S&P downgrades SA to junk while Moody’s places SA on downgrade review

27 Nov 2017
Two key events happened this week, the South African Monetary Policy Committee met to decide on interest rate movements and the ratings agencies met to decide whether they would downgrade South Africa’s local currency rating. The latter is probably more prominent with potentially large knock-on effects on the South African economy.

As expected by economists at the Old Mutual Investment Group, the South African Reserve Bank (SARB) kept interest rates unchanged at the Monetary Policy Committee meeting on Thursday 23 November. CPI inflation was announced earlier in the week at 4.8% in October and was as expected. The weak economy had a large role in the lower inflation rates as business finds it difficult to pass on price increases.

“The outlook for inflation remains relatively benign. We expect inflation to moderate further to around 4.5% in early 2018 and then broadly move sideways, ending 2018 around 4.8%,” says Johann Els, Head of Economic Research at Old Mutual Investment Group.

“Risks remain to the upside and largely come from potential ratings downgrades, the ANC’s elective conference and the fiscal policy stance in the February 2018 budget. These could all potentially impact significantly on the Rand exchange rate and thus on inflation.”

These risks are reasons behind the Reserve Bank’s rate decision last week. We therefore continue to expect that the SARB will keep rates unchanged until there is more certainty about these potential influences on the currency.

“The MPC statement was in my opinion relatively neutral, especially given the more risky environment and ratings decisions. They highlighted the relative weak economy and the low inflation rate, but also highlighted the significant risks around the outlook.

“We expect rates in South Africa to be on hold until at least after the February budget. The SARB would need to gauge the outcome and impact of the ratings decision, the ANC’s elective conference and the February budget before they can reassess the rates stance,” says Els.

The more pressing issue is the downgrade by S&P Global Ratings of South Africa’s credit ratings on Friday 24 November. S&P’s foreign currency (FC) credit rating for SA is already sub-investment grade. They now downgraded the local currency (LC) rating to sub-investment grade or junk as well. The outlook after the downgrade remains stable.

“Although some market reaction is probable, it is very possible that the markets already priced in the scenarios. The more market reaction there is, the more non-index tracker funds will likely want to invest and take up large parts of the index-tracker sales in order to take advantage of higher yields.

“I think the main reasons behind the downgrades are very weak GDP growth and the fact that S&P is not convinced that any measures in the February budget will be strong enough to stop the deterioration,” says Els.

“Moody’s deferred the decision until after the ANC’s elective conference in December and the February 2018 budget. However, it had placed the Baa3 long-term issuer and senior unsecured bond ratings of the government of South Africa on review for downgrade. This means South Africa is still included in the Citigroup’s World Government Bond Index (WGBI) for now. The single LC downgrade will lead to smaller outflows as it triggers the exclusion from the Barclays Global Aggregate Index. Although market reaction is likely in terms of the bond and currency markets, we do suspect that a large part of possible downgrades have probably been priced in,” continues Els.

“The rationale for this is that a market-friendly ANC leader might be able to restore confidence and improve growth prospects,” he says. “This outcome might lead to a renewed effort to improve the fiscal outlook at the February 2018 budget. This is the reason why Moody’s put SA on credit watch, with three months to decide on the rating.”

Apart from the fiscal deterioration, the still very weak state of SOE finances will be a key consideration in the ratings decisions going forward.

Although there will be forced selling by index funds, other yield-seeking investors may want to invest in SA’s repriced government bonds. Thus the net flows could be less than the size of the funds invested by the index funds would suggest.

Further downgrades are highly likely should the ANC’s elective conference result in a market-unfriendly candidate winning and/or the February budget not restoring fiscal consolidation.
  • Johann Els
  • MacroSolutions