in an article to the media, Efficient Group Chief Economist Dawie Roodt said the above statement means we have to spend less on current expenditure and cut back on expenditure.

“Most of the expenditure goes to salaries on civil servants,” he said. “We would need to cut back on civil servants. It was compiled by someone who doesn’t know anything about economics. South Africa is a savings deficit country. Even under Gordhan, the state was a huge destroyer of capital. South Africa invests far more than we save,” said Roodt.

Exit requirements for bond indices

Being downgraded to junk status means that acquiring foreign debt will become increasingly difficult; however, Lesiba Mothata, Chief Economist, Investment Solutions, says that the recent decision by S&P, although a hugely negative outcome for South Africa, does not impact the country’s eligibility in global bond indices as yet.

South Africa is included in a few indices with a different weighting in each. A widely-used global bond benchmark is the Citigroup World Government Bond Index (WGBI), which has clearly-stipulated exit requirements for a country. A country will be removed from the index:

• If the market capitalisation of outstanding debt falls below half entry level (in other words US$25 billion) for three consecutive months;
• If a country gets downgraded into non-investment grade by both Moody’s and S&P on its long term domestic credit; and
• If authorities deliberately introduce policies that materially change the ability of investors to replicate the returns of that country’s portion of the index.

Further, it seems that all three of these criteria need to be met. So there is some measure of light at the end of a long tunnel.

Lessons from other countries

Mothata points out that Investment Solutions study of emerging market countries that were downgraded to non-investment grade suggests the impact of junk status depends heavily on how fiscal authorities respond after the decision.

“Where there is agility in policy response — making hard and frugal decisions, which involves opening up the economy further, as seen in South Korea in 1998 — it took a shorter time to arrive back at investment grade (24 months). For countries with complex internal political structures and a lethargic fiscal policy response, it took a much longer time to shake off the effects of the downgrade. It took Colombia 12 years to get out of junk status,” said Mothata.

Risks in the market going forward

Volatility is likely to increase in local financial markets. The South African Reserve Bank (SARB) will be closely monitoring the developments in the markets to see if the ensuing sell off becomes disorderly and threatens the stability of the financial system.

Investors face challenges from this point forward. Depending on the type of response put together by authorities, usually, when countries get downgraded to non-investment grade, the cost of funding increases, a recession ensues, currency depreciation induces inflation. This leads to monetary tightening. The short to medium term impacts could prove painful.