Lullu Krugel, chief economist and Christie Viljoen, senior economist at KPMG in South Africa, offer the following analysis on the week’s news:
On 30 March 2017, President Jacob Zuma announced a reshuffle of his Cabinet. Across the country, South Africans united behind the idea that there was little merit in these changes.
Even African National Congress (ANC) Secretary General Gwede Mantashe expressed discomfort with the fact that well-performing ministers were removed from Cabinet while underperforming ministers were left in the executive. Specifically, there was widespread outrage about the dismissal of Finance Minister Pravin Gordhan and his deputy, Mcebisi Jonas, with ANC Deputy President Cyril Ramaphosa saying that this was “unacceptable”.
On the day after the midnight reshuffle, Fitch Ratings commented that the changes – including the dismissal of Gordhan and his deputy – signal “a change in policy direction” that could “potentially weaken public finances and standards of governance”. The ratings agency believes that “fiscal consolidation is likely to become less of a priority” and that recent momentum in improving transparency and governance of state-owned enterprises (SOEs) “will be halted”.
As a result, SOEs’ liabilities – and therefore contingent liabilities to the government – “will probably grow more rapidly”. Furthermore, Fitch believes the reshuffle “will heighten tensions within the ANC and increase political instability”.
The agency is expected to formally review South Africa’s rating by the start of June. Moody’s Investors’ Service has also placed its ratings for South Africa on review, giving it three months to decide about a downgrade (or not).
S&P Global Ratings announced on 3 April that it had downgraded its sovereign rating assessment of South Africa from investment-grade “BBB-” (with a negative outlook) to a non-investment-grade “BB+” (with a negative outlook.) The African country is now the eight sovereign rated “BB+” – one notch below investment-grade – by S&P Global Ratings.
The other countries in this category include oil-rich Azerbaijan, offshore tax haven Bahamas, industrial commodity exporter Bulgaria, the services-oriented economy of Cyprus, palm oil producer Indonesia, renewable energy leader Portugal and resource-rich Russia. A country would need to have two out of three rating agencies classify it as non-investment grade to be classified as being in ‘junk status’.
KPMG warned earlier this year that a Cabinet reshuffle could materialise in 2017Q1 and that a sovereign ratings downgrade is possible before the middle of 2017. The link between the two events was basically the idea that a change in the Cabinet (now with its fourth finance minister in 16 months) could signal a greater risk that the state would make changes to medium-term fiscal planning, resulting in deteriorated financial metrics for the state. And just hours ahead of the S&P announcement on 3 April, KPMG again warned that South Africa was perilously close to a sovereign ratings downgrade.
S&P commented in its downgrade report that the heightened political and institutional uncertainties in the country have led to the encompassing decision. The recent changes in executive leadership have put fiscal and growth outcomes at risk, said the agency, and internal government and party divisions could delay potential fiscal and structural reforms.
Ongoing tensions and the potential for further event risk could negatively influence investor confidence and exchange rates, and potentially drive increases in real interest rates.
The negative outlook on the current rating reflects that political risks will remain elevated in 2017, and that policy shifts are likely which could undermine fiscal and growth outcomes more than S&P currently projects. In the event of reduced political risks and strengthened economic growth and/or fiscal outcomes, S&P could revise the outlook to stable.
An analysis of sovereign credit ratings trends seems to support a view that S&P is often the first to make changes in ratings, particularly in the case of downgrades, with the other two major rating agencies following suit.
Debt by numbers
An international, non-deal roadshow undertaken by the former finance minister just days ahead of his dismissal was targeted at having face-to-face meetings with the country’s largest offshore financiers – investors in the US and UK accounted for 70% of recent international debt issuance, with another 10% going to Asian investors.
While only 9% (R208-billion) of central government debt (R2,2-trillion) was denominated in foreign currency at the end of 2016, some 36% (R750-billion) of all debt was held by offshore investors – the balance invest directly into the local capital market. The roadshow was, ironically, aimed at calming these investors’ nerves about the situation in South Africa.
Debt payments can be considered the government’s fifth-largest (out of 17) department, with 10,4% of consolidated fiscal spending during the 2017/18 fiscal year set to go towards debt servicing. The Budget 2017 Review indicated that the government planned to borrow almost R221-billion during the current (2017/18) fiscal year in order to finance a planned budget deficit of R167-billion and R54-billion in debt redemptions.
Of the R221-billion in planned borrowing, around R29,6-billion (13,4%) is planned to come from abroad – the UK, North America and Asia in particular. Even before the effect of a weak sovereign rating kicks in, the increase in secondary market yields over the past few days will result in the government having to pay an additional R1,5-billion in interest and debt servicing this year.
Previous post-downgrade experiences
Analysts believe that the immediate fallout from a downgrade would be a weaker exchange rate, a decline in local equities and a rise in bond yields. According to a recent South African Reserve Bank (SARB) study of 70 countries, a downgrade to non-investment grade is likely to increase a sovereign’s short-term foreign currency borrowing costs by 80 basis points. Indeed, ratings have for decades played an important role in the pricing and marketing of fixed-income assets to investors.
Research by KPMG into the sovereign ratings assigned by the three largest rating agencies – S&P, Fitch Ratings and Moody’s Investors Service – over the past three decades indicates that 15 countries have seen their investment-grade ratings revoked but were then able – over time – to regain this status. These include (alphabetically) Colombia, Croatia, Hungary, Iceland, India (twice), Indonesia, Ireland, Korea Republic, Latvia, Romania, Slovakia, Slovenia, Thailand, Turkey and Uruguay.
The causes behind the rating downgrades are broadly grouped into four categories:
• Economic deterioration (Colombia, Hungary, India, Latvia and Romania);
• Unsustainable macroeconomic imbalances (India, Slovakia and Slovenia);
• A domestic currency, financial or banking crisis (Croatia, Iceland, Ireland, Thailand, Turkey and Uruguay); and
• A currency, financial or banking crisis resulting directly from neighbouring or regional influences (Indonesia and the Korea Republic).
These countries’ diverse experiences show that it takes, on average, seven years to again graduate to the investment-grade club. Countries like Croatia, Iceland, Ireland, Korea Republic, Latvia and Slovenia were able to do so in three years or less. At the opposite end of the spectrum, and depending on which rating agency was involved, there were instances where it took Colombia, India, Indonesia, Turkey and Uruguay more than a decade to do so.
Returning to investment-grade
Strategies and narratives on countries that recovered their investment-grade ratings are broadly grouped into six categories:
• Fiscal consolidation and/or austerity (Hungary, Ireland, Latvia, Romania and Slovenia);
• Significant economic and political reforms (Colombia, India, Indonesia, Turkey and Uruguay);
• Declining external and fiscal vulnerabilities (India and Thailand);
• Debt restructuring and economic policy reform (Korea Republic);
• Privatisation of the sovereign’s holdings in private/semi-state companies (Croatia); and
• Active intervention by a newly elected government (Iceland and Slovakia)
South Africa is most closely associated with the countries experiencing economic deterioration and, possibly, those having unsustainable macroeconomic imbalances. On the issue of how South Africa will be able to return to its former investment-grade rating, the key element in a recovery process is that admission that a problem exists and that work is needed to rectify this.
However, in a statement immediately after S&P’s downgrade announcement, the new leadership at the National Treasury appeared far from concerned with the development. The commitment to fiscal consolidation was reiterated, coupled with a rebuttal that South Africa is committed to a predictable and consistent policy framework and that open debate on policy matters should not be a cause for concern.
