Ratings downgrade: already priced into market


Dr Adrian Saville, Citadel Chief Strategist


savilleDuring the course of 2016 we believe there is a very good chance that at least one of the major ratings agencies will downgrade South Africa to sub-investment grade. However, there are a number of technicalities involved in any decision that will result in South Africa being rated “sub-investment grade” or, perhaps less emotively, “high yield”. On a positive note, these technicalities could prevent South Africa from being pushed out of the World Government Bond Index (WGBI).

Such an ejection would represent possibly the most dramatic outcome of a ratings downgrade and should be South Africa’s biggest cause for concern. For this reason while the views of each of the agencies matters, the central concern is what the collective impact on South Africa’s status would be and whether the country’s bonds stay in the WGBI. For South Africa to be ejected from the WGBI it would require our rating on rand-denominated debt to be classified sub-investment grade and both Moody’s and Standard & Poor’s (S&P) would need to make this assessment.

Until now media attention has focussed on the ratings agencies’ views on foreign currency-denominated debt, which is indeed one step away from “sub-investment grade” in the case of S&P, and two steps away in the case of Moody’s. However, we are currently at least two steps away from this when it comes to rand-denominated debt. Thus, for both the agencies to deem South African government bonds sub-investment grade requires more than one step by a single agency.

Regardless of the technicalities, if you consider the macroeconomic variables that matter, such as economic growth, the current account deficit, government debt and the budget deficit, it is hard to escape the conclusion that South Africa ranks at the “bottom of the B class”. By these criteria we deserve to be downgraded. However, it is not all bad news for South Africa. One of the redeeming features of our economy includes institutional strength, highlighted quite forcibly in recent weeks by the rulings of the Constitutional Court.

The big question we need to ask is what a downgrade would mean for the rand, the JSE, inflation, interest rates and the economy as a whole. On this score, there is an argument to be made that South African markets were priced for the worst at the start of this year, particularly the bond and currency markets. More recently, South Africa’s benchmark bond was priced at 9.25% and the rand was trading in the region of R15 to the US dollar – both prices much stronger than the start of the year but still well below fair value and purchasing power parity, respectively.

From this, our view follows that if a downgrade occurs it is already “in the price”. By contrast, anything that points to South Africa staving off a downgrade or showing signs of stability and, ideally, structural strength, will help the rand, the bond market, other capital markets and, arguably, economic growth. To some extent, aspects of this already seems to be happening, with the rand and bond prices improving on the back of the appointment of Pravin Gordhan as Finance Minister, the reading of the government budget in February and the recent Constitutional Court ruling, among other things.

As a last thought, there is a wealth of free advice on offer regarding what South Africa can do to prevent a downgrade. We believe that the most important insights relate to squaring up to South Africa’s structural problems from a socio-economic perspective, including low growth, entrenched unemployment and grossly skewed income distribution. From an institutional perspective, it is critical at this juncture that the integrity of all institutions is preserved and independence maintained and enhanced.