​Press Room

Effect of a downgrade


Jeremy Diviani
Mar 03, 2016
Digesting what would happen in the event of junk status.

Much has been said recently about the budget speech last week and the implications it has on our stumbling economy, and coupled with that, how the ratings agencies would respond.

It is important to understand why this was built up to be one the most anticipated budget speeches since 1994. The ratings agencies were waiting in anticipation to see the direction we would take in our approach to fiscal discipline and commitment to reinvigorating economic growth, and thus influence their decision whether or not to downgrade our sovereign debt to junk status, the impact of which has far reaching effects to the economy.

In terms of a downgrade what happens is that the ratings agencies (Standard & Poor’s, Moody’s and Fitch) utilise various criteria to determine the probability that a country has of defaulting on their repayments. This is very similar to a bank manager assessing an individual’s mortgage loan application.

If we are downgraded from this point by S&P or Fitch, in essence we become junk status and the bottom line is then that it is going to cost us more to borrow money in global capital markets, through widening credit spreads. This is important as currently South Africa runs at a budget deficit, which means we spend more than we earn and we borrow to fund the difference. This spending is intended to improve the lives of South Africans and to grow the economy. It is, however, normal for an emerging market country to run a budget deficit.

The funds we require are acquired via loans (bonds) from large international bodies (pension funds; institutional investors; large money managers) through the issuance of South African bonds, which can be in local or foreign denominated currency.

Apart from the obviously increase in the interest bill comes the impact it has on financial markets. The direct impact is felt in the bond and fixed income market, with a secondary shock in currency and then finally in equities (this is not a direct impact, but rather sentiment driving nervous investors to sell out of a country deemed to be riskier.)

When it comes to government bonds (sovereign debt), certain investors cannot invest in assets with a junk status as set out by their mandate and as such will be required to sell out of these bonds and thus probably rands. This has the knock-on impact of causing bond yields to increase and stabilize around a new level that makes them attractive to investors. This increase in yields potentially could lead to a capital loss on the sale of the bond in the short term and increased volatility for an asset class that most investors deem to be “rather safe”.

Investors want to be rewarded for investing in a perceived risky investment and therefore the yield must increase to commensurately compensate for them for this. This is called the risk premium.

In order to combat this, as well as investors’ concerns around a downgrade, the South African Reserve Bank (SARB) recently increased interest rates to try and encourage investment and stabilise the currency. This has a stabilising effect on the currency due to the fact that foreign investors are again rewarded for purchasing South African debt when compared with other emerging market investment opportunities such as Brazil or Turkey (Brazil has recently been downgraded to junk across all of the big three agencies). This is called the interest rate differential and one would expect this to be high when comparing an emerging market like South Africa to the US.

This risk premium is important as we have recently seen foreign investors being net sellers of bonds and equities over the last 3 months in substantial volumes. This has been one of the drivers in the weakening of the rand and is something we could possible see exacerbated if we are downgraded to junk.

When we look at the basic fundamentals, our dilemma lies in the fact that while we have to pay the interest bill, this is often achieved via tax revenues. This is not a major problem for a stable country with strong GDP growth because as the economy grows, so does the corporate and individual revenue base and therefore corporate and individual taxes. Therefore, when you increase interest rates to combat a downgrade but we are still downgraded, we will most likely have to turn to servicing debt through increased taxes. This takes further money out of the economy, which once again is not a major problem for a healthy growing economy, but for South Africa with a GDP growth rate that is gradually slowing, we may find ourselves in a rather large predicament.

As you can start to see a vicious circle starts to form. The downgrade makes the cost of capital more expensive, this in turn puts pressure on the economy, potentially slowing GDP growth, which could lead to a need for increased taxes and a potentially weakening rand, which imports everyone’s best friend – inflation.

On the flip side, if we were to see rising GDP growth, we would hope to get a reduction in unemployment and thus an increase in the disposable income of middle class. This in turn means that there would be increased earnings in both companies and individuals, and as such improved revenue from the tax base, which assists in servicing the interest bill and helps to stimulate further economic growth.

With an expected GDP growth rate of 0.9% for 2016 and 2017 at 1.7% in 2017, there is a concern for the rating agencies that we will not be able to make the necessary changes that would result in us avoiding junk status. Interestingly, in 2008 South Africa was growing at around 4%, which represents a material slowdown in the expansion rate of our economy.

The table below shows Standard & Poor’s rating criteria and their position on South Africa.

Institutional Assessment

Neutral

Economy

Weakness

External Environment

Neutral

Fiscal Flexibility & Performance

Weakness

Fiscal :Debt Burden

Neutral

Monetary

Strength

Source [Prescient Investment Management]

We can see from the table why the budget speech was so widely anticipated, as our struggling economy and tough fiscal position has caused concern for the ratings agencies. The recent increase in interest rates by the reserve bank indicates a strong monetary policy framework, which is the one positive in an otherwise gloomy outlook.

The budget speech has (for now) stayed off the risk of a downgrade, but the reality is there is still a lot of work to be done to completely mitigate the risk of such a significant event in our attempts to re – start the fire, as it were.