In a recent Coronation article, the writer sets out the parameters of a country’s rating and the effect of a possible downgrade to South Africa. We have summarised the salient points below:
A credit rating is an independent measure of a country’s ability to timeously meet its financial obligations.
As a country’s rating improves or deteriorates, so does the price at which financial markets are willing to lend money. This is important as the rate at which the government can borrow results in the rate at which other institutions (banks) can borrow – the starting point of lending rates.
Rating downgrades started in 2012 and continued in 2014 as economic growth slowed. At the end of 2015, three rating agencies (Moody’s, S&P and Fitch) warned that ongoing deterioration of the country’s balance sheet and weak growth was putting the country at risk of another downgrade. For two agencies, the next downgrade would be “junk status”.
Junk Status means investment ‘speculative grade’ and precludes many foreign investors from investing in South African assets – most notably, SA government bonds.
The assessment framework differs between agencies but broadly speaking, they consider the following:
- Institutional and governance effectiveness, including their strength and stability, and the effectiveness of government policymaking.
- Economic strength, diversity of economy and factors that affect growth.
- Assessing general economic conditions and sound discipline policymaking.
The biggest issue for all three agencies is the weakening country balance sheet and failing growth. GDP growth was 1.3% in 2015 and is forecast at around 0.5%.
What will a credit rating downgrade mean?
Government debt will be re-priced higher resulting in general higher lending rates.
Successive downgrades will exclude SA from the world government bond index and exclude it from mandates of foreign investors. This would put further pressure on bond yields and the currency.
However, the market is already pricing in a lot of these negative effects already with bond yields out at a high 9.4% and the Rand/dollar very undervalued at 15.7.
The problem is, if a further downgrade takes place, history shows its takes much longer to regain a lost investment grade.
Investonline View and Conclusion
On 6 May, Moody’s did not downgrade SA but reduced its outlook to negative from stable, which means they are likely to downgrade in their next review. However, Moody’s is two grades above Junk status as opposed to S&P and Fitch being on one level above junk status.
On 4 June, S&P and Fitch are due to update their ratings. S&P has a negative outlook and Fitch a stable outlook.
We believe that the worst case is that only S&P downgrades to “Junk”, but is unlikely given Moody’s recent stall and Fitch’s stable outlook. If S&P downgrades, we believe the negativity is mostly priced-in. If no downgrade takes place, we expect the Rand and Bonds to strengthen materially.
Our view is that all three agencies are likely to give SA until the end of the year to get its house in order and demonstrate that better economic policy is being implemented. If not, downgrades should take place at year-end.
Click here to read full Coronation article “A Note on Ratings”.
