A Tale of Two Downgrades

The last couple of weeks have been politically tumultuous in South Africa, following the firing of Pravin Gordhan as finance minister, and the subsequent credit rating downgrades on South African government debt.

What is ‘junk status’, and why does it matter?

For those completely unfamiliar with government borrowing and bonds, it is important to first clear up some basics.

As most are now aware, Standard & Poor’s (S&P) and Fitch recently downgraded their credit ratings on South African government bonds – some of which are now rated below investment grade (i.e. they are rated as ‘junk’). S&P, which was the first to downgrade our bonds, has rated South Africa’s long-term foreign currency-denominated bonds as being below investment grade, while Fitch has applied the same rating to both our long-term foreign- and local-currency bonds.

In effect, this means that these ratings agencies view the South African government as being riskier from a credit perspective, particularly for long-term lending. To some extent, this means that the South African government will begin to pay more as it borrows money in future. As I wrote following ‘Nenegate’:

If the drop in investor confidence persists … the government is going to be paying more to borrow money in order to finance its budget deficits. This in turn means that more of the national budget will go towards debt payments, and less towards actual ‘services’. In order to maintain planned levels of expenditure, the government will either have to borrow more, or raise the taxes on our already-minute tax base.

Why was SA downgraded?

The statements put out by both S&P and Fitch justifying their ratings downgrades point largely to the same three issues at play in South Africa.

Firstly, both point to our political situation and the effect it has on government financing. In particular, S&P has voiced concern over “policy continuity” being put “at risk”, while Fitch states that “recent political events … will weaken standards of governance and public finances.” Fitch was quite explicit about the cause of their concern, going on to say that:

… Fitch believes that following the government reshuffle, fiscal consolidation will be less of a priority given the president’s focus on “radical socioeconomic transformation”.

The second major issue is that of “contingent liabilities”. Essentially, this refers to the financial guarantees that the government has made or likely will make in relation to state-owned enterprises (SOEs) and their liabilities. A major concern is the explicit guarantee pertaining to Eskom, but there are implicit or assumed guarantees that pertain to the liabilities other SOEs, which, according to Fitch, range in the hundreds of billions of rands. This says nothing, still, about the problem of municipal debt and whether or not the national government will eventually have to provide cover for that as well.

The third of these crucial issues is South Africa’s weak economic prospects. Quite simply, if the country performs poorly economically, this may lead to less tax and other revenue being collected by the government, which in turn makes it more difficult to service debt. As S&P pointed out in their statement:

An additional risk is that businesses may now choose to withhold investment decisions that would otherwise have supported economic growth.

More fallout to come?

One of the fist concerns to be brought up has been inflation. The rand weakened considerably over the last week or so; going forward, if that weakening persists, this may lead to food and fuel price increases over time.

Another concern has been potential increases in interest rates, although where this has been discussed, the reasons for possible increases have generally been articulated poorly.

There are two possible factors that could lead to the repo rate being increased. The first would be an increase in consumer price inflation (CPI). CPI has been around or above 6% for over a year now. Keeping in mind that one of the South African Reserve Bank’s (SARB) mandates is to try to keep CPI within the 3-6% range, a repo rate hike in response to increased inflation is quite possible.

The other possible factor is instability in the financial sector as a result of the downgrades. Again, achieving this stability forms part of the SARB’s mandate. If we see drastic rand weakening or bond sell-offs, the SARB may raise rates as a result.

If either of these factors triggers a repo rate increase, prime interest rates will naturally increase as well. Anyone with floating interest rate exposure – in other words, most people with home loans, vehicle finance, credit cards, and other forms of debt – will face higher interest rates, and thus higher interest payments, as a result.

At the macro level, questions have been raised about whether bond investors will continue to lend money to the South African government. This is more of an ambiguous problem.

Even though some of South Africa’s bonds have attained ‘junk status’, there are still investors here and abroad whose investment mandates and risk appetites will allow or now encourage them to buy South African government debt. This is not to say that other investors won’t be pulling out of South African bonds, though; there are others who simply won’t be able to hold onto or purchase more government bonds, precisely because of their investment mandates.

Furthermore, South African government bonds have been removed from some global government bond indices, which forces certain investors to sell those bonds. If Moody’s – the only major rating agency yet to respond to recent political events – drops long-term bonds below investment-grade level, then even more indices (such as the World Government Bond Index) and investors would have to follow suit.

History repeating itself?

In December 2015, ‘Nenegate’ took most people by surprise, and the market responses – in both the foreign exchange and bond markets – showed it. With recent events, things seem to be different.

The bond market’s reaction this time around has so far been nowhere near what happened after Nene was dismissed from his position as finance minister. It’s quite possible that bond markets have been pricing-in the underlying reality of the government’s fiscal position for a while now. In addition, the removal of a finance minister is not exactly unfamiliar territory.

Overall, the two downgrades are a bad sign, but essentially reveal no new information about our government. Arguably, this is a double-edged sword: while things are currently better than they otherwise could have been, the downgrades confirm that the government’s financial health and (by implication) that of ordinary South Africans are in long-term decline.