Cool heads will prevail in a beleaguered economy

Emile Petersen, Credit Analyst at Coface South Africa

Thursday 31 March 2016 saw a landmark day for the country’s democracy. The Constitutional Court found President Jacob Zuma in contravention of the Constitution and the court ordered him to pay back a portion of the money spent on non-security upgrades to his Nkandla homestead. While a lot of focus has been on this issue, the country is still battling to avoid an investment downgrade, which could have significant impacts on the country.

On 8 March 2016, Moody’s Investor Services placed South Africa’s Baa2 sovereign credit rating on review for a downgrade. Fitch currently has South Africa on a BBB credit rating and Standard & Poor (S&P) on a BBB- credit rating with a negative watch. Standard & Poor’s credit rating is currently one notch above junk status while Fitch and Moody’s ratings are two notches before junk status.

FAnews spoke with Emile Petersen, Credit Analyst at Coface South Africa, to find out more about this mystifying challenge.

Loading the downgrade gun

If you had asked a group of a hundred people a month ago if they knew that an investment downgrade to junk status even existed, many would look at you with blank stares. Currently, this is the foremost concern on the minds of many in the country.

What does a downgrade mean to the country? Peterson points out the anticipation of a possible downgrade in the sovereign credit rating has led to the financial market preparing for the worst case scenario and this is evident in the increasing yields on South African ten year government bonds in 2015.

“When comparing the yield return of Russian ten year government bonds before and after its credit rating to junk status, it is evident that investors prepared themselves in order not to have severe shock reactions when Russia’s sovereign credit rating was downgraded to junk status by S&P. South African investors are factoring in the possibility of a sovereign credit rating downgrade to non-investment grade, to reduce the impact of such an event,” says Peterson.

This is displayed in the spread of the credit default swap (CDS) compared to the South African ten year government bond yield. The CDS acts as an insurance tool in order for investors to take the default risk on a bond.

The CDS spread is the payment an investor will make in return for the rights to sell the bond in a credit default event. Therefore by the CDS spread trading higher than the SA government bond yield, the market is already pricing in the possibility of South Africa being downgraded to junk status because of the higher risk attached.

The image from Government

With clear reasoning from all three main rating agencies that the possibility of sovereign credit rating downgrade is weighing heavily on government, certain activities have turned into watch points. These include:

• Government debt burden (Debt as a percent of Gross Domestic Product [GDP]);

• Budget deficit;

• Ineffective implementation of the National Development Plan (NDP) for structural improvement;

• Large public wage hikes;

• Labour unrest. And;

• Expensive schemes such as the Nuclear deal and the National Health Insurance (NHI)

Added to this, Peterson points out that South Africa is currently experiencing one of the worst droughts ever. This has been accompanied by electricity and water shortages.

This impact is largely being felt by the agricultural sector contributing 2% to the country’s Gross Domestic Product in 2015, which is currently experiencing negative growth. This impact has been passed on to the general public. Food prices have increased due to a shortage in white and yellow maize and led to the import of these staple food and agricultural animal feed.

“This has had inflationary consequences, which was worsened by the depreciating Rand. South Africa’s current inflation rate has breached the monetary policy mandate range of 3% to 6% inflation, which is currently at 6.2%,” says Peterson.

What can South Africa do?

Financial advisors need to be aware, when advising clients, that the possible downgrade has already been taken into account and that the South African funds are still investment grade.

Bond indices like the Citigroup World Bond Indices, requires two or more rating agencies to downgrade South Africa to non-investment status. “Even if S&P downgrade South Africa to non-investment grade status, Fitch and Moody’s are two notches above non-investment grade. Should Fitch and Moody’s downgrade South Africa in 2016, South Africa will still be in moderate credit risk, investment grade status and participate in the World Government Bond Index,” says Peterson.

Better utilisation of capital assets by government and effective spending of the national budget needs to be emphasized and implemented. The intention exists, as displayed by finance minister Pravin Gordhan’s budget speech and stance regarding State Owned Enterprises. Government and the private sector are communicating and seeking ways to avoid the downgrade.

Editor’s Thoughts:

At the end of the day you need to carry on with business as usual. You have to accept the things you cannot change; have the courage to change the things you can; and have the wisdom to know the difference between the two. Keep calm and invest on. Please comment below, interact with us on Twitter at @fanews_online or email me your thoughts jonathan@fanews.co.za.